On the lead page of EPR Properties' (EPR -0.32%) third-quarter 2023 investor presentation are pictures of people playing golf, at a waterpark, and riding in a go-cart. That sums up the real estate investment trust's (REIT's) focus on experiential properties, but it hides an important fact about the company and its future. Here's why EPR isn't going to be the same company it is today in five years' time.
EPR is focused on bringing people together
During the early days of the coronavirus pandemic, there was a great deal of uncertainty. That led governments around the world to, effectively, shut their economies down in an effort to limit the spread of the illness. A particular effort was put toward social distancing since COVID-19 was spreading quickly in group settings. EPR's portfolio is filled with assets that bring people into groups for fun. To ensure that it could survive this period, EPR suspended its dividend, which was probably a very good idea.
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That was a long time ago now, and EPR's tenants are back open again. Most of its lessees are doing better now than before the pandemic, with rental coverage of 2.6 times today compared to 2.0 times in 2019. That's great news, but there's one specific group that's still struggling -- movie theaters. Rent coverage for theaters is just 1.4 times right now, down from 1.7 times in 2019.
That's a bigger problem than it may seem like, because movie theaters account for roughly 39% of the REIT's business. Think about that for a second -- roughly 40% of EPR's portfolio is underperforming. That is the single largest exposure to an industry that the REIT has in its portfolio. Something needs to be done about that, and that fact isn't lost on management.
Change is in the air at EPR
EPR's stated long-term goal is to reduce its exposure to movie theaters. That's the right plan, and investors should be pleased to hear it. There's just one problem: It has a lot of work to do before that exposure can be materially reduced.
For starters, there are still some movie theater operators that are struggling. EPR has reworked some leases with big tenants, but there's likely more work to be done on this front. It has 19 tenants in the theater business. Such negotiations aren't easy and take time. In other words, investors shouldn't expect quick action here.
Then there's the sheer size of the theater business in the portfolio. While EPR could sell assets, it would be hard to sell down that many assets (it owns 169 theater properties) without disrupting the company's overall business in a negative way. Spinning the theaters off would be similarly difficult, and it is unlikely that investors would be too happy with the move, given the troubles facing the theater properties.
In other words, it seems most likely that a slow and steady reduction will be the order of the day. After all, there are likely to be some worthwhile diamonds in the rough that EPR will want to keep. So, in five years, EPR's portfolio will probably look drastically different than it does today, with movie theater exposure much reduced. While the change may come in fits and starts, it probably won't be an overnight shift. But as theaters become less important, investors are likely to reevaluate their opinion of EPR in a positive direction.
EPR is already starting to look better
EPR isn't a slam-dunk investment, given that there's material execution risk ahead as it looks to shrink its single largest property exposure. That said, the dividend is back and has been increased twice. The adjusted funds from operations (FFO) payout ratio was a fairly modest 55% or so in the third quarter, which suggests management is being reasonably conservative with the dividend. Yet the yield is a very attractive 7%.
If you can stomach a little uncertainty as EPR works to adjust its portfolio, it seems likely that the changes over the next five years will be good news for the stock price. And you can collect a well-covered dividend while you wait out the overhaul.
