Learn From My Mistakes, It’s Much Cheaper That Way

Summary

  • “Always try to learn from other people’s mistakes, not your own – it’s much cheaper that way”. – Donald J. Trump.
  • If you do decide to touch the hot pan again, you’ll likely be more cautious, since your brain senses the pain of the first encounter.
  • VEREIT remains a value play versus peers, but offers less near-term growth and carries incremental risk given the ongoing civil lawsuit and the non-traded REIT business.

One of the most frequently asked questions I get from readers is: What was your worst REIT decision?

The truth is, I have made quite a few bad decisions, and my goal as an investor is to learn from my mistakes and hopefully not make the same bad decisions again. President Donald Trump once said:

Always try to learn from other people’s mistakes, not your own – it’s much cheaper that way.

As part of my God-given risk management skill set, I have learned that when you get burned touching the hot frying pan, you usually don’t touch it again. Of course, if you do decide to touch the hot pan again, you’ll likely be more cautious, since your brain senses the pain of the first encounter.

Today, I want to share one of those hot frying pan moments with you, and hopefully, you will benefit – as Donald Trump said – from my mistake, not your own – “it’s cheaper that way”.

Remember ARCP?

To set the stage for this “hot pan moment”, let’s begin with an article that I wrote on September 13, 2011 (almost 5½ years ago) on American Realty Capital Properties (formerly “ARCP”). This was the first Seeking Alpha article published on ARCP when the company listed on Nasdaq. My article was short, and I summed up the research as follows:

In the case of the new IPO, management appears to be solely focused on paying off (or bailing out) its previously arranged secured debt and not on providing a diverse, long-term triple net lease portfolio for investors. Although I would not recommend ARCP, there are many durably safe equity REITs…

Then, 10 days after my first ARCP article, I went on to write a second piece, and my comments were directed towards the poorly constructed portfolio. I wrote:

Show me some “meaningful” diversification and I will show you a better grade on your next report card.

Then, in June 2012, I began to warm up to ARCP. The company was increasing in size and adding much-needed diversification to the portfolio. ARCP’s Founder and CEO, Nicholas Schorsch, once dubbed the “Banker’s Landlord” (for his prodigious building of a portfolio of bank real estate), was beginning to carve out a name as the Net Lease REIT king.

Then, in December 2012, just 15 months after ARCP’s IPO, the company announced a merger with ARCT III, a non-traded REIT managed by Schorsch comprised of 800 properties and 18.9 million square feet. Back then I wrote:

Schorsch has mastered the art of creating full-cycle market liquidity for non-traded REIT investors. In fact, I would go as far as saying that he has “schooled” the other non-traded REIT peers by setting the bar for both record liquidity execution and best practices.

I was beginning to drink the Kool-Aid, and by March 2013, I decided it was time to “back up the truck”. I wrote that “ARCP’s dividend yield (was 6.8%) is no mirage… Cramer pointed that out on Mad Money…”

As a dedicated REIT analyst, it’s my job to remain skeptical, and although I was bullish with ACRP’s platform, I was keeping my guard up. In June 2013, I wrote:

… the invisible risk appears to be the capabilities of managing and retaining tenants in a significantly diversified net lease portfolio.

I was also skeptical about ARCP’s conflicts of interest, and I was keeping my distance, given that the REIT was externally managed at the time.

My concerns are driven more by the company’s externally-managed platform and its conflicts of interest with ARCT4 and ARCT5.

Fast forward to October 2013, and I was still on the sidelines. I explained:

The biggest risk for ARCP is also the biggest opportunity: GROWTH… the extraordinary growth does concern me and I’m not ready to commit in a significant way until I see the dust clear. There’s a lot of moving pieces and I would like to see them all come together – that means I’m going to sit on the sidelines until I see a top line pro forma.

Now fast forward to October 2014, I was still skeptical as it relates to ARCP’s growth, but I was becoming spooked by the dividend coverage. Since ARCP went public (just 3 years), the company had grown to over 4,400 properties, but I warned:

ARCP should slow down its acquisition pace so that it can continue to concentrate on dividend safety.

I was still baffled by the conflicts of interest, as I wrote:

it’s incredibly complicated, and most importantly, where is the alignment of interest with ARCP investors?

I went on to explain:

… when you consider ARCP’s AFFO payout ratio, you can see that I’m not the only one feeling queasy. As I reflect on the latest Cole deal (announced), I begin to realize that ARCP simply used investor capital to acquire Cole, and the real winner is RCAP, not ARCP. Had ARCP sold Cole to the highest bidder, ARCP’s dividend coverage would be much safer.

I concluded the article as follows:

I don’t consider the current price of $12.07 a bargain… I’m not investing another nickel in ARCP until I see more clarity (i.e. when the smoke and mirrors disappear).

Now, here’s my mistake. First let me tell you what I recommended at the time:

I will not be suckered into a trap where my principal is not safe. I’m sitting on the sidelines for now.

The rest is history. Just a week or so after my article, ARCP said it had falsified Q1-14 and Q2014 earnings report. On October 31, 2015, I wrote:

The author liquidated all ARCP shares at $9.57.

VEREIT Means Trust

I know you’re probably wondering why I am beating myself up for calling ARCP a “sucker yield” days before the train wreck.

Because the difference between a HOLD and a SELL is around $3.00 per share, had I recommended a SELL, I would have saved myself $3.00 per share. I know some followers took my SELL recommendation to heart and SOLD their shares early. It was a tough lesson for me, and I am owning up to my mistake.

Just like the hot frying pan, it took some time for me to get back to business with VEREIT (NYSE:VER), the new entity rebranded after the ARCP debacle. However, I’m becoming more and more comfortable with VER and the initiatives that are unfolding.

VER’s name was chosen because it combined veritas, the Latin word meaning “truth”, and REIT, the industry in which the company now strives to be a respected leader.

VEREIT is a Net Lease REIT that owns 4,201 properties located in 49 states, as well as the District of Columbia, Puerto Rico, and Canada. Additionally, it manages $7.1 billion of gross real estate investments on behalf of the Cole Capital non-listed REITs.

In the third quarter, VER disposed of 87 assets for $278 million. Year to date, the company has completed approximately $803 million of dispositions, which surpasses the low end of its $800 million-1 billion guidance range for the year (this is on top of the $1.4 billion of strategic dispositions in 2015). VER has a Total Capitalization of $19.5 billion:

At quarter end (Q3-16), VER’s Red Lobster exposure decreased to 8.6% from 9%. So far this year, the company has sold 51 Red Lobster properties for net proceeds of approximately $174 million at a 7% net cap rate and a gross cap rate of 6%. VER said it had 24 Red Lobster properties under PSA or LOI, and is on target to sell $200-250 million (of Red Lobster units) in 2016.

Following $1.4 billion of asset sales and $1 billion expected in 2016, VER should become a net acquirer in 2017. Recent asset sales and further culling of Red Lobster and office assets suggest that AFFO will decline in 2017, but 2018 should be the growth year. Here’s a snapshot of VER’s top tenants:

As you can see (above), Red Lobster remains VER’s top tenant (8.6% of annual rent), and the next largest tenant is Walgreens (NASDAQ: WBA), representing 3.4% of annualized rent. Red Lobster represents 35.9% of the REIT’s restaurant exposure:

As VER continues to reduce Red Lobster exposure, the company’s overall exposure to casual dining should decline:

As noted, the REIT has outsized office exposure, and I expect that to reduce:

Touted by ARCP’s management team as the “world’s largest Net Lease REIT”, that distinction now applies to Realty Income (NYSE:O); however, VER does have a diversified platform with considerable scale benefits.

The company’s previous management team was known for “empire building”, and it’s evident that the Red Lobster deal was designed to grow assets, not dividends. VER’s new management team has done an excellent job transforming the failed platform into a sound investment model.

Debt In Much Better Shape Now

VER recently completed a very successful equity offering during the quarter, netting the company approximately $702.5 million. Using these proceeds, it was able to pay off the recent $300 million secured bank loan and take the line of credit to zero. VER now has $2.3 billion of capacity available under its credit facility.

Effectively, the company was able to refinance $1.3 billion of bonds that were coming due in February 2017 with 10-year bonds, five-year bonds and the remainder in equity, staggering net debt repayment and improving the overall maturity schedule.

Additionally, S&P raised its corporate rating of VER to BB+ from BB and the rating on corporate debt to BBB- from BB+, which is investment grade. While staying within 2016 AFFO guidance range, the REIT was able to achieve its balance sheet targets faster than anticipated through the disposition program and the equity offering, and also created a well-laddered maturity schedule with the refinancing of the 2017 bonds.

With debt/EBITDA (ex prefs) at 5.7x (as of Q3-16), management will not leverage to fund growth, preferring instead to keep financial flexibility and maintain a strong balance sheet.

The company’s fixed charge coverage ratio remains healthy at 2.9x, and the net debt-to-gross asset ratio is under 41%. VER’s encumbered asset ratio was 66%, and the weighted average duration of debt increased to 4.5 years from 3.9 years. The company also put in place the $750 million ATM as part of its objective to ensure it has the right financial toolkit in place.

Fitch said the ratings are based on the company’s “improving credit metrics, strong management team, well diversified portfolio of predominantly single-tenant net-leased assets that generate consistent cash flow growth, and good recent and expected access to capital”.

The rating agency expects VER’s asset quality to improve as a result of its capital repositioning strategy. Fitch pointed out, however, that the strengths are countered by the potentially negative implications of ongoing litigation against the company.

A Quick Legal Note

On the latest earnings call, management said “legal costs related to the matters arising from the audit committee investigation which are included in litigation and other non-routine costs was approximately $5.2 million for the quarter”.

This brings the total unit costs related to these matters to $13.4 million for the year, excluding any insurance proceeds. The company said it was “reducing the previous estimate for gross legal cost for 2016 to $35 million to $40 million excluding any insurance proceeds”.

In a recent article, Seeking Alpha author Beyond Savings took a more critical tone as he explained:

… litigation expenses are going to become increasingly significant in 2017 and likely 2018… VEREIT is a speculative bet.

I agree that VER’s ongoing civil lawsuits are unknown and the fines could result in a sizeable fine, though the exact size and timing remain unknown. It would seem logical that the company will look to settle the case “sooner than later”, as this could result in improved clarity and better year-end stock performance.

However, VER has ample credit to settle the lawsuit without an impact to AFFO. The company could most likely draw down on its credit line and look to recover funds from insurance carriers. I have no knowledge as to the insurers involved in the litigation, but I am confident VER will attempt to resolve the lawsuit so the clouds don’t linger beyond 2017.

Q3 Earnings Results

In Q3-16, VER’s AFFO was $0.20 per diluted share and FFO per diluted share was $0.19 as compared to $0.20 for the second quarter, mostly due to lower rental income and increased loss from extinguishment of debt and the diluted effect from issuing the 69 million shares from the recent equity offering.

AFFO was $0.20 per diluted share as compared to $0.19 for the second quarter, primarily due to the current portion of a tax benefit of $10.9 million driven by the closing of CCIT II, along with the lower G&A and lower interest expense.

During the quarter, Cole Capital raised $136.4 million of new equity, at an average of $45 million a month. Cole also closed one offering CCIT II and launched a new REIT CCIT III. New equity for October was $23.4 million, which reflects a lower capital raise following the close of CCIT II and the ramp-up of CCIT III.

There is considerable angst in the non-traded REIT sector, and the value of Cole seems to be in question. Similar to the lawsuit, VER’s non-traded REIT business continues to create overhang for the stock. The news that Blackstone Real Estate is entering the space, hoping to raise $5 billion, is positive, and it could mean Cole Capital has an exit strategy.

However, there are still unanswered questions, as the DOL could effectively prevent access to these alternative assets. In other words, Cole remains a question mark and a layer of complexity that VER needs to remove so it can return to “normalized” net lease REIT valuation levels.

Learn From My Mistakes, It’s Much Cheaper That Way

So a few clouds still linger – legal costs and Cole. However, we are seeing more predictability as a result of the company’s disposition results and more recent credit upgrade. As referenced above, VER received an investment grade rating of BBB- from Fitch.

In an article a few months ago, I wrote:

… we believe that VER is well positioned to generate outsized returns over the next few quarters. I wish we had more clarity as it relates to the litigation, but we believe the shares are attractive based on the strong revenue drivers and disciplined management team.

Have I learned from my mistakes?

Yes. It’s clear to me that VER is no longer an “empire builder”, but instead, a “dividend protector”. The dividend is well covered by AFFO (70.5% in 2016), and we suspect the payout ratio will climb to around 76% in 2017. Here’s the forecasted FFO/share:

(Source: F.A.S.T. Graphs)

Here’s the same data in %:

As you see, VER’s earnings should “bottom out” in 2017 and begin to climb in 2018.

However, even with the overhang, VER shares are trading ~4 turns below the sector and even wider for the industry leaders (O and National Retail Properties (NYSE:NNN)):

So back to the Trump quote and the title to this article, “Learn From My Mistakes, It’s Much Cheaper That Way“.

VER is cheap based on all metrics, especially the dividend yield:

The Bottom Line

VER remains a value play versus peers, but offers less near-term growth and carries incremental risk given the ongoing civil lawsuit and the non-traded REIT business. I believe VER’s price will begin to move as the lawsuit settles and earnings begin to grow. The lesson I have learned over the course of this 5-year long story is that “the next time I smell smoke; I will assume there’s fire. To translate that, I will immediately recommend a SELL as opposed to a HOLD.

I have a BUY on VER at this time:

Check out The REIT Beat: I plan to publish a weekly Nothing-But-Net REIT Guide that will include WACC metrics and valuation tools. If you’d like to get more of my ideas, including early access to my highest-conviction REIT plays, access to Q&As with management teams, weekend REIT reports, and more. We’d love to have you on board, so have a look.

REITs mentioned: Spirit Realty Capital (NYSE:SRC), EPR Properties (NYSE:EPR), W.P. Carey (NYSE:WPC), NNN, Agree Realty Corp, (NYSE:ADC), STORE Capital (NYSE:STOR), and Four Corners Property Trust (NYSE:FCPT).

Author Note: Brad Thomas is a Wall Street writer, and that means he is not always right with his predictions or recommendations. That also applies to his grammar. Please excuse any typos, and be assured that he will do his best to correct any errors, if they are overlooked.

Finally, this article is free, and the sole purpose for writing it is to assist with research, while also providing a forum for second-level thinking. If you have not followed him, please take five seconds and click his name above (top of the page).

Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended.

Disclosure:I am/we are long APT, ARI, BXMT, CONE, CORR, CCP, CCI, CHCT, CLDT, CUBE, DLR, DOC, EXR, FPI, GPT, HTA, HASI, KIM, LADR, LTC, LXP, O, OHI, QTS, ROIC, STWD, SNR, STAG, SKT, SPG, STOR, TCO, UBA, VTR, WPC, PEI, EQR, DEA, MVEN.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.