2017 has been a mixed bag for REITs in general, and downright brutal for most retail-oriented REITs. The “death of retail” has been a recurring theme of 2017, as Amazon.com, Inc. (NASDAQ:AMZN) and other online retailers continue to erode the traditional brick-and-mortar business model. But one retail REIT in particular stands out for having been beaten like the proverbial red-headed stepchild: Spirit Realty Capital, Inc (NYSE:SRC).
Year-to-date, the battered REIT is down nearly 30%, and declines in SRC stock have pushed the yield above 9%.
After a drop like that, it’s fair to ask if Wall Street overreacted, as it is wont to do. After all, most of the decline happened on a single day last month following a disappointing earnings announcement.
So, let’s take a look at Spirit to see if we might have a value opportunity.
|REIT||Ticker||Price/FFO||Div Yield||Payout Ratio|
|National Retail Properties||NNN||15.9||4.8%||74%|
|Spirit Realty Capital||SRC||9.7||9.6%||90%|
On paper, Spirit looks cheap relative to its peers in the triple-net retail space. SRC stock trades for 9.7 times its expected 2017 funds from operations (FFO), which is about half the valuation of industry leader Realty Income Corp (NYSE:O). For the uninitiated, FFO is a measure of earnings for REITs that strips out non-cash expenses such as depreciation. You can think of the Price/FFO ratio as the REIT equivalent of the Price/Earnings or P/E ratio.
Likewise, Spirit’s dividend yield is significantly higher than its peers. Its yield is double that of National Retail Properties, Inc. (NYSE:NNN) and more than double that of Realty Income.
Of course, an extremely high dividend yield is usually a sign of trouble ahead… and a sign that the market expects a dividend cut. Indeed, Spirit’s dividend currently eats up 90% of its FFO, and that’s cutting it close. So, we’re likely looking at zero dividend growth over the next few years.
To be clear, I don’t consider SRC to be at immediate risk of a dividend cut, at least as long as it avoids a major tenant bankruptcy. More on that later.
Why the Discount?
So, we’ve established that Sprit Realty Capital is cheap, at least relative to its peers. The next question is why?
It comes back to Amazon and the death of retail. One of Spirit’s largest tenants is the struggling retail chain Shopko, which is having to close stores. Shopko is responsible for 8.1% of Spirit’s revenue, so any major setback here could make it difficult for Spirit to continue paying its dividend at current levels.
Spirit announced higher-than-expected impairment charges in early May related to Shopko and other struggling tenants and also lowered its earnings guidance and reduced its expansion plans as a result. That lead to the massive rout in the stock price.
But, is it justified?
Let’s imagine the worst happened and Shopko stopped paying rent at all of its locations at the same time. That revenue isn’t lost “forever.” Spirit could either sell the stores or find new tenants. But that could also take several months, and finding quality big-box tenants isn’t particularly easy these days.
So, we’re not talking about a cataclysmic, company-ending disaster. But, it would be something that would likely cause Spirit to substantially lower its dividend.
A more likely scenario would be that Spirit muddles through, taking additional impairment charges over the next few quarters, but manages to keep its dividend intact, albeit barely. Assuming no major, unexpected hiccups, Spirit will probably modestly outperform its safer but more expensive peers. Your risk is that a steady stream of disappointing earnings reports keeps a lid on the stock price for the time being.
Charles Sizemore is the principal of Sizemore Capital, a wealth management firm in Dallas, Texas. As of this writing, he was long O and STOR.