In business it pays to focus, but if you focus too much, a lack of diversification can end up being a huge risk factor. Four Corners Realty Trust (FCPT 1.59%) is a case in point, thanks largely to the way it became a publicly traded company. However, it has been working on the issue and, slowly, moving in what is likely to be a much better direction for its portfolio.
The "Olive Garden" of my eye
The tortured play on words in that subhead is because Darden Restaurants (DRE) had long found value in owning the restaurants it operated. But it ran into some financial troubles a while back, and activist investors started to get mouthy. One suggestion was to stop serving customers as many breadsticks (that's not a joke). Another was to spin off the properties it owned as a real estate investment trust (REIT) and for Darden to become a tenant. Which is exactly what happened in late 2015 (as for the breadsticks, ask for more and you'll likely still get them).
Image source: Getty Images.
It's not uncommon for REITs to be spun out from operating companies that own property, but there is one major problem for investors in these transactions. When a company spins off its properties as a REIT, then the REIT tends to have a very small number of customers. In this case, Four Corners started out with 424 restaurant properties with 98.5% of them leased to Darden subsidiaries. That's a lot of concentration on both the industry and customer fronts.
In fact, for most investors, that's probably too much concentration given that there are plenty of other REITs that don't have so many eggs in just one basket. Four Corners was cognizant of the issue and started to diversify away from Darden as best it could -- one property at a time.
Where things stand
At the end of the third quarter of 2021, Four Corners' portfolio stands at 886 properties. During the quarter it bought 53 properties. Darden restaurants have gone from, basically, the entire portfolio to around 60% of rents. Olive Garden is still the biggest tenant, representing 45% of rents, with Longhorn Steakhouse and other smaller Darden concepts making up the rest of the Darden exposure. In fairness, given where the REIT started, that's a material amount of progress in six years or so.
The next big brand in the portfolio is Chili's, which makes up 9% of rents. Another 44 restaurant brands collectively make up 22%. Four Corners announces every single acquisition it makes, no matter how small, so that shareholders are well aware of what's going on here. In fact, between the third quarter's end and the time of this writing, the REIT had already announced another six acquisitions. And that list is actually quite telling.
But there's another important shift taking shape here as well. Although there are restaurant locations in the mix of recent acquisitions, there's also a couple of healthcare-related assets (an urgent care clinic, for example), a pair of auto-related properties (body shops), and a bank. All are retail-focused properties, so Four Corners isn't suddenly buying medical offices or something like that. But shifting beyond restaurants provides important diversification and is, as management noted in Four Corners' third-quarter 2021 earnings conference call, a purposeful effort. Non-restaurant properties were around 8% of rents at the end of the third quarter.
Is it safe yet?
There's plenty of work that needs to be done with the portfolio on the diversification front, noting the still-massive exposure to just one tenant and one property sector. However, Four Corners is clearly aware of the issue and, importantly, working on multiple paths to address it. For more aggressive investors, the progress being made here could be enough to justify doing a deep dive on this REIT. Notably, it has been growing rapidly, including rewarding investors with regular dividend increases as it works on the diversification problem.
That said, more conservative types should probably continue to take a wait-and-see attitude. Yes, a lot of heavy lifting has been done, but the nearly 60% share price drop in the early days of the pandemic shutdown in 2020 was largely a result of Four Corners' concentrated portfolio and notably worse than the drop experienced by the average REIT, using Vanguard Real Estate ETF as a proxy. In fact, while the average REIT is just about back to where it started out in 2020, Four Corners is still more than 10% below that level.
