With the sudden increase in interest rates, investors are beginning to worry about financial stocks. Last year was particularly hard on the real estate investment trust (REIT) sector. Apartment, retail, and office REITs all had issues with struggling tenants and vacancies. The triple-net lease REITs, including STORE Capital (STOR +0.00%), seemed to weather the storm a little better than most given their tenant mix and business model. Now that rates are increasing, what does the future look like for this sector?
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Triple-net lease REITs have a different business model
The triple-net lease REITs generally focus on stand-alone properties, where a single tenant occupies a space and is responsible for insurance, taxes, and maintenance. These leases are generally longer-term and have automatic rent escalators. STORE Capital (the STORE stands for Single Tenant Operational Real Estate) has a heavy focus on service industries, with restaurants and child education as the biggest industry concentration. This is a bit different from Realty Income, which has a higher focus on nondiscretionary retail.
STORE recently reported fourth-quarter 2020 revenue of $173 million, which was flat compared to a year ago. For the full year, revenue rose 4.3% to 694.3 million. Adjusted funds from operations (AFFO, what REITs use for earnings) rose 1.1% to $463 million, but AFFO per share declined from $1.99 to $1.83 due to a share issue. Increased income from new tenants were offset by COVID-19 expenses and rent deferrals.
Despite COVID, occupancy rates remain high
STORE's occupancy rate was extremely strong at the end of the year, with only nine vacancies. This works out to be a 99.7% occupancy rate. Cash rental collections in the fourth quarter were 90%, but they are improving, with a 93% collection rate in February. Rent deferrals in the fourth quarter came to $5.8 million, which was a decrease from $13 million in the third quarter. Rent deferral repayments began accelerating in the fourth quarter.
STORE's revenue increase was driven largely by acquisitions. Total property locations rose from 2,504 on Dec. 31, 2019, to 2,634 at the end of 2020. Customer count rose from 478 to 519. Total investment activity in 2020 was $1.09 billion, consisting of 214 properties with an average capitalization rate of 8.1%. Cap rate is the expected income from a property, as a percentage of the total investment. That said, cap rate isn't the whole story; these long-term leases often have rent escalators, which adds to the return.
What happens when rates rise?
The big concern with these sorts of REITs is what happens when interest rates begin to rise. There are two sides to the story. On one hand, you have to think about cap rates and rent escalators, which is the revenue side of the ledger. On the other side will be borrowing costs. Last year, borrowing costs were extremely low due to interest rate actions by the Fed. This will likely reverse in 2021.
That said, the reason for rising rates is investor expectations of a V-shaped recovery, where the second half of the year sees high growth as the COVID-19 pandemic fades. For a business like STORE, this isn't a bad thing; it is a good thing since it means its tenants will be in better shape. In fact, on the earnings conference call, CEO Chris Volk said the company would welcome higher rates:
So we borrowed money at 2.75%, we put out the money at 8.10%. So you're talking north of 500 basis points, which is historically wicked high. If this year, it comes in as a result of that, that's OK. There's plenty of room for solid return on equity, and we'd like to see rates go a little bit higher if [it] were up to us.
STORE reaffirmed its November guidance, with projected acquisition volume of $1.0 to $1.2 billion and a cap rate around 7.7%. 2021 AFFO per share is expected to be within a range of $1.90 to $1.96. At the midpoint, that works out to be an increase of 5.5% compared to 2020.
STORE Capital pays a $0.36 dividend, which works out to a 4.4% yield at Thursday's closing price. With the company's AFFO per-share guidance of around $1.93, this is a 75% payout ratio, which is certainly not stretched; it also indicates that the company has room to hike the dividend. STORE Capital is trading at almost 17 times the midpoint of 2021 guidance, which is reasonable for a triple-net REIT.
Is it a buy? Certainly Warren Buffett thinks so, given that Berkshire Hathaway owns more than 9% of outstanding shares. Income investors might find the stock attractive, too.
