Description

We think that SRC is a long as it is trading at an unsustainable 7.7% dividend yield and could provide total returns of between 25%-50% over time.  Spirit Realty Capital (SRC) is a triple net lease (TNL) REIT that owns 1,900 properties with 383 tenants across 48 states.  SRC, one of the largest TNL REITs, was formed by the merger of Spirit Realty Capital and Cole Credit Property Trust II (CCPT) which closed on July 17, 2013.  SRC was a publicly-traded TNL REIT prior to the merger so the closing of the deal created a long-awaited (CCPT’s offering period ran from mid-2005 to Jan-2009) liquidity event for CCPT’s shareholders.  Prior to the merger, CCPT had 208mln shares outstanding so we suspect that this liquidity event is temporarily depressing SRC’s share price which is creating an opportunity to own SRC at a 7.7% yield and potentially a total return as high as 50% over time as SRC settles in at yields closer to the TNL REIT average.

Business

SRC is an internally managed triple net lease REIT.  As mentioned above, the company has 383 tenants across 1,900 properties in 48 states.  SRC’s portfolio has 54.3mln square feet and is around 98% leased with an average remaining lease term off 10.6 years, top 10 tenant concentration (based on revenue) of 37% with 19% of its revenue from investment grade tenants.  Top five tenants are Shopko 15.7%, Walgreens 4.4%, 84 Lumber 3.5%, Church’s Chicken 2.6% and Academy Sports 2.4%.

Upside

At today’s price of $8.50, SRC is trading at a 7.7% dividend yield, around 11.7x 2013 AFFO of $0.70 - $0.75 and at cap rate of approximately 7.6%.  The average of the comp group for dividend yield, AFFO multiple and cap rate is 5.5%, 14.9x and 5.8%.  If SRC were valued at the averages of the comp group it would be trading at $11.85 based on a dividend yield of 5.5%, $10.80 based on 14.9x 72.5c in 2013 AFFO, and around $13.72 at a 5.8% cap rate.  If we average these three valuations we arrive at a price of approximately $12.10 for SRC which represents appreciation of approximately 42.5% from current levels excluding the dividend yield of 7.7%.  Add in the dividend yield and you are at a potential 50% total return.  Even if we discount the above metrics by 10% to factor in some of the SRC-specific risks that we detail below we still get to an average value for SRC of approximately $10.70 which represents 26% of upside excluding the dividend and 33.5% total return potential.  To be very conservative, even if we discount the above metrics by 25% we still get to an average share price of around $8.90.  As such, we feel that there is very little permanent downside in SRC at current levels.

Catalysts

We don’t have a list of hard catalysts here, we simply think that SRC’s extremely high dividend yield, low AFFO multiple and high cap rate will eventually draw investor attention to the name.  In addition, we do believe that some of the weakness in the shares can be attributed to the CCPT non-traded REIT holders selling so as this subsides the stock should lift.  In the meantime, you are getting paid 7.7% to wait.

Risks & Mitigants

• Interest rate risk.  As we have all witnessed, REIT stocks tend to go down when interest rates rise.  TNL REITs tend to fare worse than the average equity REIT because they tend to have long-term leases that do not allow for significant annual re-pricing.  I think the mitigant here is the fact that by buying SRC at current levels, you are locking in a 7.7% yield which, in my opinion, provides a pretty decent level of downside protection even if rates continue to rise.  In addition, SRC’s average annual contractual rent increase is approximately 1-1.25% and the vast majority of their balance sheet is fixed-rate debt which should allow for some rate increase protection.  If you are still concerned, then you can short some of the lower yielding triple net REITs as a hedge.
• SRC is fairly highly levered. Based on my calculations, net debt/NOI is around 6.8x for SRC vs a group average of around 6.2x.  In addition, its NOI / interest coverage is approximately 2.0x vs around 3.5x for the group.  The mitigant here is the likelihood of continued divestitures by SRC of the multi-tenant exposure that it acquired in the Cole deal which will allow for the reduction of debt as well as its fixed rate balance sheet and lack of significant debt maturities until 2016.
• Proforma Shopko exposure is still significant at 15.7% of revenue.  The brief history of how SRC came to have such a large tenant is Sun Capital LBO’ed Shopko in 2005 and then subsequently did an $815mln sale leaseback with SRC for 178 stores.  The perceived risk in regards to Shopko is that corporate-level rent coverages are fairly tight at around 1.8x-2.0x and corporate-level rent and interest coverages are even tighter at around 1.5x.  Regardless of the fact that it was massively levered up just prior to 2008 as a result of the LBO and sale/leaseback transaction, Shopko came through the financial crisis with only a small ($2.6mln over ~ 1.5 years) rent deferral which was granted by SRC starting in Jan 2009 which Shopko promptly repaid with interest.   While Shopko is a risk that must be monitored we feel that it is mitigated by, 1) long-term (average 12.5 years remaining lease term) master lease structure for all but two of the Shopko stores which prevents Shopko from cherry-picking locations, 2) Shopko unit-level rent coverages are in the 2.6x range according to a conversation with the company which lines up with SRC printed disclosure and communications on conference calls, 3) Shopko Pamida merger should be positive for operating performance and 4) Shopko’s performance has been fairly stable despite extensive competition from Walmart over the last decade and a major recession.
• Significant non-rated tenant exposure and only 19% investment grade.  Proforma the merger, SRC’s portfolio is approximately 66% non-rated tenants meaning that SRC does the credit analysis themselves instead of leaving that to the rating agencies.  The rest of the portfolio is either non-IG rated (15%) or IG rated (19%).  The mitigants here are 1) SRC actually analyses the unit-level financials of its tenants so it has a much better handle on the overall credit quality of its portfolio and it is also able to negotiate better deals with its tenants because they are not rated, 2) SRC seeks to own properties that are operationally essential to its tenants, 3) SRC uses master leases where it leases properties on an "all or none" basis, 4) SRC uses a credit modeling product developed by Moody's Analytics that assesses credit risk of its tenants vs other triple nets that focus on rated tenants and thus do not collect financials at the tenant level , 5) SRC has a fairly diverse portfolio with 1,900 properties in 48 states spread across over 18 different industries and over 380 tenants, 6) SRC has a successful history of dealing with (and accessing the risk of) non-rated tenants, and 7) as a comparison, NNN, a TNL REIT that trades at a 5.2% dividend yield and around 16x AFFO, only has 6% of its portfolio in IG-rated tenants.
• SRC has stated that in the short term, their dividend will grow at a slower rate than AFFO as they would like to increase their dividend coverage ratio. The mitigant here is the fact that at $8.50 investors are able to buy (and lock in) a 7.7% dividend yield which is currently the highest in the triple net space by around 60bps.
• SRC has a limited history as a publicly-traded company.  SRC was founded in 2003, became public in Dec 2004, was taken private by a consortium of private investors in Aug 2007, was taken public again in Sep 2012, and closed its merger with Cole in July 2013. This limited trading history and the fact that the proforma entity has been trading for just over one month, could impact the comfort level that REIT investors will have with owning the shares. The only mitigants here are time and the fact that investors are being generously compensated for that risk by the current 7.7% dividend yield.

Catalyst