Why I’m Buying ROIC

Frequently cited stories of financial empires elicit romanticized notions of visionaries and thinkers ages ahead of their time -- railroad barons, tech entrepreneurs, and colorful dealmakers. But making millions isn't always sexy. YKK Group's minted billions producing 90% of the world's pants zippers. (Yeah, the YKK on your pants. Take a look, no one's watching.) Berkshire Hathaway's (BRK.B 0.54%) GEICO pulls pre-tax profits larger than several African countries' GDP. All on auto insurance. Making millions can be downright boring.

Enter Retail Opportunities Investment Corporation (ROIC 0.92%), a West Coast-focused real estate investment trust (REIT). ROIC's sex appeal is greater parts Talbots, and fewer Victoria's Secret. It invests in necessity-based shopping centers -- think grocers, banks, and pharmacies -- in space-constrained markets with above-average incomes. On account of local market dynamics and consumer staple orientation, they're perfectly boring, stable, cash-producing properties. Led by CEO Stuart Tanz, a proven capital allocator with a penchant for distressed or under-performing assets, ROIC is designed to slowly, opportunistically build wealth.

Still a young company, the market's not quite hip to ROIC's promise. Recently acquired shopping centers are underperforming their potential on paper but should improve in short-order. Potentially dilutive share issuances -- an issue I expect management to resolve -- overhang ROIC's otherwise sterling prospects. That's created an opportunity for us, today. Add a proven management team and unique strategic orientation to the mix, and we've got the makings of a nice package. That's why I'm buying a position equal to 3% of my Real Money Portfolio.

What, and who, is ROIC?
Just about three years ago, ROIC was little more than a pile of cash, a special purpose acquisition corporation (SPAC). Funded by a group of real estate investors, NRDC Capital, they recruited Stuart Tanz as CEO, and commissioned him with this REIT's raison d'etre -- to accumulate a collection of hard-to-replace shopping centers in space-constrained markets. Since 2009, ROIC's bought 4.4 million square feet of gross leasable area for just about $900 million. Most of its 44 shopping centers are triple net leased (meaning tenants cover all the costs), with inflation-linked price adjustments. Anchor tenants sign for 15 to 20 year terms and comprise 50%-60% of a center's revenue, and the remaining space is leased to "satellites," smaller stores, for three to five years. These are sleepy, steady-as-she goes cash producers -- the types that don't typically come cheap.

Tanz's investment approach is unique. A well-connected, value-oriented investor with 30 years' experience, Tanz and ROIC's employees possess deep networks in West Coast domains. They employ their experience and connections to ROIC's advantage, acquiring properties in off-market transactions, a less efficiently priced corner of the market. Target buys take one of a few forms: a distressed asset facing foreclosure or debt maturities; longtime owner-operators looking to retire, and seeking a source of liquidity; or an under-managed, poorly tenanted, or improperly maintained property. Sometimes it's a combination of the three. (Less frequently, they'll buy a property that's just plain good.) The strategy affords a nice counter-cyclical bent: ROIC buys properties on the cheap in down markets, and sells or releases them at higher rates as markets turn up.

If there's a common theme, it's this: They're buying solid shopping centers, which, given a little TLC, could do a lot better. In his prior life as CEO of Pan Pacific, Tanz and his deputies -- who are employed in executive capacities at ROIC -- used the same strategy, presiding over a four-fold share price increase before selling to retail property giant Kimco (KIM 0.80%).

Why today?
So, where's the mispricing? I see upside from three possible sources: improving property-level results, and benefits from increasing scale at the company-level; declining risks of dilutive shares issuances; and the possibility of an acquisition.

More ROIC
In the time since ROIC's inception, management's done an admirable job -- increasing rent per square foot from $13 to $18. At last year's close, my estimate of NOI yield (a measure of property-level returns on investment) put ROIC at a run-rate of 7.8%, up from less than 7% a few years back.

That's good, but there's still room for improvement. For perspective, good REITs can earn full-cycle NOI yields around 8%-10%. Pan Pacific earned a 10.9% Remember: A critical element of ROIC's strategy is to buy poorly maintained and under-leased properties, improve them, and release them. As the tenant mix improves, they release them again, at even higher rates. A virtuous cycle follows: higher rents beget rents.

To get a sense, take a look at full-cycle NOI yields (across 10 years) from Acadia Realty Trust (AKR 0.66%) and Federal Realty Investment Trust (FRT) -- two REITs that own retail properties in space constrained markets -- alongside Pan Pacific. These aren't perfect comps, as Acadia and Federal occupy slightly different niches and geographic areas, but they give a sense. In time, I'd expect ROIC's NOI yields to approach 9.5%-10%.

These improvements should result in steady increases to ROIC's dividend, and according share price increases.The far right column gets to the second point. As a small REIT, administrative costs still comprise a relatively large portion of overall cash flow. But as ROIC scales up, they should decline, and cash flows to shareholders will grow. I'd expect them to decline to 6%-8% of revenue over time, from 11% currently.

Dilution?
Let's take a trip back to the days when ROIC was a kernel of its current self. When first created, ROIC offered 40 million warrants to the original owners, and 8 million "Founders Warrants" to NRDC -- as an enticement, of sorts. Warrants are long-term call options, giving holders the right to buy shares at a specified price within a corridor period. In ROIC's case, warrantholders can buy shares for $12, any time before October 2014. That gets to the problem: If all warrantholders were to exercise in October 2014, and ROIC management can't deploy the cash, it'd seriously dilute cash flow per share. On account of that risk, ROIC shares have languished -- what longtime ROIC holders refer to as the "warrant overhang."

But recently, ROIC management's taken steps to remedy this issue. ROIC has repurchased or exercised 57% of outstanding warrants, significantly reducing the risk of a dilution. On the news, shares have shot higher, but the risk-reward has actually improved. I think management will continue to repurchase warrants, if they are not exercised in an orderly manner, to reduce the risk of dilutive exercise. As the so-called warrant overhang diminishes, I expect the shares will steadily march higher.

Acquisition potential 
It's hard to ignore history, here. At ROIC, Tanz assembled the exact same management team as the Pan Pacific days. A refresher: That's the very company he sold to Kimco for a hearty sum. It's also hard to ignore the prospective benefit from selling ROIC to a large retail-focused REIT. A buyer would immediately realize value by reducing overhead costs at ROIC, or scaling them across a larger sales base. And because ROIC trades cheaper than most of its REIT brethren, a larger, more richly valued REIT could use its shares to purchase ROIC's comparatively undervalued shares, and immediately accrue value to its shareholders.

So, what's our ROIC?
To put things in context, ROIC shares are current priced as if existing properties increase rents at just 3%, and management's hardly able to improve occupancy rates. I don't think that's likely to happen. As ROIC leases up currently underperforming properties, I expect occupancy to increase to something in the 94%-95% range, from 93.5% at current. Likewise, as ROIC improves its properties and tenant mix, and releases on expiration, I expect its NOI yield to creep toward 9.5%-10%, the upper end of its peer group range. In coming years, I peg transaction volume at $150 million per annum, and as ROIC's scale grows, envision administrative expenses falling to 6% of revenue.

On this basis, I peg the shares worth at $19, about 40% upside. Along the way, we'll collect a 4.4% dividend, which I expect to steadily increase. In an acquisition scenario, I wouldn't be surprised to see the shares go for $21 a stub.

Risks
First and foremost is execution risk. As an investment company, ROIC's fortunes depend on continued execution from management. Bungled transactions will destroy value, and while I doubt it'll happen, I'd sell if management gets trigger happy. Second, the grocery business is a cutthroat place, and ROIC's cash flows depend on its tenants' financial health. By management's account, ROIC's tenants continue to perform well -- but competition, or regional macroeconomic troubles, could put a hurt on their results. Also notable: ROIC has a large presence in California, and while the impact is hard to ascertain, the state's continuously precarious finances could exacerbate macro-troubles. Last, as a REIT, ROIC must tap capital markets with relative frequency. A freeze-up in debt markets, or downdraft to equity markets, could destroy value for shareholders.

Bottom line
ROIC possess a lot of the characteristics I love: Boring, cheap, and helmed by a best-in-class capital allocator. Think of it as wolf in sheep's clothing, of the good variety. An unsuspecting wealth accruer.