AMERICAN REALTY CAPITAL TRUST ARCT W
July 12, 2012 - 4:52pm EST by
gary9
2012 2013
Price: 10.73 EPS $0.805 $0.82
Shares Out. (in M): 159 P/E 13.3x 13.1x
Market Cap (in M): 1,701 P/FCF 13.3x 13.1x
Net Debt (in M): 864 EBIT 65 67
TEV: 2,587 TEV/EBIT 40x 39x

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  • Special Situation
  • Discount to Peers
  • Triple net REIT
  • Underfollowed
  • Broken IPO
 

Description

LONG American Realty Capital Trust (ARCT)

Stock Price: $11

Market Cap: $1.7 b

Dividend Yield: 6.5%

Average Daily Value Traded: $15 mm

 

Thesis

 

ARCT is a Joel Greenblatt “special”; it is a long because it trades at a significant discount to comparable triple net lease REIT’s due to technical reasons around how the company became publicly traded. We expect the stock to re-rate to valuation levels closer to its comps over the next 3 months due to increased awareness of the stock through index inclusions and sell side initiations and IR effort, and more importantly, the incentive of the management team to get the stock price higher by mid-October due to how their deferred compensation vests.

 

At $11, ARCT currently trades at a 7.0% cap rate and a 6.5% dividend yield. Our price target is $14 (30% ups) which is equal to a 6.0% cap rate and a 5.0% dividend yield. This compares to Realty Income (O) which trades at a 5.75% cap rate and a lower 4.2% dividend yield, even though ARCT has a much higher quality real estate portfolio than O.

 

In addition to an outright long of ARCT, we also think a hedged position by shorting O is an attractive opportunity. Both are triple-net lease REIT’s and both pay a monthly dividend…the discount in valuation has to narrow.

 

 

Business Description

 

ARCT is a real estate portfolio of 485 properties covering 15.6 mm sqft leased out on a triple net basis with an average duration of 13.5 years. Less than 1% of the rent roll comes up for renewal before 2018 with average rent increases of ~1.5% annually. 70% of the rent comes from IG-rated tenants and there is no problem credits in the portfolio currently. The top 3 credits represent 1/3rd of the total rent and are Fedex, Walgreens, and CVS. Current leverage is ~35% LTV. In other words, this is a low risk, steady cash flow real estate portfolio. 

 

 

Reason for Mispricing

 

ARCT was conceived as a private REIT in 2009 to put together a collection of low risk cash flows for dividend-oriented retail investors. ARCT raised $1.9 b of equity over 3 years in ~$50k checks from 40,000 individuals through the different retail advisory platforms. As part of the deal, ARCT was required to have a liquidity event for shareholders in late 2012. Through 2011 and early 2012 management explored various alternatives such as selling the entire portfolio in 1 transaction or in chunks as well as taking ARCT public. Ultimately, management decided to list ARCT on the NYSE but NOT raise capital through a typical IPO process because they did not need additional capital and the price talk from the underwriters was less than management’s view of fair value and therefore dilutive to their existing shareholders.

 

Management instead decided to list ARCT shares on an exchange and allow for the price to settle out on its own. This created a similar dynamic to when new equity is issued to creditors in a reorganization and just begins trading without the marketing support of a sponsored IPO to create demand for the security. Much like when you have previous creditors selling their new equity, in ARCT’s case you had retail investors taking advantage of their first liquidity opportunity by selling their shares on the NYSE. Management did try to set a floor on the stock by executing a dutch tender for 12% of the shares out at $10.50 which was over-subscribed and pro-rated.

 

This chain of events has resulted in few investors knowing of ARCT’s existence and excess supply of stock for sale, resulting in the supply/demand imbalance that has contributed to the current undervaluation. The stock listed March 1st and has traded in a range between $10-$11/share for the last 4 months. $10-$11 was cheap to comps in March and has only widened since then as O and NNN have rallied 7-14% while ARCT has been stagnant.

 

 

Valuation

 

ARCT currently trades at a 7.0% cap rate, 6.5% dividend yield, and 13.5x FFO.

 

O currently trades at a 5.6% cap rate, 4.2% dividend yield, and 20.5x FFO.

 

Our target price for ARCT of $14/share uses a slight discount in cap rate to O (and higher dividend yield) even though ARCT has a higher quality portfolio than O. 70% of ARCT tenants are IG-rated (O is less than 20%), ARCT has no credit issues (O has had several top 10 tenants file BK in the last few years), ARCT has less than 1% of NOI renewing in the next 5 years (O has 19% renewing), ARCT has 100% occupancy (O has 97%), both companies have similar leverage, and both pay out a MONTHLY dividend.

 

 

Catalysts

 

Increased investor awareness will come from 1) index inclusions  2) sell side initiations and  3) an aggressive IR effort from the company. ARCT was added to the Russell 2000 last month and should be added to the RMZ index in Q4. 3 boutique sell side firms have initiated coverage of ARCT and the company expects several bulge brackets will initiate before the end of the year.

 

More importantly, management is highly incentivized to see that the stock price of ARCT appreciates by mid-October. Their incentive compensation while ARCT was a private REIT was a 15% carried interest after a 6% hurdle rate, paid out once value was crystallized. This arrangement was restructured in the process of listing ARCT as a more permanent vehicle. Management will get paid their prior carry that has been deferred based on the following formula: take the average price of the stock for the 30 trading days period immediately after 180 regular days from listing (3/1), subtract the NAV (of the initial shareholders) which is $9.81/share, multiply by the shares out before the buyback, and multiply by 15%. This formula closely replicates their prior deal, but instead of using the “crystallized value” as if the assets were sold, they will use the average price of the stock as a proxy for this value. As an example, if the average price of the stock in September is $12/share, management will get paid out $58 mm. For every additional $1 they can get the stock price, management will get an additional $26.7 mm.

 

 

Management

 

ARCT was formed by Nick Schorsch who has a large presence in the private REIT space. Some investors have a negative bias towards Schorsch because he was the founder and CEO of American Financial Realty (AFR) which was a REIT that massively over-promised and under-delivered from 2003-2007.

 

We have diligenced the AFR experience and Schorsch himself and are still comfortable investing with him in ARCT for several reasons: 1) Schorsch left AFR in 2006 before the particularly bad decision-making around diversifying the portfolio ended up destroying a lot of shareholder value  2) Schorsch understands the lack of focus is what investors are concerned about and has been emphatic that the only thing ARCT will be doing is buying long-duration single-tenant cash flows and paying out a monthly dividend  3) most importantly, Schorsch’s incentives are aligned with ours: management will be paid more money if the share price is higher. Like us, they believe the stock is undervalued and have been personally buying shares on the open market. The company has also bought back shares through a tender offer that was completed at $10.50 when the stock was first listed; this was used as a way to make sure liquidity was provided to previous investors who wanted to exit, but also had the effect of taking out 12% of the shares at what we believe was an attractive price.

 

 

Risks

 

The main risk is that valuations for triple net REIT’s decline. Importantly, the private market value of these assets is below where the public markets trade the stocks…private market is an average cap rate of ~7.5% for ARCT and higher for O. This risk is easy to hedge against shorting O.

 

ARCT may always trade with a management-discount because we are not being skeptical enough of Schorsch or management is not able to convince some investors that ARCT is not another AFR.

 

Catalyst

Increased investor awareness will come from 1) index inclusions  2) sell side initiations and  3) an aggressive IR effort from the company. ARCT was added to the Russell 2000 last month and should be added to the RMZ index in Q4. 3 boutique sell side firms have initiated coverage of ARCT and the company expects several bulge brackets will initiate before the end of the year.

 

More importantly, management is highly incentivized to see that the stock price of ARCT appreciates by mid-October. Their incentive compensation while ARCT was a private REIT was a 15% carried interest after a 6% hurdle rate, paid out once value was crystallized. This arrangement was restructured in the process of listing ARCT as a more permanent vehicle. Management will get paid their prior carry that has been deferred based on the following formula: take the average price of the stock for the 30 trading days period immediately after 180 regular days from listing (3/1), subtract the NAV (of the initial shareholders) which is $9.81/share, multiply by the shares out before the buyback, and multiply by 15%. This formula closely replicates their prior deal, but instead of using the “crystallized value” as if the assets were sold, they will use the average price of the stock as a proxy for this value. As an example, if the average price of the stock in September is $12/share, management will get paid out $58 mm. For every additional $1 they can get the stock price, management will get an additional $26.7 mm.

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    Description

    LONG American Realty Capital Trust (ARCT)

    Stock Price: $11

    Market Cap: $1.7 b

    Dividend Yield: 6.5%

    Average Daily Value Traded: $15 mm

     

    Thesis

     

    ARCT is a Joel Greenblatt “special”; it is a long because it trades at a significant discount to comparable triple net lease REIT’s due to technical reasons around how the company became publicly traded. We expect the stock to re-rate to valuation levels closer to its comps over the next 3 months due to increased awareness of the stock through index inclusions and sell side initiations and IR effort, and more importantly, the incentive of the management team to get the stock price higher by mid-October due to how their deferred compensation vests.

     

    At $11, ARCT currently trades at a 7.0% cap rate and a 6.5% dividend yield. Our price target is $14 (30% ups) which is equal to a 6.0% cap rate and a 5.0% dividend yield. This compares to Realty Income (O) which trades at a 5.75% cap rate and a lower 4.2% dividend yield, even though ARCT has a much higher quality real estate portfolio than O.

     

    In addition to an outright long of ARCT, we also think a hedged position by shorting O is an attractive opportunity. Both are triple-net lease REIT’s and both pay a monthly dividend…the discount in valuation has to narrow.

     

     

    Business Description

     

    ARCT is a real estate portfolio of 485 properties covering 15.6 mm sqft leased out on a triple net basis with an average duration of 13.5 years. Less than 1% of the rent roll comes up for renewal before 2018 with average rent increases of ~1.5% annually. 70% of the rent comes from IG-rated tenants and there is no problem credits in the portfolio currently. The top 3 credits represent 1/3rd of the total rent and are Fedex, Walgreens, and CVS. Current leverage is ~35% LTV. In other words, this is a low risk, steady cash flow real estate portfolio. 

     

     

    Reason for Mispricing

     

    ARCT was conceived as a private REIT in 2009 to put together a collection of low risk cash flows for dividend-oriented retail investors. ARCT raised $1.9 b of equity over 3 years in ~$50k checks from 40,000 individuals through the different retail advisory platforms. As part of the deal, ARCT was required to have a liquidity event for shareholders in late 2012. Through 2011 and early 2012 management explored various alternatives such as selling the entire portfolio in 1 transaction or in chunks as well as taking ARCT public. Ultimately, management decided to list ARCT on the NYSE but NOT raise capital through a typical IPO process because they did not need additional capital and the price talk from the underwriters was less than management’s view of fair value and therefore dilutive to their existing shareholders.

     

    Management instead decided to list ARCT shares on an exchange and allow for the price to settle out on its own. This created a similar dynamic to when new equity is issued to creditors in a reorganization and just begins trading without the marketing support of a sponsored IPO to create demand for the security. Much like when you have previous creditors selling their new equity, in ARCT’s case you had retail investors taking advantage of their first liquidity opportunity by selling their shares on the NYSE. Management did try to set a floor on the stock by executing a dutch tender for 12% of the shares out at $10.50 which was over-subscribed and pro-rated.

     

    This chain of events has resulted in few investors knowing of ARCT’s existence and excess supply of stock for sale, resulting in the supply/demand imbalance that has contributed to the current undervaluation. The stock listed March 1st and has traded in a range between $10-$11/share for the last 4 months. $10-$11 was cheap to comps in March and has only widened since then as O and NNN have rallied 7-14% while ARCT has been stagnant.

     

     

    Valuation

     

    ARCT currently trades at a 7.0% cap rate, 6.5% dividend yield, and 13.5x FFO.

     

    O currently trades at a 5.6% cap rate, 4.2% dividend yield, and 20.5x FFO.

     

    Our target price for ARCT of $14/share uses a slight discount in cap rate to O (and higher dividend yield) even though ARCT has a higher quality portfolio than O. 70% of ARCT tenants are IG-rated (O is less than 20%), ARCT has no credit issues (O has had several top 10 tenants file BK in the last few years), ARCT has less than 1% of NOI renewing in the next 5 years (O has 19% renewing), ARCT has 100% occupancy (O has 97%), both companies have similar leverage, and both pay out a MONTHLY dividend.

     

     

    Catalysts

     

    Increased investor awareness will come from 1) index inclusions  2) sell side initiations and  3) an aggressive IR effort from the company. ARCT was added to the Russell 2000 last month and should be added to the RMZ index in Q4. 3 boutique sell side firms have initiated coverage of ARCT and the company expects several bulge brackets will initiate before the end of the year.

     

    More importantly, management is highly incentivized to see that the stock price of ARCT appreciates by mid-October. Their incentive compensation while ARCT was a private REIT was a 15% carried interest after a 6% hurdle rate, paid out once value was crystallized. This arrangement was restructured in the process of listing ARCT as a more permanent vehicle. Management will get paid their prior carry that has been deferred based on the following formula: take the average price of the stock for the 30 trading days period immediately after 180 regular days from listing (3/1), subtract the NAV (of the initial shareholders) which is $9.81/share, multiply by the shares out before the buyback, and multiply by 15%. This formula closely replicates their prior deal, but instead of using the “crystallized value” as if the assets were sold, they will use the average price of the stock as a proxy for this value. As an example, if the average price of the stock in September is $12/share, management will get paid out $58 mm. For every additional $1 they can get the stock price, management will get an additional $26.7 mm.

     

     

    Management

     

    ARCT was formed by Nick Schorsch who has a large presence in the private REIT space. Some investors have a negative bias towards Schorsch because he was the founder and CEO of American Financial Realty (AFR) which was a REIT that massively over-promised and under-delivered from 2003-2007.

     

    We have diligenced the AFR experience and Schorsch himself and are still comfortable investing with him in ARCT for several reasons: 1) Schorsch left AFR in 2006 before the particularly bad decision-making around diversifying the portfolio ended up destroying a lot of shareholder value  2) Schorsch understands the lack of focus is what investors are concerned about and has been emphatic that the only thing ARCT will be doing is buying long-duration single-tenant cash flows and paying out a monthly dividend  3) most importantly, Schorsch’s incentives are aligned with ours: management will be paid more money if the share price is higher. Like us, they believe the stock is undervalued and have been personally buying shares on the open market. The company has also bought back shares through a tender offer that was completed at $10.50 when the stock was first listed; this was used as a way to make sure liquidity was provided to previous investors who wanted to exit, but also had the effect of taking out 12% of the shares at what we believe was an attractive price.

     

     

    Risks

     

    The main risk is that valuations for triple net REIT’s decline. Importantly, the private market value of these assets is below where the public markets trade the stocks…private market is an average cap rate of ~7.5% for ARCT and higher for O. This risk is easy to hedge against shorting O.

     

    ARCT may always trade with a management-discount because we are not being skeptical enough of Schorsch or management is not able to convince some investors that ARCT is not another AFR.

     

    Catalyst

    Increased investor awareness will come from 1) index inclusions  2) sell side initiations and  3) an aggressive IR effort from the company. ARCT was added to the Russell 2000 last month and should be added to the RMZ index in Q4. 3 boutique sell side firms have initiated coverage of ARCT and the company expects several bulge brackets will initiate before the end of the year.

     

    More importantly, management is highly incentivized to see that the stock price of ARCT appreciates by mid-October. Their incentive compensation while ARCT was a private REIT was a 15% carried interest after a 6% hurdle rate, paid out once value was crystallized. This arrangement was restructured in the process of listing ARCT as a more permanent vehicle. Management will get paid their prior carry that has been deferred based on the following formula: take the average price of the stock for the 30 trading days period immediately after 180 regular days from listing (3/1), subtract the NAV (of the initial shareholders) which is $9.81/share, multiply by the shares out before the buyback, and multiply by 15%. This formula closely replicates their prior deal, but instead of using the “crystallized value” as if the assets were sold, they will use the average price of the stock as a proxy for this value. As an example, if the average price of the stock in September is $12/share, management will get paid out $58 mm. For every additional $1 they can get the stock price, management will get an additional $26.7 mm.

    Messages


    SubjectRequired Liquidity Event
    Entry07/16/2012 09:15 PM
    Memberquads1025
    Nice write-up.  Like this idea.  Thank you for posting.
     
    Quick question - You mentioned under the heading "Reason for Mispricing" that ARCT was required to have a liquidity event for shareholders in late 2012 and this basically forced the company to IPO.  I've been digging for many hours now through ARCT's public documents and can't find any mention of this requirement.  Is there a SEC document which contains the details on this?  If you could specify the filing (8-K, 10-Q, etc.), filing date, and section with relevant text that would be very helpful.
     
    Reason I ask is I just want to verify that this was a pre-agreed liquidity event or this was the result of Obama changing the tax law such that dividends would be taxed at 30% starting Jan 1, 2013 and shareholders wanted liquidity before then.

    SubjectQuestions
    Entry08/23/2012 02:43 PM
    MemberWains21
    gary9-
     
    I like this idea and have started to do some work on it.  I'm not through all of the material yet but have some initial questions that have come up.  Would love to hear your views:
     
    1.  Why is ARCT able to acquire recent properties at a cap rate equal to 8.66% vs O's 7.2%?  I would be surprised if the answer was simply ARCT can buy things cheaper.   Any help?
     
    2.  I'm a little confused on the payout due ARC.  From what I read on pg 18 of the 6/30/12 10Q, ARC is due 15% multiplied by the Amount over $9.81.    The Amount is equal to the average share price PLUS "all distributions made between May 2008 and March 2012", which essentially would count all dividends paid.  If that's the case, the amount due ARC could be much greater than the $58MM you calc'ed, unless I'm missing something.   

    SubjectRE: RE: Questions
    Entry09/05/2012 03:25 PM
    MemberWains21
    gary9-
     
    Thanks for the responses.  I was actually able to get in touch with the company and have some additional color to share.
     
    For the first question, to my surprise, they actually had some good reasons that they were acquiring companies at a better cap rate.  Hard to prove these are true without a seat in each negotiating room, but the following is what they said:
     
    i) they acquire properties in "onesies and twosies" as opposed to O who has to acquire large portfolios to move the needle.  This allows them to handpick which properties they want.  Typically it's "main on main" meaning they acquire one or all of the four corners of a main intersection in a "secondary or tertiary" city.  In other words, they buy the Walgreen's, the fast food chain, the dollar store and the bank on a suburban main street in Hartford or Boise and stay away from the "trophy properties" in major urban centers.
     
    ii) they will work with big IG companies like FedEx on a new site for say a distribution center and will basically agree to buy a piece of property before the building is built.  This gives the developer cover with the seller and the bank to go ahead and build with a contract in hand that ARCT will buy the property once the building is finished.  For their trouble, ARCT will negotiate a better cap rate then they would be able to get if the buidling was already developed.
     
    For the second question, you're correct, it's whatever the average stock price is for those 30 trading days over $9.81.  They admitted the language was written poorly, but it was meant to say the dividends paid between May 2008 and March 2012 were included in the $9.81.  I asked them for back-up numbers for the $9.81, they politely refused as they haven't released those to the market.
     
    One last interesting thing they told me was that all dividends currently are considered "return of capital" and are therefore tax deferred to shareholders.  I suppose one will pay the tax by having a lower basis if/when you sell the stock and have to pay cap gains. I don't totally follow the tax reasons behind this, any thoughts? 

    SubjectRE: RE: RE: ARCT / O: congrats...but
    Entry09/06/2012 09:12 AM
    MemberWains21
    O is getting a seriously good deal which doesn't seem lost on anyone.  Don't want to be overly cynical, but this is very odd timing.  As yarak775 also pointed out, we're right at the beginning of the 30 day window which dictates the size of mgmt's subordinated incentive listing fee (described in gary9's write-up and page 18 of the 10Q).  Mgmt will need to address this, especially if for some reason the transaction doesn't happen.  Frankly I was hoping for a 30-50% increase in the stock over the next couple years as more analysts picked up the name and the stock moved from a 6% div yield to O's 4.2% div yield.  Selfishly, I loaded up a few days ago on ARCT so happy to take my gains and go home, but something isn't quite adding up.
     
    Either way, thanks for the idea gary9, nice work indeed.
     
     

    SubjectRE: RE: RE: RE: RE: RE: ARCT / O: congrats...but
    Entry09/06/2012 10:17 AM
    MemberWains21
    no, the link mojoris posted is actually for a different entity which is managed by ARC, the former manager of ARCT.  ARCT internalized management so is no longer affiliated with ARC.  I wasn't positive either so double checked with the company and they confirmed that was the case.  It's certainly a little confusing.  

    SubjectI don't get it
    Entry09/06/2012 10:08 PM
    Memberyellowhouse
    Here is my summary of the call for those who did more productive things with their day: O said: "we are doing this deal because it's accretive, is better credit quality and has longer term leases than our existing portfolio." ARCT said: "we are doing this deal because it gives our shareholders the privilege of owning O and our stock has gone up a little bit since we did a half ass IPO" Am I alone in being completely perplexed here? How is this in the best interest of anyone (management and shareholders alike) on the ARCT side? Is this part if a plan to solicit a higher bid? I suppose NNN could pay more, but ultimately O has the lowest cost of capital (which Nick Schorsch reminded everyone of many times).

    SubjectRE: I don't get it
    Entry09/06/2012 10:39 PM
    Membermatt366
    Management incentives drove the timing.  O stock should have rallied and I bet they expected it would, but there was a lot of Arb pressure, look at the volume match with arct, and little institutional ownership to step in day 1.  Given the looming index inclusion for arct prior to the deal closing, there is a strong argument for arct owners to vote no at the current price.  I am not even certain arct management would dislike that, despite their voting agreements.  

    SubjectClose out ARCT
    Entry01/17/2013 12:36 PM
    Membergary9
    Closing out position.  O could grind a little higher (it's at a 4.9% pf yield today) but the deal is done and there are better uses of capital from here.  Thanks for the $5,000 VIC!
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