Spirit Realty Capital’s 6.7% Yielding Shares Offer an Excellent Risk/Reward Ratio

Introduction

Since I anticipate that the rate hikes will be coming to an end, and I am building out my fixed income portfolio, I decided to take a closer at the preferred share issued by Spirit Realty. ( SRCspan – class=”paywall full-content invisible “>). Spirit Realty has been the subject of some very insightful articles (here and there). In this article, I will focus specifically on a preferred share investment.

An in-depth look at financial results through the eyes of an investor

Spirit Realty is a Net Lease REIT, and tenants pay a large portion of their property costs. The REIT’s income statements clearly show that the REIT has only $7.2M in property expenses, but $188.3M of total revenue. This indicates that the REIT is earning approximately $181M.

While the $93.6M net income is not important to a REIT, it is significant for two reasons. The bottom line includes the impact from the preferred dividends ($2.6M per quarterly, in this example), and the net income is used to calculate the FFO and AFFO.

You can see in the table below that the total FFO was $127.7M, despite the fact that the gain from the sale of assets had been removed. The FFO per share was $0.90 based on an average of 141.1M diluted shares.

The FFO is $0.90 based on current share counts. The AFFO came in just a little lower at $0.89 per shares. The AFFO on an annualized basis is close to $3.55-3.60 per share, and this is exactly what the REIT has guided for. When it released its first quarter results, it gave a guidance of $3.54-3.60 per share. The stock, which is currently trading just above $39 is only 11 times its anticipated AFFO. This is not bad at all for a REIT with a minimal number of leases expiring in the coming years. You can see that 60% of leases will expire in 2030 and the remaining lease terms are longer than 10 years.

Calculating the FFO and AFFO can provide valuable information about the level of coverage for preferred dividends. The FFO and AFFO calculations already include $2.6M of quarterly preferred dividends. This means that the AFFO prior to making the preferred payments would be 128.5M. This is a very comfortable situation.

We must also be aware of the cost of borrowing. Spirit Realty is taking advantage of cheap debt because it has secured interest rates on 97% of their debt.

The financial statements show that the average weighted cost of debt is approximately 3.36%. This is a very low cost, but it shows that even an increase in debt costs shouldn’t affect preferred dividends. Even if debt costs double to 6.7%, AFFOs will still only drop by 25%. This excludes potential rent increases over the next few year, while Spirit’s cost of debt is expected to increase.

The preferred dividends will be covered even at higher rates of interest. Spirit’s primary task will be to maintain high occupancy rates, as higher interest rates do not pose a threat.

Series A preferred shares: Details

Spirit Realty Capital has only one series of preferred stock. The Series A ( SRC.PA are cumulative and pay a Fixed preferred dividend of $1.50 each year payable in four equal quarter payments of $0.375 each share). Since October of last year, these preferred shares can be called at any time. However, since 6% equity is a bargain and the dividend yields on preferred shares are lower than common shares’ dividends currently being paid out, it would make sense for Spirit not to call the preferred shares. The total value of the 6.9M outstanding preferred shares is just under $175M. As mentioned earlier, the REIT is paying about $2.6M in quarterly preferred dividends.

The excellent coverage ratio for preferred dividends was already mentioned, but I am also interested in the asset-coverage ratio. You can see that Spirit’s total assets are $8.5B, and about $225M of them is goodwill. The total tangible equity amounts to just over $4.3B. If you consider that the total preferred equity is less then $175M there are more than $4.1B in equity ranking junior to preferred shares. This is still a good result, even after subtracting the $300M difference between intangible assets and liabilities.

The book value is also important. The Q1 adjusted NOI is approximately $181M, which is about $725M a year. The current book value for the assets is $7.47B. Therefore, the implied cap (NOI divided by book value) is $9.7%. This is too high for a REIT that leases net. By applying an 8.5% cap, the fair value would be $1B higher than the book value. This provides additional cushion to the preferred shares.

Investment Thesis

The preferred shares have a high asset coverage ratio, and their dividends are safe. (Even if interest costs doubled), it’s easy to make the case that you should just buy the ordinary shares. The preferred shares yield 6.72% at the current price, while the commons yield 6.73% and offer the possibility of capital gains.

A mix of common and preferred shares may make sense, depending on an investor’s risk profile. The preferred dividends seem to be safe, but capital gains are not likely. There is still upside potential in the common shares, which are currently trading for only 11 times AFFO. While the preferred dividends will remain fixed, the payout ratio on common shares is only around 75%. This means that there is plenty of room to increase the distributions.

I do not currently hold any preferred shares or common stocks of Spirit. However, I could buy the preferred and put options on the shares in order to use this “mixed strategy”.