Description

LONG American Realty Capital Trust (ARCT)

Stock Price: $11

Market Cap: $1.7 b

Dividend Yield: 6.5%

Average Daily Value Traded: $15 mm

Thesis

ARCT is a Joel Greenblatt “special”; it is a long because it trades at a significant discount to comparable triple net lease REIT’s due to technical reasons around how the company became publicly traded. We expect the stock to re-rate to valuation levels closer to its comps over the next 3 months due to increased awareness of the stock through index inclusions and sell side initiations and IR effort, and more importantly, the incentive of the management team to get the stock price higher by mid-October due to how their deferred compensation vests.

At $11, ARCT currently trades at a 7.0% cap rate and a 6.5% dividend yield. Our price target is $14 (30% ups) which is equal to a 6.0% cap rate and a 5.0% dividend yield. This compares to Realty Income (O) which trades at a 5.75% cap rate and a lower 4.2% dividend yield, even though ARCT has a much higher quality real estate portfolio than O.

In addition to an outright long of ARCT, we also think a hedged position by shorting O is an attractive opportunity. Both are triple-net lease REIT’s and both pay a monthly dividend…the discount in valuation has to narrow.

Business Description

ARCT is a real estate portfolio of 485 properties covering 15.6 mm sqft leased out on a triple net basis with an average duration of 13.5 years. Less than 1% of the rent roll comes up for renewal before 2018 with average rent increases of ~1.5% annually. 70% of the rent comes from IG-rated tenants and there is no problem credits in the portfolio currently. The top 3 credits represent 1/3^rd of the total rent and are Fedex, Walgreens, and CVS. Current leverage is ~35% LTV. In other words, this is a low risk, steady cash flow real estate portfolio. 

Reason for Mispricing

ARCT was conceived as a private REIT in 2009 to put together a collection of low risk cash flows for dividend-oriented retail investors. ARCT raised $1.9 b of equity over 3 years in ~$50k checks from 40,000 individuals through the different retail advisory platforms. As part of the deal, ARCT was required to have a liquidity event for shareholders in late 2012. Through 2011 and early 2012 management explored various alternatives such as selling the entire portfolio in 1 transaction or in chunks as well as taking ARCT public. Ultimately, management decided to list ARCT on the NYSE but NOT raise capital through a typical IPO process because they did not need additional capital and the price talk from the underwriters was less than management’s view of fair value and therefore dilutive to their existing shareholders.

Management instead decided to list ARCT shares on an exchange and allow for the price to settle out on its own. This created a similar dynamic to when new equity is issued to creditors in a reorganization and just begins trading without the marketing support of a sponsored IPO to create demand for the security. Much like when you have previous creditors selling their new equity, in ARCT’s case you had retail investors taking advantage of their first liquidity opportunity by selling their shares on the NYSE. Management did try to set a floor on the stock by executing a dutch tender for 12% of the shares out at $10.50 which was over-subscribed and pro-rated.

This chain of events has resulted in few investors knowing of ARCT’s existence and excess supply of stock for sale, resulting in the supply/demand imbalance that has contributed to the current undervaluation. The stock listed March 1^st and has traded in a range between $10-$11/share for the last 4 months. $10-$11 was cheap to comps in March and has only widened since then as O and NNN have rallied 7-14% while ARCT has been stagnant.

Valuation

ARCT currently trades at a 7.0% cap rate, 6.5% dividend yield, and 13.5x FFO.

O currently trades at a 5.6% cap rate, 4.2% dividend yield, and 20.5x FFO.

Our target price for ARCT of $14/share uses a slight discount in cap rate to O (and higher dividend yield) even though ARCT has a higher quality portfolio than O. 70% of ARCT tenants are IG-rated (O is less than 20%), ARCT has no credit issues (O has had several top 10 tenants file BK in the last few years), ARCT has less than 1% of NOI renewing in the next 5 years (O has 19% renewing), ARCT has 100% occupancy (O has 97%), both companies have similar leverage, and both pay out a MONTHLY dividend.

Catalysts

Increased investor awareness will come from 1) index inclusions  2) sell side initiations and  3) an aggressive IR effort from the company. ARCT was added to the Russell 2000 last month and should be added to the RMZ index in Q4. 3 boutique sell side firms have initiated coverage of ARCT and the company expects several bulge brackets will initiate before the end of the year.

More importantly, management is highly incentivized to see that the stock price of ARCT appreciates by mid-October. Their incentive compensation while ARCT was a private REIT was a 15% carried interest after a 6% hurdle rate, paid out once value was crystallized. This arrangement was restructured in the process of listing ARCT as a more permanent vehicle. Management will get paid their prior carry that has been deferred based on the following formula: take the average price of the stock for the 30 trading days period immediately after 180 regular days from listing (3/1), subtract the NAV (of the initial shareholders) which is $9.81/share, multiply by the shares out before the buyback, and multiply by 15%. This formula closely replicates their prior deal, but instead of using the “crystallized value” as if the assets were sold, they will use the average price of the stock as a proxy for this value. As an example, if the average price of the stock in September is $12/share, management will get paid out $58 mm. For every additional $1 they can get the stock price, management will get an additional $26.7 mm.

Management

ARCT was formed by Nick Schorsch who has a large presence in the private REIT space. Some investors have a negative bias towards Schorsch because he was the founder and CEO of American Financial Realty (AFR) which was a REIT that massively over-promised and under-delivered from 2003-2007.

We have diligenced the AFR experience and Schorsch himself and are still comfortable investing with him in ARCT for several reasons: 1) Schorsch left AFR in 2006 before the particularly bad decision-making around diversifying the portfolio ended up destroying a lot of shareholder value  2) Schorsch understands the lack of focus is what investors are concerned about and has been emphatic that the only thing ARCT will be doing is buying long-duration single-tenant cash flows and paying out a monthly dividend  3) most importantly, Schorsch’s incentives are aligned with ours: management will be paid more money if the share price is higher. Like us, they believe the stock is undervalued and have been personally buying shares on the open market. The company has also bought back shares through a tender offer that was completed at $10.50 when the stock was first listed; this was used as a way to make sure liquidity was provided to previous investors who wanted to exit, but also had the effect of taking out 12% of the shares at what we believe was an attractive price.

Risks

The main risk is that valuations for triple net REIT’s decline. Importantly, the private market value of these assets is below where the public markets trade the stocks…private market is an average cap rate of ~7.5% for ARCT and higher for O. This risk is easy to hedge against shorting O.

ARCT may always trade with a management-discount because we are not being skeptical enough of Schorsch or management is not able to convince some investors that ARCT is not another AFR.

Catalyst

Increased investor awareness will come from 1) index inclusions  2) sell side initiations and  3) an aggressive IR effort from the company. ARCT was added to the Russell 2000 last month and should be added to the RMZ index in Q4. 3 boutique sell side firms have initiated coverage of ARCT and the company expects several bulge brackets will initiate before the end of the year.

More importantly, management is highly incentivized to see that the stock price of ARCT appreciates by mid-October. Their incentive compensation while ARCT was a private REIT was a 15% carried interest after a 6% hurdle rate, paid out once value was crystallized. This arrangement was restructured in the process of listing ARCT as a more permanent vehicle. Management will get paid their prior carry that has been deferred based on the following formula: take the average price of the stock for the 30 trading days period immediately after 180 regular days from listing (3/1), subtract the NAV (of the initial shareholders) which is $9.81/share, multiply by the shares out before the buyback, and multiply by 15%. This formula closely replicates their prior deal, but instead of using the “crystallized value” as if the assets were sold, they will use the average price of the stock as a proxy for this value. As an example, if the average price of the stock in September is $12/share, management will get paid out $58 mm. For every additional $1 they can get the stock price, management will get an additional $26.7 mm.