Spirit Realty Capital (NYSE: SRC) is a net lease real estate investment trust (REIT). However, it comes with a couple of wrinkles that investors need to understand before jumping aboard. And the next three years could be important as management looks to move past a big corporate action made in 2018. Here are some things to look for in the days ahead.
Spirit Realty owns single-tenant properties, with its tenants responsible for most of the property-level operating expenses. This is what's known as a net lease and, generally, the business is considered fairly low risk. Simplifying things greatly, Spirit just has to collect the rent, making the difference between its financing costs and the rent it collects on its nearly 1,900 properties.
The REIT has a heavy focus on retail assets, which makes up around 77% of its rental income. That, however, isn't uncommon in the net lease niche, with some of its peers exclusively owning retail. Adding a little diversification to the mix here, Spirit Realty also invests in industrial (16% of rents) and office (nearly 7%) properties. Diversification is good for your portfolio and for a REIT's portfolio, but it's still probably best to consider this a retail REIT.
That said, the properties are fairly well diversified across different retail types with a focus on service- oriented assets (gyms and restaurants) and necessity businesses (discount stores and pharmacies). The average remaining lease term is an attractive 10 years or so, which is fairly long, and most of its leases (covering roughly 90% of rents) have built-in contractual rent increases. Add in an investment-grade-rated balance sheet and there's a lot to like about Spirit Capital Realty.
There's just one big problem here, the dividend, which is the whole point of the REIT pass-through structure. Spirit offers a fairly generous 5.3% yield today, which is more than a full percentage point higher than net lease industry bellwether Realty Income's (NYSE: O) 4.3% yield. The thing is, Realty Income, a Dividend Aristocrat, has a long history of increasing its disbursement annually (including four times in pandemic hit 2020). Spirit cut its dividend in 2018 and hasn't increased it since despite a stated goal "to maximize stockholder value by providing a growing stream of earnings and dividends."
So what's going on? In 2018 the REIT jettisoned a portfolio of underperforming assets so it could refocus its business. At the time of the spin off, it had around 1,460 properties, so over the past two to three years it has grown its business, noting again that it owns nearly 1,900 properties today. What hasn't happened yet is dividend growth. But management deserves a little slack on that front.
After a material corporate makeover, which the June 2018 spinoff definitely was, it's normal for a company to take some time to regroup. That said, just 18 months or so after this transaction, Spirit was facing the coronavirus pandemic. That was a tremendous headwind, and it's impressive that the REIT muddled through without a dividend cut. Although still lingering, it appears the pandemic impact is fading and Spirit's business can start to operate more normally.
That means portfolio growth, which didn't actually stop even during the pandemic. But it also means investors should start looking for the dividend to grow as well. Indeed, with adjusted funds from operations (FFO) of $0.76 per share in the first quarter of 2021 and a dividend of $0.625 per share, it had an adjusted FFO payout ratio of roughly 82%. That's probably a bit higher than the company would like, but as the U.S. economy comes back and the REIT's portfolio continues to expand, the payout ratio should improve. Although it would be better if it happened sooner rather than later, dividend growth in the next three years is going to be a key issue to watch.
A solid REIT with something to prove
Spirit Realty has repositioned itself and muddled through a global health crisis. There's just one thing left to do: Start growing the dividend. For dividend investors looking to maximize their current income in the net lease space, this is an interesting option. While the dividend has been stagnant of late, there are fairly good reasons for that but they are slowly receding. Although you could wait until the dividend actually gets increased, buying now in anticipation of that event will net you a material yield advantage over some of the biggest names in the net lease industry. Just make sure you keep an eye on that dividend, looking for management to live up to its own stated goals now that things are getting back on track.