By
Morningstar
:
By Todd Lukasik, CFA and Philip J. Martin
Realty Income(
O
) will acquire publicly traded American Realty Capital Trust(
ARCT
) for $3 billion -- $1.9 billion of Realty Income shares with the
rest in debt. The transaction achieves management's goals of
diversifying further into nonretail assets and with
investment-grade tenants, but it represents a substantial departure
from Realty Income's normally patient and measured approach to
acquisitions. The deal is expensive and huge, and there is a
minimal margin of safety, in our opinion.
What Is Realty Income Buying?
Realty Income is paying a dear price for a ready-made portfolio
that helps it achieve management's diversification goals. We
estimate that 45%-50% of the portfolio is in nonretail assets (such
as distribution, manufacturing, other industrial, and office
properties) while 75% of revenue is from investment-grade tenants.
This supports management's strategy of positioning the firm for a
possible future with rising interest rates (i.e., toward
investment-grade tenants) and weakness among U.S. consumers (i.e.,
toward nonretail properties). Regardless of one's view on the
merits of this diversification strategy, this deal is in keeping
with the strategy management has outlined.
After the deal's close, nonretail assets will make up 23% of
Realty Income's portfolio (versus 14% currently), while 34% of its
revenue will come from investment-grade tenants (versus 19%
currently). The ARCT portfolio will also provide immediate benefits
to other portfolio metrics, such as tenant and industry
diversification, lease maturity profile, and weighted-average
occupancy, although we view the improvement to occupancy to be a
short-term boost that becomes a long-term drag in a decade or so
when the ARCT leases begin to expire.
Importantly, Realty Income will not be taking on any ARCT
employees, so the key management team that we have grown to admire
over the years will remain in place at Realty Income, as will the
current board structure. This translates into what we estimate to
be roughly $8 million per year in general and administrative
expense savings for the combined firm. This also leaves the legacy
ARCT management to continue as a Realty Income competitor after the
acquisition.
What Price Is Realty Income Paying?
The price is high. We'd grown accustomed over the years to
seeing Realty Income acquire assets at relatively high cap rates,
due to a combination of its ability to source off-market deals and
its willingness and ability to underwrite non-investment-grade
retailers, where it ran into less competition from those
institutions focused on investment-grade tenants. Such deals
generally came with not only relatively high cap rates but also a
margin of safety in the cash flow coverage of rent built into the
sale-leaseback transaction, allowing for some deterioration in
tenants' store performance before rent payments were compromised.
Over time, therefore, as Realty Income achieved diversification in
its portfolio (by adding different types of retail assets such as
theaters, convenience stores, and fitness centers to its portfolio
for the first time), it was pursuing diversification while paying
prices that left a reasonable margin of safety. Although it does
achieve diversification, it seems unlikely that a meaningful margin
of safety is built into this ARCT deal. The 5.9% cap rate is low by
both absolute and relative standards, and the nonretail assets
cannot be underwritten to property-level profitability as easily,
if at all (so they are then often backed by investment-grade
credit). Furthermore, while Realty Income did extensive due
diligence on all 501 properties it plans to acquire from ARCT, it
was ARCT's management -- and not Realty Income's -- that originally
underwrote these transactions, with Realty Income now paying a
premium for that underwriting.
One thing that makes this deal more palatable for Realty Income
is its plan to buy out ARCT shareholders with its own stock, which
is expensive by historical standards and trades a bit above our own
$39 fair value estimate. This is no reason in and of itself to pay
up for a deal, though it helps soften the impact of the high
purchase price. Furthermore, the deal would be immediately cash
flow accretive to Realty Income, prompting the firm to announce
plans to increase its annual dividend payment by $0.13 per share,
or roughly 7%, if the deal closes.
Primary Benefits of the Deal to Realty Income
Cash flow positive.
We agree with Realty Income management that the deal should be
immediately cash flow accretive and support an increase to the
common dividend. Our new 2013 forecasts for funds from operations
and adjusted FFO are $2.30 and $2.33, respectively, which fall at
the low end of the new guidance range management provided, and our
model supports management's assertion that an increase to its
common dividend upon the deal's close of $0.13 per share is
manageable.
Further portfolio repositioning.
Realty Income has identified two strategic portfolio repositioning
objectives: improve credit quality and reduce exposure to retail
tenants. This transaction does both. Investment-grade tenants make
up 75% of ARCT's portfolio, which would boost Realty Income's
exposure to investment-grade tenants to 34% from 19%. The deal
would also boost Realty Income's percentage of nonretail assets to
23%, up from 14%, and within the 20%-30% target range management
has identified.
Improved short-term portfolio metrics.
Given the characteristics of ARCT's portfolio, the deal would
immediately improve Realty Income's tenant and industry
diversification, occupancy, and remaining lease term, while
lowering the average age of portfolio properties.
Scale.
This deal would make Realty Income the largest publicly traded
triple-net lease company by a factor of roughly 2 times. We believe
this scale would solidify its position as a preferred capital
provider to the triple-net sale-leaseback industry, enabling it to
contemplate an expanded opportunity set, in terms of scope and
size, while maintaining its reputation for reliability.
Furthermore, we agree that ARCT's operations could largely be
absorbed by Realty Income with minimal incremental hiring,
resulting in $8 million or so of annual G&A expense savings,
which we value at roughly $100 million.
Organic growth potential.
While we do not know the exact extent of the opportunity,
management has indicated that a number of the nonretail properties
in the ARCT portfolio may contain excess land, which Realty Income
could utilize in the future to meet tenants' growth needs,
providing organic growth and an opportunity to extend lease terms
on the original properties. Realty Income's legacy retail portfolio
contains little opportunity for this, and we view this type of
potential development to meet existing tenants' expansion
requirements as carrying relatively lower risk than greenfield
development deals in new markets with new tenants.
Our Primary Concerns
Nontraditional transaction at huge scale.
While Realty Income has purchased parts of portfolios in the past,
it has done nothing near this size. Furthermore, we believe that
the vast majority of value from past acquisitions has been
concentrated in traditional sale-leaseback transactions with the
eventual tenants. The ARCT deal is a departure in size (it is
roughly 6 times larger than Realty Income's next biggest deal, done
last year) and the fact that it is a portfolio of lease
transactions put together by another management team instead of one
Realty Income underwrote itself. One of Realty Income's positive
attributes, a differentiating factor and the source of its narrow
moat, is the firm's underwriting expertise and discipline. This has
historically resulted in investing in a high percentage of
off-market deals at relatively more attractive returns. On the
other hand, this deal allocates $3 billion in capital at a premium
of roughly 40% to another firm's original underwriting. Management
has assured us that it has reviewed all of the properties and
leases in the deal thoroughly, but the deal is nonetheless a
departure from the type that has brought success historically, and
it is being done at huge scale.
Timing.
We would have preferred to see Realty Income in a position to bid
more aggressively on some of the ARCT portfolio assets when they
were originally up for sale, but it appears that the firm was not
yet geared up to source such deals, which is disappointing. By our
reckoning, Realty Income made well known its strategy to diversify
into nonretail assets and investment-grade tenants in mid-2010,
when it purchased Diageo's winery assets, and then confirmed this
strategy with its early 2011 $544 million ECM portfolio deal. We
suspect Realty Income management was considering the implications
of this diversification strategy and potential eventual targets
well before the close of its Diageo deal in mid-2010. So, it's
disappointing that the firm didn't get more of the ARCT portfolio
assets at the time they were originally up for sale, given that
ARCT compiled more than half of its portfolio in 2011 at an average
cap rate of 7.9%.
ROREA dilution.
One of the metrics we consider when evaluating real estate
investment trusts is return on real estate assets, which we
estimate as EBITDA less maintenance capital expenditures divided by
the gross book value of revenue-generating real estate assets. We
think this metric provides insight into a firm's value creation
from property acquisitions and developments, as it includes an
earnings component as well as a price paid component. The higher
the ROREA the better, and likely the more value creation management
has achieved, all else equal. We estimate ARCT's level of ROREA
(based on its second-quarter results) to be 7.6%. Consolidating its
business with Realty Income's would increase EBITDA thanks to lower
estimated G&A expenses while increasing the cost basis in the
assets to reflect the higher price Realty Income is paying. As a
result, after the acquisition, we estimate Realty Income's ROREA
for the ARCT portfolio to fall to 5.7%. This pales in comparison
with Realty Income's five-year trailing ROREA of 8.6% and is well
below our estimate of Realty Income's cost of capital. Although we
expect the ROREA that Realty Income earns on the ARCT assets to
increase over time as annual rent bumps flow through EBITDA, the
relatively low level of initial ROREA post-close suggests that the
firm is diluting its portfolio's overall relative earnings power
while setting a very high hurdle of future performance for the ARCT
portfolio to clear in order to approach parity with Realty Income's
legacy portfolio.
Potentially tighter spreads on future
acquisitions.
For much of Realty Income's history, its superior underwriting
allowed it access to one-off sale-leaseback deals that many other
financiers avoided, mainly transactions with non-investment-grade
or nonrated retail tenants. Less competition meant better pricing
for Realty Income. Going forward, there is risk that Realty
Income will focus its acquisition resources on larger deals, as
it will take more and more in annual acquisitions to move the
needle on growth. This may mean more portfolio deals or larger
sale-leaseback deals, which we worry will be more likely to be
market-rate deals with more potential bidders than Realty
Income's traditional transactions. This could mean tighter
spreads -- and less value creation -- on future deals than
shareholders have enjoyed in the past. We have no reason to think
that Realty Income will engage in transactions that don't make
sense for shareholders, but the future bang for Realty Income's
acquisition buck may not be as great as it has been
historically.
Potentially more cyclicality and capex.
We think the industrial, distribution, manufacturing, and office
assets Realty Income is adding bring different risks to the
portfolio because of the economic cyclicality of the assets and
in some cases the lack of a strong link between the tenant and
the particular asset, especially upon lease expiration. We
associate these types of nonretail assets with slightly higher
volatility in cash flows and operations and the potential for
higher levels of capital spending over time, especially in the
event that re-leasing becomes necessary.
Portfolio churn.
Normally, when making an acquisition, Realty Income likes to
cherry-pick a portfolio to include in its deal only the
properties it likes best, leaving the counterparty to find other
buyers for the other properties. But the acquisition of ARCT in
its entirety doesn't allow Realty Income to do that. Although
management has no specific plans yet for divestitures from the
ARCT portfolio, we would expect a meaningful percentage (say,
5%-15%) of the ARCT portfolio to eventually be sold over the
medium term. While we agree with this strategy, it nonetheless
adds uncertainty and will require new acquisitions to offset
sales to maintain cash flows for dividend payments. Furthermore,
if Realty Income did pay a portfolio premium of 120-230 basis
points, as we estimate, flipping assets over the short term would
be value destroying and cash flow dilutive, if that portfolio
premium disappears upon resale. We estimate that it would take 12
years of 1.5% annual rent bumps in the portfolio for net
operating income to recover sufficiently such that potential
future divestitures would be value neutral at cap rates 120 basis
points higher. There is potentially a silver lining in this
portfolio churn. We think that among its nonretail assets, Realty
Income is least enamored of suburban office assets, and they are
likely candidates for divestiture. This is an area that has
lagged the recovery witnessed across most other property types
since the last downturn. With potential further firming of the
macro economy, suburban office may be a property type for which
performance and values improve meaningfully, making it a
potentially good environment into which Realty Income can market
its assets.
Price.
Realty Income is paying a dear price for the ARCT portfolio. The
deal's 5.9% initial yield is 120 basis points below the average
cap rate of 7.1% that Realty Income paid on its $211 million of
second-quarter acquisitions, traditional sale-leaseback
transactions, nearly all of which were with investment-grade
tenants (as opposed to 75% exposure to investment-grade tenants
in the ARCT portfolio). It is 230 basis points below ARCT's
average cost basis in the assets. Still, we think the deal is
largely value neutral for Realty Income, partially because it is
using its own stock for financing, which appears to be a slightly
overvalued currency. Nonetheless, at such a low initial yield,
there's not a lot of leeway in the portfolio's potential future
performance before its value takes a hit. Nearly everything needs
to go right with this portfolio, or the price paid may look too
high in retrospect. Paying a full price up front shifts more risk
to Realty Income, minimizing its margin of safety on the
deal.
What Does the Deal Signal About Realty Income's
Future?
We view the deal itself as value neutral. But we think its
potential implications point to the risk of lower acquisition
spreads going forward and slightly lower long-term performance
assumptions for Realty Income's portfolio. Furthermore, although
this deal is expected to provide a 7% boost to Realty Income's
dividend upon closing, we think it may also slightly reduce
future dividend growth prospects. To the extent that the
nonretail assets do require more cash for maintenance and do
ultimately display greater cash variance in cash flows and
operations, the board may consider an additional buffer in its
dividend payout ratio, perhaps moving from a mid- to high 80s
level of adjusted funds from operations to a low to mid-80s level
instead.
We expect most of the potential operating changes to Realty
Income's business model to show up over the medium to long term
and not in the near term (although there may be perception risk
over the near term). This is because we view most of the
potential risks to the performance of the nonretail assets to
materialize at the end of the lease term. The ARCT portfolio, for
example, has a 13-year weighted average lease term, with few
material lease expirations until 2018. Given that the majority of
these leases are with credit tenants, we view them to be
relatively more reliable over the lease term than those with
Realty Income's traditional non-investment-grade retail tenants.
But we also view the leases on nonretail properties to be less
predictable at lease expiration, given that the money the tenant
earns is not always tied as closely to the specific property it
leases.
On the other hand, we expect to be able to effectively measure
management on its acquisition discipline over the next 18-24
months, which will help us confirm or refute our position
regarding the risks to Realty Income's spreads on future
acquisitions. Despite its $3 billion ARCT bid, Realty Income has
confirmed that its acquisition pipeline remains robust and its
acquisition capacity remains large. The company still plans to
acquire roughly $1 billion over the next 18 months or so. We will
be watching to see whether spreads are pressured and whether the
mix leans toward market-rate deals or its traditional off-market
variety.
Although we have lowered some of our expectations for Realty
Income, the firm remains one of the best-positioned real estate
investment trusts that we cover. Even after the deal's close, the
firm's balance sheet should remain strong, its dividend should
remain well covered, and its capacity for incremental
cash-flow-accretive acquisitions should remain large. We still
think Realty Income has a narrow economic moat, thanks to its
favorable triple-net leases, exemplary management, and
historically superb underwriting.
If the deal fails to close, we will revisit our recent model
changes. However, we anticipate little change to our model
assumptions reflecting the portfolio's shift toward more
nonretail assets with investment-grade tenants and tighter future
acquisition spreads, as the ARCT deal -- whether or not it closes
-- suggests that the company will eventually execute on its
diversification strategy, perhaps with lower-yielding portfolio
deals along the way.
Disclosure:
Morningstar licenses its indexes to certain ETF and ETN providers,
including BlackRock, Invesco, Merrill Lynch, Northern Trust, and
Scottrade for use in exchange-traded funds and notes. These ETFs
and ETNs are not sponsored, issued, or sold by Morningstar.
Morningstar does not make any representation regarding the
advisability of investing in ETFs or ETNs that are based on
Morningstar indexes.
See also
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Justified Or Over-The-Top?
on seekingalpha.com