The Necessity Retail REIT: Misaligned Interests Didn’t Change With Company Name

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Metamorphosis of RTL

The Real Estate Investment Trust (“REIT”) formerly known as “American Finance Trust” recently announced the acquisition of a $1.3 billion portfolio of outdoor shopping centers along with a name and symbol change scholarship. On February 14, the REIT announced the completion of the initial $547 million tranche of this acquisition and officially changed the company’s name to “The Necessity Retail REIT” (RTL).

American Finance Trust (AFIN) is now RTL, whose management aspires to be “the preeminent retail-focused, necessity-based REIT with a premier portfolio that will include more than 1,000 properties, 29 million square feet and $382 million in pro forma annualized linear rent.”

One thing, however, has not changed about this REIT: it is still managed externally by AR Global. This external management team has overseen extraordinarily weak returns over the REIT’s nearly four-year history.

Since RTL’s IPO in 2018, the stock has lost more than half of its value:

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Data by YCharts

So, will this transformative deal actually transform RTL into something resembling the “preeminent necessity-based” REIT that management claims to be? Or was it simply an excuse for external management to increase assets under management and associated fees?

I will not bury the lede. I think RTL should be a “pass” for any investor who doesn’t own it yet and a “find your first sales opportunity” for any investor who does. But the 7.5% yield preferred shares are another story.

A transformative acquisition or an excuse to issue shares?

The total portfolio of retail shopping centers under acquisition is made up of a mix of power centers (44.7%), non-grocery anchored centers (43.8%) and grocery anchored centers ( 11.5%).

Despite only a minority of the portfolio in grocery anchored centers, 22% of pro forma linear rent will come from grocery store tenants. If nothing else, RTL will certainly live up to its name and its “necessity-based” purpose.

The rest of the acquisition of the shopping center should be finalized by the end of March 2022. Alongside this operation, RTL is also getting rid of its office buildings to devote itself entirely to retail.

Once the full acquisition is complete, RTL’s portfolio will consist of approximately 90% retail properties and 10% distribution facilities. This compares to the composition of AFIN’s portfolio in Q3 2021 with 81% retail, 11% distribution and 7% office.

However, even strong assets can be financially mismanaged.

Most of the time, externally managed REITs produce low returns for shareholders due to misaligned interests. Often we see external managers issuing high cost stocks and debt to expand the asset base (thus increasing the fees they can earn) while producing little or no growth per share in FFOs or dividends. .

RTL has historically fit into this mould, despite a fairly solid real estate portfolio.

In fact, RTL has one of the worst alignments of interests between management and shareholders that I have ever seen. Here is an excerpt from the 10-K 2021 (annual report) recently published by RTL, under a risk titled “Our advisor faces conflicts of interest related to the structure of the compensation he may receive” (bold text added by me) :

Under the Advisor Agreement, the Advisor is entitled to substantial minimum compensation whatever the performance as well as incentive compensation if certain thresholds are reached. The variable portion of the base management fee payable to the Advisor under the Advisory Agreement increases in proportion to the cumulative net proceeds of the issuance of common, preferred or other forms of equity by us. In addition, under our multi-year outperformance agreement entered into with the Advisor in 2021 (the “2021 OPP”), the Advisor may earn LTIP Units if certain performance conditions are met over a three-year performance period that ends ends in July 2024. These arrangements may cause the advisor to take action or recommend riskier or more speculative investments in the absence of these compensation arrangements..

RTL’s external managers literally get paid to dilute their shareholders! It’s right there in the 10-K!

Suddenly, this huge $1.3 billion acquisition of a shopping center portfolio just looks like an excuse for management to issue a bunch of stock.

Here’s the part of the 10-K commenting on management fees for 2021 (again, in bold on my part):

Asset management fees paid to the advisor increased by $5.0 million to $32.8 million for the year ended December 31, 2021, compared to $27.8 million for the year ended on December 31, 2020, mainly due to a $2.1 million increase in the variable portion of base management fees due to the increase in our share issuances in 2021 and 2020 (which begin to impact fees in the month following the capital increase) and a $2.9 million increase in variable incentive management fees.

But RTL cannot broadcast only common and preferred stocks for growth, because the combined dividend yields of these two types of stocks significantly exceed the acquisition cap rates. So what does management do? They also issue high-cost debt, loading the REIT to the end of the debt.

High debt, heavy equity issuance, and a lack of focus on any particular real estate sector led to lower AFFO growth per share, and lower AFFO/equity growth has, in turn , led to poor stock price performance.

Given RTL’s emphasis on investment-grade retail in both single-tenant and multi-tenant space, it would seem fair to compare its total returns to peers Realty Income (O) and Kimco Realty Trust ( KIM), which have similar portfolio profiles:

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Data by YCharts

These two REITs, which are both internally managed, stomped RTL on a total return basis.

But then the management teams of these REITs were incentivized to grow AFFO per share over time. The external management of RTL does not have this incentive. Here is AFFO’s history by AFIN/RTL share over time:

  • AFFO 2016/share: $1.22
  • AFFO 2017/share: $1.18
  • AFFO 2018/share: $0.98
  • AFFO 2019/share: $0.99
  • AFFO 2020/share: $0.90
  • AFFO 2021/share: $1.02

Obviously, the trend was going in the wrong direction, at least until 2021. Last year, while the total AFFO was up 20%, the AFFO per share was up 13.3%. It’s not a bad performance at all, thanks to higher rent collection rates, collection of deferred rent, increased occupancy of outdoor properties and $178 million in purchases.

Interestingly, however, in the fourth quarter of 2021, AFFO per share decreased by two cents year-on-year, from $0.24 in Q4 2020 to $0.22 in Q4 2021. This while total AFFOs increased by 2.8% year-on-year. The answer to the riddle, for those who haven’t guessed it yet, is to issue shares. Shares outstanding were 123.2 million in Q4 2021, up 13.7% from 108.4 million shares outstanding in Q4 2020.

You know what they say about tiger stripes.

Here are some other notable points from the results of the results of the year 2021:

  • Revenues increased by 10% between 2020 and 2021.
  • Cash ROI increased by 18%.
  • The rental areas of outdoor centers fell from 85.2% at the end of 2020 to 88.8% at the end of 2021.
  • Acquisition of 69 properties for approximately $178 million at a capitalization rate (initial) of 7.6%.
  • Approximately 66% of tenants, based on base rent, are either classified as investment grade or deemed “investment grade equivalent” by management.
  • Issuance of $500 million of 4.5% notes due 2028, in accordance with RTL’s BB+ rating by S&P and Fitch.
  • Management fees increased by 17.9%.
  • Stock-based compensation increased by 32.4%.
  • General and administrative expenses increased by 6.0%.
  • Together, management fees, stock-based compensation, and general and administrative expenses accounted for 21.2% of total revenue in 2021, compared to 19.8% of total revenue in 2020.

Pause for a moment on this last point.

The best-managed net-lease REITs have general and administrative expenses, which include management compensation (including equity), amounting to about 5-8% of revenue. For shopping center REITs, G&A typically represents around 7-9% of revenue. RTL’s total management expenses, which amount to more than 21% of revenues, are significantly higher than those of similar internally managed REITs.

Bottom Line: Avoid Common Stock

It’s hard not to conclude that RTL is another example of an externally managed REIT with horribly misaligned interests between shareholders and management.

Again, remember that RTL produced AFFO growth per share of 13% in 2021. Doesn’t that mean something? Well, yeah, double-digit growth in AFFO per share still means Somethingbut I think “something” is that RTL’s rent collection (including deferred rent) and occupancy have created a temporary but strong tailwind in 2021.

In other words, last year was special.

Management also says the $1.3 billion shopping center acquisition, priced at a cash cap of 7.19%, should be accretive to AFFO per share this year. But I’m not so sure.

Assume that 100% of the recently issued $500 million of 4.5% debt goes to acquisition and the rest comes from common stock issued at an average price of $8.25 (dividend yield of 10.3 %). This would represent a weighted average cost of capital of just over 8%.

Even assuming that office divestitures are sold at a cap rate of less than 7%, adding these products to the mix is ​​unlikely to lower RTL’s WACC below 7.19%.

Unless RTL partially funds the remainder of the acquisition with more debt (which management is discouraged from doing), I don’t see how this will be accretive to the bottom line. RTL’s cost of equity is simply too high. So it looks like this transformative deal will end up being dilutive for AFFO per share after all.

Personally, I own RTL’s Preferred Series A (RTLPP) yielding 7.5% because this large common stock issue ends up making the preferred dividend safer by reducing reliance on debt (which is higher in the capital stack).

If the price of RTLPP drops below the $25 redemption value, I would consider buying more. But I wouldn’t touch RTL common stock with a ten foot pole.

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