As a value investor, I aim to do good due diligence and rely on my own theories over the opinions of others. But Capital Lease Funding (NYSE:LSE) CEO Paul McDowell pointed out that, in a previous article, I had miscalculated its stock's return; he also said that I had unfairly made allegations toward Capital Lease chairman Lewis Ranieri, of Liar's Poker fame. In an attempt to turn lemons into lemonade, I asked Paul for a phone interview, so that he could share some of his experiences with myself and fellow Foolish readers.
Emil Lee: Please describe your company.
Paul McDowell: Capital Lease Funding is a REIT. We focus on owning commercial real estate properties, subject to long-term leases, with very high-credit-quality tenants -- primarily investment-grade tenants such as the U.S. government. We also provide mortgage financing on net lease properties. Unlike a company like American Financial Realty (NYSE:AFR), which focuses just on financial-services tenants, we focus across the single-tenant spectrum -- so we own and finance properties with retail, bank, commercial office, government and warehouse distribution tenants.
EL: Can you explain to me the pros and cons of single- versus multi-tenant properties?
PM: We focus on single-tenant transactions -- very often, we have a net lease, where the tenant not only occupies the property, but occupies it as if they were the owner. This arrangement allows us to essentially just clip the coupon associated with the transaction. The benefits: A single user takes care of the property, and agrees to pay you net rent on a defined schedule for a very long time.
The downside of single tenant properties is by virtue of having the long-term leases -- you can't raise rents or increase occupancy because you're already at full occupancy. In addition, at expiration, occupancy can go from 100% to 0%. Because of the long-term fixed-rate nature of cash flows, financing those cash flows with the lowest-cost possible cost of debt is the magic to providing value to our shareholders.
While you don't have as much in upside potential, you have very, very, very strong downside protection, given the exceptional credit quality of our tenants and the strong real estate they occupy. This is the type of company that will produce a very strong and stable dividend.
EL: What is the competitive landscape like?
PM: Most of the properties that we buy or finance, the tenant is already in occupancy and has executed a long-term lease. That's not always the case; sometimes the developer will come to us and say the tenant has already agreed to occupy the property, but it still needs to be developed and built. We're typically competing to buy properties against individual investors, quite often pension funds and insurance companies, sometimes foreign buyers -- Australians are particularly active. We sometimes compete against REITs -- Lexington (NYSE:LXP), very infrequently against American Financial Realty, Spirit Finance (NYSE:SFC). For the most part, the competition to buy properties is from pension funds and foreign buyers. We also are the third-party financing source; we provide long-term mortgages.
[Spirit Finance agreed to a buyout from a consortium including Australian investment bank Macquarie. I calculate the Spirit Finance buyout multiple at 17 times trailing funds from operations, and Capital Lease Funding's current trading FFO multiple at 13.]
EL: In college, I interned on a CDO [collateralized debt obligation] team at a hedge fund. Can you talk about that side of your business?
PM: As a general kind of background, one of the unique strengths that LSE has is our financing expertise. I am one of the founders of the company [since 1994] and we were the first ever to securitize net lease mortgage loans in a CMBS [commercial mortgage-backed security] style transaction securitizing, way back in 1997. Later on, we securitized a couple [of] billion dollars' worth of net lease loans. We have a deep financing expertise, [which] helps us when we go to the rating agencies when we're selling bonds. By doing that, we get a very, very low cost of funds.
Our current business model is getting those net lease loans, and getting the lowest cost of funding.
EL: It seems like you guys have very low credit losses.
PM: There were some small credit losses on some subordinate bonds due to Winn-Dixie (NASDAQ:WINN). Very small impact. In our entire history since we founded the company, for every transaction we've ever underwritten, we've only had one transaction go into default [again, because of Winn Dixie's bankruptcy]. I would suggest we have the strongest underwriting track record in the industry.
EL: Would it be fair for me to invert your current 12 times trailing FFO multiple, and say that's an 8% yield on a trailing basis?
PM: [That] 8% number is a pretty good number -- my CFO can give you far better information.
EL: What about internal growth prospects?
PM: In 2005, we added $750 million of assets. In 2006, we added $550 million in assets. For 2007 -- it's a question of what we see in the marketplace. We can do anywhere from $400 million to $1 billion in assets per annum. Historically, we've grown FFO far faster, but for 2007, we have projected growth of around 11%-12% -- as you get bigger, it takes a lot more to move the needle.
EL: Your G&A [general and administrative] costs run you 8% of sales -- how much can you leverage this going forward?
PM: We continue to leverage our G&A -- when we went public, we had 22 people. Now we're getting closer to $2 billion in assets, and we still have 22 people. Our growth in G&A will be dramatically outpaced by our growth in assets, which increases our leverage on G&A. Our cash G&A stayed at about $10 million, while at the same time, we doubled assets -- that was expected, the company had been running for a long time before we went public. We have a bunch of very talented people, and we're seeing [the] positive impact of levering that G&A.
EL: So from what I understand from our conversation, your cash flows are very stable and high-quality due to long term leases. The downside of that is, you can't adjust rents. However, your ability to get match funding -- from CDOs and such -- mitigates your interest rate risk?
PM: The match funding mitigates interest rate risk -- we lock in very high-quality, very long-term quality cash flows from our leases. Our portfolio has a bond-like nature to it -- long-term, fixed-rate, very high quality. I'm not going to be able to report next year that our vacancy went down 10%, and rent rates were up 10%. [Conversely] when real estate cools off, I won't report falling vacancy and rent, either.
EL: Lastly -- do you think your chairman, Lewis Ranieri, is unfairly labeled -- by myself included -- because of his associations with Computer Associates (NYSE:CA) and Reckson?
PM: Lew has always insisted on a very ethical conduct of business, very careful review of how our businesses is conducted -- he's always concerned with how the company looks to outsiders, what our corporate governance standards are, and what is best for our shareholders.
Lew owns a significant stake in CapLease that he paid for with his own money. A lot of the companies Lew has been associated with, such as Computer Associates (for example) -- Lew was brought in there to try to maintain jobs in Long Island, and to provide discipline on the Board. When everything went crazy, Lew stepped up, walked the company through the troubles - and fired the executives who were bad guys. Lew was the guy who spent the time to get that cleaned up and save the company. People can debate tactics -- did he do it fast enough? The end result, however, is that Computer Associates is a stable company today because of his efforts.
He really looks to managers to be of the highest ethical standards, which matches our philosophy. He has never insinuated to me to do anything that I would interpret to be unethical in our business or practice.
In conclusion
In the world of fixed income, many investors will sell their souls for excess yield -- look at certain subprime loans, in which borrowers don't even have to verify their income.
However, in Capital Lease's case, you get their roughly 8% FFO yield, with net leases signed by tenants such as AON, Tiffany's, Johnson Controls, and the U.S. Government. You also get management's ability to achieve a low cost of funds through securitization, and internal growth prospects. Capital Lease's dividend yield is currently 7.4%, so I'd advise investors seeking a high-quality dividend stock to take a look.
Further Foolishness that's REIT for you:
American Financial is a Motley Fool Income Investor recommendation. Discover James Early's entire portfolio of dynamic dividend payers with a free 30-day trial subscription
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.
