There's a lot going on at Spirit Capital (NYSE: SRC), but there's one thing that's missing. So when you look at this net lease real estate investment trust (REIT) as a potential long-term holding you need to step back and think about your real goals. Here's why Spirit Capital could be a millionaire-maker REIT but still not a great fit for a whole lot of investors.
The core of the story
REIT Spirit Capital owns single-tenant properties for which the tenant is responsible for most of the costs of the assets they occupy. This is known in the industry as a net lease, and generally speaking, it's a fairly low-risk way to invest in real estate. After signing a lease, Spirit effectively gets to sit back and relax while it collects the rents it's due, making the difference between what it charges and its cost of capital.
Growth in the net lease space generally comes from two main areas. First is rent increases on the existing portfolio. To that end, about 10.5% of Spirit's rent roll has no rent increases built into their leases, which means that nearly 90% of tenants have either set contractual increases (roughly 72% of rents) or increases tied to inflation (about 17%). That's a pretty solid foundation for future growth, but rent increases tend to be modest in any given year. Which leads to the second growth avenue: acquisitions. This is the more important of the two main growth drivers over the long term but tends to be lumpy in nature. That said, even during pandemic-hit 2020, Spirit continued to put capital to work, buying 146 properties for roughly $880 million. It added another 25 properties in the first quarter, at a cost of about $192 million. There were some asset sales in both periods, but Spirit bought far more than it sold.
The focus of the REIT is largely single-tenant retail properties, which make up around 77% of the portfolio. The rest is mixed between industrial (16%) and office/other (7%). The average remaining lease on the REIT's 1,880 properties has about 10 years on it, which is a fairly decent number. Occupancy is around 99.5%. So far so good, but there are some major caveats here for long-term investors.
On an absolute basis, first-quarter adjusted funds from operations (FFO) rose roughly 8% year over year in the first quarter of 2021. However, on a per-share basis, adjusted FFO fell from $0.78 per share in the first quarter of 2020 to $0.76 in the same stanza of 2021. The reason for the drop in per-share adjusted FFO was an increase in the number of shares outstanding. Essentially, Spirit uses equity sales to help fund its acquisitions, which is something it intends to keep doing, noting that at the end of the first quarter, the REIT had forward sales contracts for 5.5 million shares.
To be fair, this isn't in any way unusual. REITs have to pay out most of their taxable earnings as dividends to investors, which leaves little left for reinvestment in the business. Thus, selling debt and equity is the main avenue for funding new investments. However, investors need to understand that, at least for right now, Spirit appears to be heavily focused on growth. If it keeps expanding at a rapid clip, it could easily be a key part of a million-dollar portfolio... but there's a fly in the ointment here.
After repositioning the portfolio in 2018 by jettisoning less desirable assets, the REIT cut its dividend. The payout hasn't been increased since. Again, it's not unusual for a company that goes through a big directional change to cut its dividend and then take a few years to solidify its business before getting back to dividend increases. However, dividend investors shouldn't ignore the fact that dividend growth is clearly on the back burner right now, based on the REIT's clear focus on expanding the portfolio. In time, perhaps, dividend growth will resume, but until it does there are likely to be better options for income-focused investors in the net lease space. Indeed, a stagnant dividend will lose ground to inflation over time.
The final call
So could Spirit Capital help an investor build a seven-digit portfolio? The answer is yes, specifically because it is working to expand its portfolio. However, income investors, while perhaps interested in its 5.1% dividend yield, need to recognize that portfolio growth is the main story here, at least until the dividend finally starts getting increased again. That limits the appeal of this REIT in many ways, especially as the threat of inflation starts to garner more attention on Wall Street.