2 Net Lease REIT Rascals To Avoid
Summary
- If you really want to feel old, think about the shows you used to watch as a kid.
- As I note in my upcoming book, The Intelligent REIT Investor, when a REIT does start to “go bad,” investors typically have plenty of time to get out.
- Bad management can destroy value in a portfolio of real estate properties.
- Looking for a helping hand in the market? Members of iREIT on Alpha get exclusive ideas and guidance to navigate any climate. Learn More »
If you really want to feel old, think about the shows you used to watch as a kid.
No doubt, you can recall them pretty easily, but here are some that may or may not ring a bell…
If you were around in the 1950s, you may very well have watched The Twilight Zone and I Love Lucy. Then there was The Honeymooners, Leave It to Beaver, Adventures of Superman, and The Lone Ranger.
In the 1960s, TVs were filled with Gunsmoke, Wagon Train, The Andy Griffith Show, and The Beverly Hillbillies. And Bonanza, My Favorite Martian, Gomer Pyle U.S.M.C., Hogan’s Heroes, Bewitched, and Green Acres deserve shoutouts too.
For the 1970s, I have to mention M*A*S*H. Obviously. Happy Days was enormous too. Three’s Company, Columbo, The Six Million Dollar Man, Laverne & Shirley, The Brady Bunch, The Jeffersons, The Mary Tyler Moore Show, Mork & Mindy, The Odd Couple, The Love Boat, CHiPs…
Need I go on?
Moving on to the 1980s, and we’ve got Knight Rider, The A-Team, The Cosby Show, and The Dukes of Hazzard. And what TV watchers from that time can forget The Golden Girls, Dallas (Who shot J.R.?) Magnum P.I., Cheers, Miami Vice, Who’s the Boss, or The Cosby Show?
I won’t touch on the 2000s since this century of ours is still young. But in the 1990s, there were Friends, The X-Files, Roseanne, ER, The Fresh Prince of Bel-Air, Seinfeld, Full House, Frasier, and Mad About You.
Did I list your favorite show?
“The End Can Come Like That!”
Maybe I did. Maybe I didn’t.
Just because some website somewhere lists its “Top 10” or “Top 20” favorites from the decade doesn’t mean you have to agree.
Besides, I didn’t touch on anything from before the ‘50s – the beginning of the TV era – like The Little Rascals, which hardcore fans will know as Our Gang.
As noted Hollywood expert Wikipedia notes, “The series was produced in various formats from 1922 to 1944 and is noted for showing children behaving in a relatively natural way.”
In other words: mischievous, hard-headed, and hopelessly idealistic. Alfalfa, Darla, Buckwheat, Porky, Butch, Woim, and Waldo were always getting into something or other.
Take Alfalfa’s short-lived attempt at running the “Eegle Eye Detektive-Agensy X-10 Sooper-Slooth.” To fit the part, the freckle-faced protagonist put on a grey suit, black bowtie, and Sherlock Holmes-like hat.
Clearly, he learned the lesson early on to “dress for the job you want, not the one you have.”
When two of his friends come by because they “want to be detectives” too, Alfalfa doesn’t sugarcoat the biz.
“Do you kids know what being detectives mean?” he demands, then answers his own question when he’s not impressed with theirs. “Your life’s always in danger. The end might come like that!”
With “that” being a very dramatic snap of his fingers, by the way.
Because everything is dramatic when you’re a child.
Then again, Alfalfa wasn’t entirely wrong. The end really might come “like that” – for us or the businesses we invest in.
For his Eegle Eye Detektive-Agensy, it happens after he accepts a case to track down supposedly stolen candy… accidentally ending up at a haunted house that scares him out of ever wanting to be a “sooper slooth” again.
In the space of 10 minutes, his career is over.
Avoid the Haunted REIT Houses
There have been a few cases where publicly traded companies have gone almost as quickly. And we always have to be aware of that possibility, limiting our position sizes and allocating our assets accordingly.
Fortunately though, it usually doesn’t happen that fast, especially not with REITs. They tend to be slow-moving stocks, whether up or down… one of the many reasons why we like them.
As I note in my upcoming book, The Intelligent REIT Investor, when a REIT does start to “go bad,” investors typically have plenty of time to get out. They don’t have to run screaming from (the commercial real estate) building, happy to have their lives intact.
With that said, there’s no reason to be complacent about investing in this asset class. Don’t ignore warning signs like unsustainably high yields or repeatedly risky business practices.
If you’re already in the stock, get out. And if you’re not, don’t get in.
The same holds true for REITs that find themselves in untenable situations they did nothing to deserve. By that, of course, I mean last year’s shutdowns and the continuing social distancing mandates making it so hard for landlords to survive.
In too many cases, would-be tenants and their customers really are treating commercial real estate-like haunted houses. Only the brave go in.
It may have felt that way on the investing side of things too last year. Though, this year, stock prices are rising all across the REIT landscape.
That doesn’t mean you want to tag along with every rascal out there though. The following two are bound to lead you nowhere appealing.
2 REIT Rascals I’m Avoiding
I’m sure that you heard the news this week that Realty Income (O) is merging with Vereit (VER) in a deal that makes the combined entity worth over $50 billion, and the overall 6th largest REIT in the US.
That was no surprise to me whatsoever, as I wrote about that possibility back in 2015,
“Considering Realty Income's track record of acquiring office and industrial properties, remember that the company closed on two successful REIT portfolios that included office and industrial.
Back in January 2014, Realty Income acquired American Realty Capital Trust, the flagship Net Lease REIT created by Nick Schorsch, and that portfolio included 515 assets, many of which were industrial and office assets.
Then, in the first quarter of 2014, Realty Income acquired an 84-property portfolio of single-tenant, net-leased retail and industrial real estate assets from Inland Diversified Real Estate Trust for around $503 million.”
In that same article (written over 5 years ago) I added,
“Realty Income's G&A cost is around 5.5% (of revenue), and the company's infrastructure could easily accommodate more employees. In other words, should Realty Income acquire a portfolio of $5 billion to $20 billion, there would not be much G&A impact whatsoever. (Keep in mind, San Diego is much cheaper than New York City - I'm talking about occupancy and management costs).”
Déjà vu right?
I also wrote (again, 5 years ago),
“If this were to occur, I believe it would present the opportunity for continued accelerated FFO growth. With this calculation, I am utilizing Realty Income's most recent 1-year growth rate of 19.3% as my forecast.”
Let me be clear, Realty Income is a textbook example of a highly disciplined business model in which the management team understands that to generate consistent earnings and dividend growth, you must have these two “wide moat” advantages:
- Low-Cost Capital
- Size/Scale
But remember, I am focusing on REIT Rascals today and these 2 Net Lease REITs that I’m avoiding are all direct peers to Realty Income.
Our first “REIT rascal” is American Finance Trust (AFIN), an externally-managed REIT that owns a portfolio of over 920 properties representing over 19 million square feet of space. The portfolio generates around $280 million in annual rent and is comprised of single-tenant retail (50%), multi-tenant retail (30%), office (10%), and distribution (10%).
As the end of Q4-20, the portfolio was 93.9% occupied with a weighted average remaining lease term of 8.8 years and in January 2021 the cash collection for the portfolio was 97%.
As noted, AFIN is externally-managed by AR Global Investments LLC and several key executives are also key real estate professionals of both firms. As many readers know, I am not a big fan of external management, and in addition to conflicts of interest, AFIN may be required to pay a substantial internalization fee at some point.
In addition, the advisory agreement with AR Global does not expire until April 29, 2035, and is automatically extended for successive 20-year terms.
My biggest angst with AFIN has to do with its cost of capital and the payout ratio.
Starting with the cost of capital, we estimate AFIN’s weighted average cost of capital (or “WACC”) at around 6.5%. In 2020, “AFIN closed on 107 single-tenant assets for $218 million at an 8.6% weighted average Cap Rate with a $39 million 2021 forward pipeline to be acquired at an 8.8% weighted average Cap Rate.”
This means that based on the 6.5% WACC and average cap rate of 8.7% the company generates investment spreads of around 220 basis points.
Not bad, right?
It appears that AFIN is financial engineering the portfolio with shorter duration leases (i.e. Advance Auto with 6.4 years remaining) in order to achieve higher yields. And to be clear, there’s nothing wrong with fishing in higher-risk ponds, but investors should be aware that there’s a price to pay for putting expensive bait on the hook.
My other gripe with AFIN has to do with the payout ratio.
Keep in mind that the company did take the opportunity to cut the dividend in 2020 from $.0917 per share to $.0708 per share, and is currently paying out $.8496 per year (in dividends). That’s a 22.8% dividend cut…for a Net Lease REIT (that also owns 33 shopping centers).
And even after a dividend cut, AFIN shares are now yielding 8.5% and the 2021 AFFO Payout Ratio remains risky, at 92%:
Source: F.A.S.T. Graphs
And sooner or later the lower quality tenants with shorter lease terms could impact earnings such that another dividend cut could be in order. The multi-tenant properties have a weighted average lease term of 4.7 years (that represents 30% of the portfolio).
In addition, AFIN has 10% in office, and when these leases roll over, AFIN will be exposed to higher cap ex ad leasing costs that could impact the payout ratio.
Thus, we are steering clear from AFIN, as we believe the company is a classic example of a value trap.
Our next “REIT rascal” is Global Net Lease (GNL), this “kissing cousin” to AFIN.
You see, GNL is also externally-managed by AR Global, and of course, both of these REITs (AFIN and GNL) are considered competitors. Here’s what we found in filing documents:
“An investment opportunity allocation agreement to which we and GNL are parties states that we will have the first opportunity to acquire one or more domestic retail or distribution properties with a lease duration of ten years or more and that GNL will be given first opportunity to acquire office or industrial properties.
However, there can be no assurance the executive officers and real estate professionals at our Advisor or its affiliates will not direct attractive investment opportunities for which we do not have contractual priority to GNL, or other entities advised by affiliates of AR Global.”
Hmmmm…
What does this mean?
While I appreciate the disclosure, I am still not clear on how these conflicts of interest can be avoided.
GNL owns 237 properties in the U.S. and Canada (64% of ABR) and 69 properties in Europe (36% of ABR) that are diversified across 130 tenants in 48 industries. GNL focuses on “mission critical industrial and distribution assets and high Investment Grade rated tenancy” and the portfolio today consists of Industrial/Distribution (49%), Office (46%), and Retail (5%).
Similar to AFIN, GNL also cut its dividend in 2020 (from $.53/sh to $/40/sh) although the 2021 AFFO payout ratio is in better shape, as a result of the (dividend) cut in 2020.
Source: F.A.S.T. Graphs
GNL has also done a better job with lowering its WACC on the debt side; however, the equity multiple is not helping (AFFO yield is 9.5%) which has become a hindrance to investment spreads. Our “back of the napkin” WACC for GNL is around 7.0%.
The average cap rate for GNL on the most recent “pipeline” transactions was 8.4% (compared with the average cap rate for all transactions in 2020 or 7.9%) and based on this math provides the company with investment spreads of around 140 basis points.
Again, GNL’s payout ratio is in better shape than AFIN, but the company’s cost of capital remains elevated and does not allow the company to compete “head on” with peers like W. P. Carey (WPC) and Realty Income.
The Takeaway
The biggest lesson that has resulted from the recent merger news (Realty Income and Vereit) is that the power scale and cost of capital are “REAL”. As I explained in a recent marketplace article,
“That day has come, and although the Vereit deal is no surprise to me, I began to ponder other possible outcomes, such as…
- Will STORE Capital (STOR) pursue Spirit Capital (SRC) next?
- Will Spirit Capital (SRC) pursue National Retail Properties (NNN)?
- Will W.P. Carey pursue Broadstone Net Lease (BNL)?
- Will Essential Properties (EPRT) pursue National Retail Properties?
- Will Four Corners (FCPT) pursue Getty Realty (GTY)?
Many things to ponder with this news today, but rest assured, I am thrilled that Realty Income is my largest REIT and non-REIT holding, and I sleep well at night knowing that since its 1994 NYSE listing, Realty Income shares have outperformed benchmark indices by a “country mile”.
And of course driving the success is 24 of 25 years of positive earnings growth (5.1% Median AFFO Per Share Growth Since 1996) and in the year of a pandemic, Realty Income is just 1 of 3 Net Lease REITs with positive earnings growth.”
Source: Yahoo Finance
There is a very good reason that “the cream always rises to the top”.
As I explain in my new book, The Intelligent REIT Investor, management matters:
“…bad management can destroy value in a portfolio of real estate properties. Good management can add value. I often tell people that, when you invest in a REIT, you’re not only placing your “bet” on the underlying real estate. You’re also putting your hard-earned money toward paying the “jockey” that’s running it for you.”
Hopefully, this article is helpful, as I consider harbinger’s like these just as important as my series of “my oh my, another strong buy” articles. Remember what Spanky (in The Little Rascals) said,
Porky, I’ll never forget you, you saved my life.”
Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: written and distributed only to assist in research while providing a forum for second-level thinking.
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This article was written by
Brad Thomas has over 30 years of real estate investing experience and has acquired, developed, or brokered over $1B in commercial real estate transactions. He has been featured in Barron's, Bloomberg, Fox Business, and many other media outlets. He's the author of four books, including the latest, REITs For Dummies.
Brad, with his team of 10 analysts, runs the investing group iREIT® on Alpha, which covers REITs, BDCs, MLPs, Preferreds, and other income-oriented alternatives. The team of analysts has a combined 100+ years of experience and includes a former hedge fund manager, due diligence officer, portfolio manager, PhD, military veteran, and advisor to a former U.S. President. Learn moreAnalyst’s Disclosure: I am/we are long O, BNL, EPRT, FCPT, NNN, STOR, WPC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (76)
AFIN is up another 1.5% too. Nice yields with MOMO too.
AFIN up 70% plus about .42in divvies
GNL up 32% plus about .80 in divvies
Both now yield about 8.5% fully covered and collecting 99% of rent
Lets see the Q 1 #'s this week, I bet they will be better than Q4
Brad always discounts how much investors overreact to div cuts- and precisely why I look to go in then ;)
Watched the Twilight Zone and Rat Patrol back to back late night in high school. And yes had to get up to change the channel on the old B&W.
Reading your first book now so i can be ready for your follow up work.
All the best
And thanks for the walk down memory lane!
