In an article I wrote last week I explained that "value investors can find success these days with buying all-star REITs that are sitting on the bench. It's kind of like investing in Kobe Bryant but only paying for Mark Madsen." It's true; the game of value investing is all about price and value. That is, paying less than what you are getting and more importantly, getting excited when share prices are falling.
As Ben Graham explained, buying stocks when they are cheap is the best way to grow money. As Graham defined it, the margin of safety constitutes a "favorable difference between price on the one hand and indicated or appraised value on the other." That is why stocks of good companies on sale reap the highest returns.
As we approach 2014 I wanted to survey the list of Triple Net REITs to find the best bargains and more specifically to examine the outlier among the growing free-standing net lease sector. As Christopher Browne wrote in The Little Book of Value Investing "value investing, buying earnings cheaply is the most reliable way I know to grow your nest egg, not because I say so, but because it's also been shown to be so - time and again, throughout the decades in numerous academic studies."
Browne went on to say,
Buy stocks as you would groceries - when they are on sale.
Lexington Realty Trust - A Dark Horse REIT
A few days ago I wrote an article explaining that Gramercy Property Trust (GPT) was my best performing overall REIT in 2013. With a 1-year total return of over 90% Gramercy "has demonstrated it can generate outsized returns" and while the outperformance was extraordinary in 2013, I believe there's a dark horse REIT in 2014. As Kate Perry sang in her recent best seller, Dark Horse:
So you wanna play with magic
Boy, you should know whatcha falling for
Baby do you dare to do this
'Cause I'm coming atcha like a dark horse
Wikipedia defines a dark horse as a little-known person or thing that emerges to prominence, especially in a competition of some sort or a contestant that seems unlikely to succeed. In terms of the odds of a black horse REIT winning the race in 2014, Mr. Market has provided us with a bit of research. As evidenced by the latest Price to Funds from Operations (P/FFO) metrics (below), the underdog Triple Net REIT is Lexington Realty Trust (LXP), with a P/FFO multiple of 10.2x.
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Earlier in the year I wrote two articles on Lexington. One article was published on March 25th (when LXP was trading at $11.85) and another article on June 10th (when LXP was trading at $12.23). Since my last article, Lexington shares have declined to $10.17 or over 20%.
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Lexington has a Total Capitalization of around $4.4 billion and a Market Capitalization of around $2.3 billion. The New York-based REIT has around 213 properties with approximately 40.6 million square feet of space. Although the larger three REITs - Realty Income (O), American Realty Capital Properties (ARCP), and W.P. Carey (WPC) - continue to dominant in size, Lexington makes up in "quantity" for its differentiated investment objective of "quality".
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Lexington's Differentiated Net Lease Model
Lexington has a highly diversified portfolio of 213 properties in 41 states and the breakdown of assets consists of 113 office properties (46.3% of ABR), 60 Industrial properties (28.5% of ABR), 28 Retail/Specialty properties (2.4% of ABR), and 12 Multi-Tenant properties (7.4% of ABR). The average occupancy of Lexington's portfolio is 98.1%.
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Much like the other Triple Net REITs Lexington generates stable cash flows through its high quality tenant base. In 2013 Lexington completed 5.2 million square feet of leases raising occupancy to 98.1%. Here is a snapshot of Lexington's geographic representation:
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Lexington's top markets are Dallas/Fort Worth, Houston, and Baltimore. Here's a snapshot that illustrates the Top 20 markets where over 63% of revenues are generated:
As noted above, Lexington derives the majority of its revenues from Office and Industrial properties.
Lexington also has a diverse representation of tenant categories including finance, technology, energy, automotive, consumer products, healthcare, and others.
Lexington's Top Tenants represent a diverse and stable group including FedEx (FDX), Metalsa Structural Products, Bank of America (BAC), and the US Government. No one tenant has more than 3.2% of exposure (based on ABR).
Also, Lexington has a large percentage (48%) of tenants that are investment grade rated and that provides the REIT with more predictable cash flows and steady and stable returns.
Lexington has a balanced lease rollover schedule with minimal expirations. Here is a snapshot of the company's lease expiration schedule based on cash rentals.
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Lexington Can Move the Needle
As a much smaller Triple Net REIT, Lexington has significant external growth opportunities. In 2013 Lexington acquired over $560 million in deals, more than the combined volume for the REIT over the previous four years (2009-2012).
Core and external portfolio growth is enhanced via a robust build-to-suit (or BTS) pipeline that offers attractive yield with less risk than traditional development. Through November 30th (2013) Lexington completed acquisitions and BTS transactions for an aggregate cost of $560 million. The company has five BTS projects underway for an aggregate estimated investment of $197.2 million, of which $60 million was invested as of September 30 (2013). Here is a snapshot of the BTS deals:
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During a recent (Q3-13) earnings call, Lexington's President and CEO, T. Wilson Elgin, remarked:
With respect to growth, we are interested in growing the company, but one of the things that we like about our size is that it doesn't take a gigantic amount of investment opportunity to move the needle for us. So we know if we can find $300 million or $400 million or $500 million worth of new business every year that's good. We're not so big that we have to find $1.5 billion or $2 billion worth of business and the single tenant marketplace is a large one, but the more you have to buy to move the needle the more likely it is that you're probably going to compromise on your underwriting somewhere.
One of Lexington's BTS transactions, a lease to McGuire Woods (900 attorney law firm) in Richmond, Virginia, should provide immediate accretion. The 279,000 square foot office building will cost around $98 million and the initial cap rate (net income dividend by cost) will be around 8%. The lease is 15 years and it will generate 2.5% annual escalations. This project is expected to be completed in the third quarter of 2015.
Also, Lexington recently closed on an extraordinary sale-leaseback deal in New York City. The REIT acquired a portfolio of three parcels of land in New York City consisting of an aggregate of 0.6 acres, which are net leased to tenants under non-cancellable 99-year leases. The purchase price was $302 million and the improvements on these parcels are owned by the tenants under leases and currently consist of three high-rise hotels built in 2010, which contain an aggregate of approximately 480,000 square feet, 103 floors and 1,179 guest rooms.
The hotels are known as the DoubleTree by Hilton Hotel New York City - Financial District, the Sheraton Tribeca New York Hotel and the Element New York Times Square West. The aggregate initial annual rent under the leases is approximately $14.9 million, which represents approximately 4.93% of the purchase price.
The rent under each lease increases by a minimum of 2.0% each year with further annual increases, not to exceed 3.0% per annum in the aggregate, at specified intervals based on the increase in the Consumer Price Index. The total aggregate minimum rent (excluding any additional CPI increases) under the leases over the 99-year term is approximately $4.5 billion.
Although this sale/leaseback deal has lower initial yields, it is a compelling total return opportunity when residual value and rent growth are taken into consideration. I believe this $302 million deal is highly complementary to Lexington's model and although it serves more like a "bond" to the portfolio, the long-term potential should yield enhanced value.
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Lexington, A Work Horse Too
Lexington - my "dark horse" REIT for 2014 - has also been a "work horse" in 2013. By refinancing its debt, Lexington has significantly improved its debt metrics. As of Q3-12 Lexington's debt was $2.040 billion that consists of $283 million of unsecured credit, $64 million of unsecured term loans, $255 million of unsecured term loans, $29 million of convertible notes, $250 million of unsecured bonds, $1.029 billion of mortgages, and $129 million of trust preferred.
Lexington has also a Preferred C issue with a coupon of 6.5%. When combining the preferred ($96.8 million) with the debt ($2.039 billion) and common equity ($2.436 billion), we arrive at Lexington's Total Capitalization of $4.572 billion.
Lexington's balance sheet is as strong as ever. The company has $111.4 million of cash at quarter end (Q3-13), including cash classified as restricted. At quarter end, Lexington had about $1.8 billion of consolidated debt outstanding, which had a weighted average interest rate of 4.8%, of which 96.3% is at fixed rates. Here is a snapshot that illustrates Lexington's improved balance sheet strength:
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Also, Lexington has well-laddered debt maturities as evidenced below:
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Lexington's credit metrics have improved considerably, primarily driven by the company's reduced reliance to secured debt. Here is a snapshot that illustrates Lexington's pattern of secured debt reduction:
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Here is a snapshot of Lexington's debt to market cap that current stands at 41.22% (as of Q3-13):
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Other credit metrics for Lexington have improved during the latest earnings call the company said its "objective is to lower secured debt to 20% or less."
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Part of my bullish sentiment towards Lexington and a reason that I call the REIT a "dark horse" candidate is because I believe the company has a significant opportunity to reduce debt service payments in the future. 2013 through 2015 balloon debt maturities for Lexington total $410 million at a weighted-average rate of 5.4% with a current pay rate of 8.5%.
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In 2013 Lexington obtained a $250 million, 5-year term unsecured financing with current interest at LIBOR plus 135 bps. Also, this year (2013) Lexington issued $250 million of 10-year unsecured bonds with a fixed interest rate of 4.25%. By continued to refinance debt in 2014 Lexington should benefit from considerable costs savings and drive earnings per share higher.
I'm Going to Ride This Dark Hors
For the latest quarter (Q3-13) Lexington's funds from operations (or FFO) was $0.25 per share. The initial average yield on investments in the year was approximately 6.1% and 12% on a GAAP basis. As noted above Lexington is building its pipeline for 2014 and 2015 and by further recycling capital and trimming non-core assets from the portfolio, Lexington should generate outsized returns in 2014. As the CEO, W. Wilson Elgin, explained (on the latest earnings call):
In 2014, we will continue to look at capital recycling opportunities as part of the ongoing effort to further transform our portfolio with a greater emphasis on office dispositions. One of our objectives is to get better balance between office and industrial revenue in the part of our portfolio that has lease term shorter than ten years.
Elgin went on to say:
It's been an exceptional nine months for Lexington, where our successes so far outweighed our challenges.
As the FAST Graph (below) illustrates, prior to the Great Recession, Lexington was able to generate strong cash flow and Funds from Operations (or FFO); however, when the financial meltdown and weakened credit markets worsened, Lexington's cash flows suffered. Upon further examination, we can see that Lexington was forced to make a significant dividend cut in 2009.
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However, post-Recession, Lexington has started to rebuild its dividend. Here is a snapshot of the company's dividend history:
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While other Triple Net REITs either paid or maintained its dividend during the Great Recession, Lexington did not.
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Since the drastic cut (in dividend) in 2009 Lexington has begun to improve considerably.
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So while Lexington is not as "well-liked" (by Mr. Market) as the larger "dividend champions", the FAST Graph below provides an illustration of an opportunity! That is, a stock that can be purchased with a margin of safety. Much like a "dark horse", by getting in at the bottom, the investment may produce better returns than getting in at the top.
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Look ahead to 2014 and beyond, Lexington appears to be a very attractive opportunity - one in which I can invest in a stable asset class (triple net REITs) that pays an attractive dividend yield (6.49% today). Compared with the other Triple Net REITs, that's above average. But also keep in mind that Lexington has a conservative FFO payout ratio of 60% and I expect to see the company grow its dividend.
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Finally, picking a "dark horse" REIT is kind of like picking a bottom. In other words, I don't claim to be a market timer and instead I have picked Lexington as a "dark horse" REIT because I believe that the principal is safe and over the long term, I believe the shares will out-perform.
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Picking a "dark horse" and picking a stock are similar in that they both require the ability to go "against the herd" and to risk being called a "dummy" from time to time. In the case of Lexington, I believe the facts are sound and at $10.17 (recent close) I like my chances with this "dark horse".
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Ben Graham once remarked that earnings are the principal factor driving stock prices and I believe that Lexington could grow by 45% in 2014 and combined with the healthy 6.5% dividend yield, the $10.16 priced shares could be the "needle in the haystack". No guarantees, but a 50% total return is something special and that's why I'm picking Lexington as my "dark horse" for 2014. Amanda Marshall said it best, "My money's riding on this dark horse, baby. My heart is sayin' it's the lucky one and its true color's gonna shine through someday if we let this, let this dark horse run."
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Source: SNL Financial, FAST Graphs, and LXP Investor Presentation.
REITs mentioned: (NNN), (STAG), (SRC), (EPR), (MNR), (ADC), (CSG), and (OLP).
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 long O, ARCP, CSG, UMH, STAG, DLR, VTR, HTA, HCN, CBL, ROIC. 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. (More...)
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