Description

Business Description

Cole Real Estate is a triple net lease REIT.  It manages a $7.5B portfolio comprised of 1,014 properties that are geographically diversified.  The portfolio is 55% investment grade and has an average lease duration of 12.2 years.  The industry mix is 68% retail, 18% office, 7% industrial, and 7% other.  The top three tenants are Walgreens, Albertsons, and Petsmart.  The top three sub-industries are grocery, drugstore, and discount stores.

What is triple net?  Triple net is a lease structure where essentially all costs are passed onto the tenant (taxes, insurance, maintenance, opex, etc.).  The tenants typically sign longer term leases with low annual rent escalators.  Credit risk is typically the most important metric to track since the main risk to occupancy is tenant bankruptcy or distress.  Triple nets are very easy to model - AFFO or cash flow will essentially be unchanged quarter to quarter excluding M&A.

In addition to its internal portfolio, Cole has a Private Capital business that manages $3.1B of real-estate assets in several non-traded private REITs.  The Private Capital business generates about 10-15% of Cole's AFFO.  Cole currently has three open non-traded REITs: CCPT IV (focused on single tenant and multi tenant retail), CCIT (focused on single tenant office and industrial), and INAV (no industry focus).  Cole earns money in this business from offering fees, transaction fees, management fees, and incentive fees.  The REITs usually have a 2-3 year life and then some type of liquidity event.

The core business benefits from the Private Capital business because it provides it with M&A expertise and scale.  Despite only being public for a few months, Cole has been in the triple net lease business for decades.  Since inception, it has deployed $14B of capital.  Over time, Cole has proved to be a better acquirer of properties than its peers.  Unlike many of its competitors, Cole tries to buy single assets instead of portfolios because they are cheaper to acquire.  It also only sources about half of its properties from brokers, which helps keep prices lower.  As a result, Cole has been able to consistently acquire properties at a higher cap rate than the industry average (8-8.5% vs. 7-7.5% according to Real Capital Analytics).

Link to investor presentation, which provides a good overview of the company: http://ir.colereit.com/file.aspx?IID=4200055&FID=1500050291

Investment Thesis

Until 2Q13, Cole was a private external REIT manager.  Then in 2Q13, Cole merged with one of its private non-traded REITs (CCPT III).  After it merged, the new entity was owned by retail investors who owned CCPT III prior to the merger and the owners of Cole (mostly Chris Cole).  In late June, Cole decided to list on the NYSE to give its 100,000+ retail investors liquidity.  After years of illiquidity, many of these investors started to sell, which caused a lot of selling pressure and volatility in the stock.  To alleviate selling pressure, Cole tendered for $250MM of shares in August and authorized a $250MM buyback.  Because of this technical overhang, Cole still trades at a meaningful discount to its peers despite an arguably better portfolio of assets.  Cole trades at 12.5x AFFO vs. its closest peer O at 15.8x AFFO.  On the surface, this relative value gap may not seem that compelling, however, there are several catalysts over the next 6 months that should close the gap and may even cause Cole to trade at a premium.  These catalysts include:

• Increased sell-side coverage.  Cole is a $5.7B market cap company that had zero sell-side coverage until about a month ago.  O and NNN are close comps and each have 10+ analysts covering them.  Given the discount relative to O and NNN, I expect most analysts will initiate positively.  Cole currently has three analysts covering it (Ladenburg, JMP, and FBR), but all of them are boutique banks.  Management is hoping to get a bulge bracket bank to pick up coverage by year-end.

• Index inclusion.  Over the past month, Cole was added to several FTSE NAREIT, Dow Jones, and S&P real-estate indices.  Eventually, I expect Russell to add Cole to its indices.  These additions will cause forced buying by index funds and "closeted" index funds.

• Increased marketing by mgmt due to HUGE incentives.  Management marketed aggressively this summer and plans for another road show after 3Q earnings.  If management gets the stock 35% higher within the next 4 months, they will earn up to $330MM!  This incentive will be paid to Chris Cole, but he will likely share it with the rest of the management team.  After speaking with the company, it is clear that everyone is aware of this incentive and is doing whatever they can to market the story.  If Cole trades in-line with O within the next few months, most of this gap will be closed and management will earn most of their money.  ARCT (previously written up on VIC) had a similar incentive/event path and was eventually taken out by O.  It's also interesting to note that management received an offer of $13.59 for CCPT III in March and turned it down.  They are clearly focused on achieving the high-end of the incentive payout by getting the stock up to $16.50 per share and were not interested in settling for $13.59, which would have only earned them $165MM of their payout.  The incentive will be measured using the volume weighted average price from 12/14/13 to 1/30/14 or about 3-4 months from today.  Link to an overview of management's incentives: http://ir.colereit.com/file.aspx?iid=4200055&fid=1001177911

• Investment grade rating.  Cole currently meets 11 of 13 of Moody's key criteria for investment grade.  The two areas it needs to improve are the % of unencumbered assets and the amount of secured debt.  Once it achieves an investment grade rating, Cole will become more investable for REIT investors.  In addition, its cost of capital will improve which will make acquisitions more accretive.

• Accretive aquisitions.  REIT investors are very focused on AFFO and dividend growth.  For triple nets, the main source of growth is M&A.  Cole hopes to acquire ~$500MM of properties in 2H.  Next year, it could potentially acquire CCIT, one of its private non-traded REITs that is about to close to new investors and pursue strategic alternative (i.e. liquidity).  This would add nearly $1B of new property to Cole's portfolio.  Cole is best positioned to acquire this portfolio because it knows it the best and it does not have to pay an incentive fee since it will come out of one pocket and go into another.

• Full year of merged financials / more public history.  Cole has only reported one quarter of fully merged financials.  As Cole reports more quarters, REIT investors will become more comfortable with the story.

Price Target

At 16x AFFO, there is 30% upside in the stock.  Given management's incentives and the catalysts, I think we could see this return in the next 6 months.

Interest rates rising is the biggest risk to this investment.  Because Cole is a triple net, it has higher exposure to rising interest rates (longer duration assets).  I recommend shorting O or NNN to hedge this risk.  O is probably the most similar comp.

Comps

Catalyst