How Big Is American Realty Capital Properties Inc's Diversification Problem?

American Realty Capital Properties (NYSE: VER  ) has grown up fast over the last couple of years. And now it's just agreed to buy so many Red Lobster properties that the chain will make up over 12% of its rent roll. That's a concentration risk, to be sure, but how does that compare to competitors like Realty Income (NYSE: O  ) and National Retail Properties (NYSE: NNN  ) ? The answer might surprise you.

OK, that's big!
To start any discussion of customer diversification as it relates to American Realty Capital Properties, you have to admit the obvious: Red Lobster accounting for 12.2% of this real estate investment trust's (REIT) total rents is a clear concentration risk. There's no question about it. However, stepping back to look at that risk from just a little further away can change your perception.

For example, the number two customer at American Realty Capital Properties accounts for just 3.5% of the REIT's rents. Realty Income has five customers that each account for more than that. In fact, each of Realty Income's top three lessees provide 5% or more of the company's rent roll. (The next two come in at 4.7% and 4.6%, respectively.)

(Source: I, Laslovarga, via Wikimedia Commons)

National Retail Properties, meanwhile, has seven customers that provide 3.5% or more to the top line. The range goes from 5% for the largest lessee to 3.5% for the seventh largest.

So while Red Lobster will be a disproportionally large customer at American Realty Capital Properties, the rest of the REIT's portfolio is actually much more diversified. And having large customers isn't unusual, as both Realty Income and National Retail Properties show.

What about the top 10?
And that's where things start to get interesting. Realty Income's top five customers account for roughly 25% of its top line. The top five at National Retail Properties comes in at 22.5%. At American Realty Capital Properties that number is right in the middle at 23.4%. And that includes the 12.2% of rent provided by Red Lobster.

Pushing out to the top 10 shows an even more interesting picture. At American Realty Capital Properties the top 10 customers account for 32.3% of rents. At Realty Income the top 10 is 37.6%. And at National Retail Properties it's 38.8%. So, in some ways, Realty Income and National Retail Properties are both less diversified than American Realty Capital Properties.

And that's true despite the fact that American Realty Capital Properties gets 12.2% from just one customer. So, in reality, diversification here depends somewhat on how it's defined. And that puts American Realty Capital Properties' portfolio into a somewhat better light.

The elephant in the room
So for investors enticed by American Realty Capital Properties' relatively juicy yield of around 8.4%, compared to Realty Income's 5% and National Retail Properties' 4.5%, diversification may not be as big a concern as it first appears. However, the elephant in the room is still Red Lobster.

(Source: Joachim Beuckelaer, via Wikimedia Commons)

American Realty Capital Properties will definitely be hit hard if Red Lobster has problems. And since the chain is being sold because, well, it's having problems, you can't ignore Red Lobster.

That said, the chain has around 700 locations and the REIT is only buying 500 of them. Presumably, it is only buying the best performing and/or located properties.

Moreover, the deal was structured with lease pools and a master lease. Thus, Red Lobster should find it hard to ditch out of individual locations without upsetting the broader relationship. However, this same structure might also make it more difficult for American Realty Capital Properties to sell off individual properties.

And even if it can start to trim its Red Lobster exposure, this one relationship is likely to remain a big top line contributor for years to come. Worse, with Red Lobster being sold to a private equity shop, public information could be increasingly difficult for investors to find on what is American Realty Capital Properties' largest customer.

At the end of the day, there is clearly concentration risk here, but it is really all about Red Lobster. Pulling out to the top ten shows that American Realty Capital Properties is no different than its peers.

While conservative investors might want to avoid this REIT, more aggressive types should consider this a buying opportunity, while making sure to keep a close eye on Red Lobster's turnaround progress.

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Reuben Brewer

Reuben Gregg Brewer believes dividends are a window into a company's soul. He tries to invest in good souls.

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