Description

Long American Realty Capital Properties (ARCP)- A triple net lease REITpeat with 35% upside

Stock Price: $14.05

Market Cap: $2.3B

Dividend Yield: 6.4%

ARCP is a triple net lease REIT managed by American Realty Capital (ARC) that is undergoing significant structural change due to its merger with American Realty Capital Properties III, a private triple net lease REIT also managed by ARC.  The way in which the merger occurred effectively created a non-marketed IPO for ARCT III.  The deal which closed on Feb 28^th, has temporally depressed ARCP as ARCT III holders sell to achieve liquidity.  This is similar to the dynamic in which ARCT (see VIC write-up) came public. This has created an opportunity to buy ARCP at a 6.4% yield vs. peers at sub 5% yields.  As ARCP gets added to the REIT indices and the sell side initiates on it we believe this gap will close, creating a 35% total return by the end of 2013 in a business that has very low operational and economic risk. 

Business Description:

ARCP owns a real estate portfolio of 692 single tenant free standing properties covering 16.4mln sq. feet.  They lease these out on a triple net basis to 49 different tenants across 20 industries.  79% of their rent comes from investment grade tenants and they have an average lease duration of 11.5 years.  The top three tenants represent ~30% of rent and are Dollar General, Citizens Bank and FedEx.  This is very similar to ARCT’s portfolio mix before it was acquired by O in late 2012.  Given the lease duration and tenant quality I believe these assets will produce very stable cash flows. 

Deal Dynamics:

Prior to the merger ARCP was a tiny company (11mln s/o and a ~150mln market cap).  It was also illiquid, trading less than $1mln per day, which prevented it from being in any major REIT index or on the radar screen of most investors.   Post the merger with ARCT III, ARCP will be a much larger company with a $2.2bln market cap and 163mln shares outstanding.  ARCP used stock to acquire ARCT III, issuing approximately 150mln shares to ARCT III holders.  Prior to the deal ARCT III was a non-listed REIT that had raised $1.7bln since late 2011 thru ~ $30K-$50K checks from income seeking investors through various retail brokerage platforms at a cost of $10/shr.  In the merger ARCT III investors could choose either $12/shr in cash or .95 shares of ARCP for every share of ARCT III they owned.  16.5% of ARCT III holders took the cash election, the rest took stock.  The deal closed on February 28^th and ARCT III holders were able to trade their new ARCP shares on March 1^st.  Because former ARCT III holders make up 92% of the new ARCP share count, I view this as a non-marketed IPO.  The brokers that raised the capital for ARCT III also have an incentive to trade their clients out of ARCP, as this will generate commissions and there is another ARC triple net lease deal behind this one called ARCT IIII to flip into. 

So you have a situation where a ton of new supply came on the market without any marketing, from sellers who are likely more interested in generating commissions than maximizing value. 

Because of ARCP’s formerly small size, there is little sell side coverage, and no index funds or other large institutional shareholders to absorb the large supply of new ARCP shares. The selling pressure from the former ARCT III holders caused ARCP to fall from ~$14.50 on 2/27 to a low of $12.50 on 3/4.  In an attempt to put a floor on the stock management has authorized a $250mln buyback.  Several senior executives also bought stock as ARCP sold off on 3/4, which has helped ARCP to stabilize near $14/shr.  Given the many positives from the deal, including larger size, liquidity and diversification, ARCP should have traded up post deal not down.         

Valuation

ARCP currently trades at a 6.4% yield and 14.8x 2013 E FFO.  This compares to peers O and NNN, which trade at 4.7% and 4.4% yields respectively and 19x E 2013 FFO.  This is despite ARCP having a higher percentage of its tenants at investment grade, (79% vs. 19% and 6% for O and NNN) and a higher occupancy (100% vs. 98%).  ARCP has also guided to 12.6% FFO growth in 2014, consensus currently expects O and NNN to grow FFO ~5% in 2014. 

Our target for ARCP is $18.00/shr, which is a 5% yield on its current annualized dividend of 90 cents.  When you factor in expected dividends over the next year, our total return target goes to $18.90, which is 35% upside.  At this valuation ARCP would still trade at a discount to O and NNN, despite having a higher quality portfolio and better growth.   

Dividend Growth Opportunity

Since they plan to grow AFFO ~16% in 2014, we believe the dividend should also grow more than the historic half a cent per quarter that they have historically done.  Assuming an 88% AFFO payout ratio, which is in line with where ARCT was, 2014’s dividend should be 96 cents.  At a 5% yield this would imply a $19.20/shr target and $20.10/shr when you include the 2013 estimated dividends-representing a 43% total return. 

Catalysts

ARCP has several upcoming catalysts to help it close its valuation gap.  The first is the start of the $250mln buyback, which will start once ARCT III files their 10-K in the first two weeks of March.  The second is index inclusion; ARCP should be included in the RMZ at its next index review in May and the Russell 2000 in July.  The third are sell side initiations; ARCP is currently only covered by 2 boutique firms and expects larger firms to pick up coverage due to its increased size.  The fourth is a credit rating initiation which will help assure low cost, long term access to the debt markets.  The fifth is a dividend increase, which should come in May for the June dividend. 

Risks

The biggest risk that ARCP faces is a decline in triple net lease REIT valuations.  This can be hedged out by shorting O or NNN. 

Catalyst