Introduction
One of the salient features of REITs is that profits and prices often move in cycles. And there are two cycles worth considering. First, there is the space market cycle which describes the supply and demand for a type of space. In the case of STAG Industrial, Inc. (NYSE:STAG), the space would be industrial space that is leased to tenants that have favorable tailwinds. STAG’s tenants are beneficiaries of secular trends with respect to the onshoring of light manufacturing activities and the continued penetration of e-commerce as a method of consumption. The second type of cycle is the capital market cycle. This relates to the level of investor demand for real estate assets and the valuations at which they trade. This article is focused on the capital market cycle and how it affects STAG’s operating performance. In particular, we review the capitalization rate and its spread with the cost of capital. We further consider the capitalization rate of the industrial REIT sector in comparison with the 10-year treasury for the 2010 to 2019 time period. We corroborate our analysis with commentary from the recent earnings call and review the implication of the recent pace of share issuance on operating performance. We tie the different aspects of the analysis together and form a view on the worthiness of an investment in the security in the current environment. At the end of the article, an investment recommendation is presented.
Source: Investing in REITs, Fourth Edition, Ralph L. Block. Published by John Wiley & Sons, Inc.
Risk and Return
STAG enjoys a BBB rating from Fitch and a Baa3 from Moody’s. Both credit agencies have stable outlooks for STAG. Please take a look at Table 1 which compares the total return that can be earned from an equity interest in STAG and the 5-year median yield on the Corporate Baa/BBB.
| Table 1: Comparison Between Equity and Fixed Income Return | |||
| Equity Return | Fixed-Income | ||
| Dividend Yield | 4.05% | Corporate (Baa/BBB) 5-year Median Yield | 5.69% |
| 5 Year Dividend Growth Rate | 0.70% | ||
| Total Return | 4.75% | ||
Source: Seeking Alpha on August 24, 2023 for the dividend yield and 5-year growth rate. Fidelity.com on August, 24 2023 for the 5-year median yield on the Corporate Baa/BBB. STAG’s issuer rating is presented in their Q2 2023 Earnings Supplement.
Finance is based on several fundamental precepts, one of which is a balance of risk and return. When you can earn 94 basis points more in an instrument that has less risk, it may be time to reevaluate the investment thesis for a stock.
Creating Value
In economic theory, when a business can deploy assets and earn a return that exceeds the cost to acquire the assets then value is created. In the case of a REIT, value is created when the capitalization rate, or cap rate, exceeds the cost of capital. The cap rate is the net operating income obtained from the assets and the cost of capital is the cost to use capital to purchase the assets for which income is generated. This is especially important for a REIT because they are not able to retain earnings and have to rely on capital markets to fund their growth. In general, REITs tap debt and equity markets to fund acquisitions for growth and to refinance debt as they come due.
Let us now evaluate how much value is created by looking at the difference between the cap rate and the cost of capital for STAG. Please take a look at Table 2:
| Table 2: Cap Rate | |
| Stabilized Cap Rate | 6.13% |
The cap rate presented is the midpoint of the guided stabilized cap rate in STAG’s Q2 2023 Earnings Supplement. For STAG to create value, their cost of capital must be less than this figure.
In order to calculate the cost of capital, we have to calculate the cost of debt, the cost of equity and weigh each cost to the extent they are used in the business. Let us review the capital structure to see how much debt versus equity is being employed by STAG. Please take a look at Table 3.
| Table 3: Capital Structure | |
| Debt | 27.1% |
| Equity | 72.9% |
Source: Q2 2023 Earnings Supplement
STAG does not currently have any preferred shares outstanding.
Now that we have the relative weights, we now look at each source of capital and estimate the cost. Please take a look at Table 4 for the cost of equity.
| Table 4: Cost of Equity | |
| Beta | 0.92 |
| Risk free rate | 4.24% |
| Equity risk premium | 4.38% |
| Cost of equity | 8.26% |
Source: US 10-year Treasury is from Yahoo! Finance on August 24 2023, Beta statistic is from Seeking Alpha.
There are different methods and philosophies around calculating the cost of equity. We use the Capital Asset Pricing Model (CAPM) in which we essentially add a spread to the risk-free rate and scale the spread by the volatility of the particular stock.
The beta statistic measures the volatility with respect to the market. The beta is 0.92 which implies that STAG’s stock is less sensitive than the market. Conceptually, this is justified because REITs as an asset class generally have revenue streams that are contractual and more stable than non-REITs. I use the 10-year treasury as my risk-free rate and apply a spread, or an equity risk premium of 4.38%. The equity risk premium I used is from Aswath Damodaran at NYU. The cost of equity arrived at using this approach is 8.26%. STAG would have to offer an 8.26% return to entice equity investors to purchase shares by this estimate.
Now that we have a cost of equity, let us now estimate the cost of debt. Please take look at Table 5 in which we provide the issuer rating for STAG as before and the 10-year Corporate (Baa/BBB) median yield.
| Table: 5 Issuer Rating and Cost of Debt | ||
| Rating/Yield | Outlook/Time Horizon | |
| Fitch Credit Rating and Outlook | BBB | Stable |
| Moody’s Credit Rating and Outlook | Baa3 | Stable |
| Corporate (Baa/BBB) Median Yield | 5.70% | Ten year maturity |
The implication of the cost of debt is that should STAG wish to refinance debt at about the 10-year tenor, it would be facing a cost of debt of 5.70%. This does not mean that their interest expense is going to be exactly 5.70% of their long-term debt because some fixed-rate debt could have originated at a different time when interest rates were lower. Because of this, the actual cost of debt may be somewhat less. In general, businesses will be slow to refinance debt in an inflationary environment to take advantage of previous interest rate regimes and will be quick to refinance debt in a declining interest rate environment to take advantage of lower available interest rates. STAG also employs swaps to manage their interest rate exposure. Nevertheless, for our purposes, 5.70% is the most accurate reflection of the current market conditions and so we will use this as our input.
Now that we have a cost of debt, the cost of equity and the weights of each in the capital structure, we can calculate the weighted average cost of capital. Please take a look at Table 6.
| Table 6: Weighted Average Cost of Capital (WACC) | |
| Weight of Equity | 72.90% |
| Weight of Debt | 27.10% |
| Cost of Equity | 8.26% |
| Cost of Debt | 5.70% |
| WACC | 7.57% |
The tax shield normally included in the calculation of the weighted cost of capital is ignored because REITs generally do not pay taxes at the corporate level.
Taking into account the current macroeconomic environment, STAG would have to generate a cap rate of more than 7.57% to create economic profit. In Table 7 we quantify the amount of the deficit between cap rate and the weighted average cost of capital for STAG.
| Table 7: Cap Rate Minus WACC | |
| Cap rate | 6.13% |
| WACC | 7.57% |
| Difference | -1.44% |
The calculation indicates that STAG does not create value as measured by this framework. Let us explore further why this may the case. We have looked at the spread between the cap rate and the cost of capital for STAG. Let us take a broader perspective and look at the spread between the Industrial REIT cap rate and the 10-year treasury from 2010-2019. Please take a look at Table 8.
| Table 8: Spread Analysis 2010- 2019 | |
| Implied Cap Rate on the Industrial REIT Sector | 5.45% |
| Market Yield on US 10-Year Constant Maturity | 2.41% |
| Spread | 3.04% |
| Standard Deviation | 0.93% |
| Low | 2.11% |
| High | 3.97% |
Source: Nareit T-Tracker. Federal Reserve Bank of St. Louis.
In Table 9 we look at the spread as of the second quarter of this year.
| Table 9: Spread Analysis as of Q2 2023 | |
| Implied Cap Rate on Industrial REIT | 4.23% |
| Market Yield on US 10-Year Constant Maturity | 3.60% |
| Spread | 0.63% |
The 63-basis point spread as of the second quarter is beyond two standard deviations from the mean spread from 2010 to 2019. These figures suggest that cap rates have yet to meaningfully adjust upwards. In the recent earnings call, STAG’s leadership offered the following:
“When you have a rapid rise in the interest rates like we had over the past couple of years, sellers don’t know what their properties are valued at.”
“We’re hoping the opportunities increase, but we’re very cognizant of the stabilized yield versus the cost of debt, and I think that’s flowing through…What, I think time has been helpful in that respect. I think the volatility of interest rates coming down has helped. So, the stable – let’s say another way, the stabilization of interest rates. And now sellers really understand where their cost of capital is. And when they know that, that generates where they are willing to trade their assets. So, you are seeing that bid-ask spread between sellers and buyers come down.”
The commentary suggests that sellers still have in their recent memory high asset prices that were reflective of a low interest environment. There seems to be some hesitancy on their part to accept the new market environment. When sellers reduce the price, that will potentially increase cap rates in deals moving forward.
Implications
For cap rates to increase, either the net operating income has to increase or the asset values have to come down. One way for net operating income to increase is when leases come up for renewal, they are re-leased at a higher contractual base rent which is reflective of the current market conditions. For the second quarter, renewals showed a cash rent change of 28.3% which was higher than the year-to-second quarter rent change of 23.5%, suggesting an accelerating trend. The comparable statistics for 2022 were 13.7% and 11.2% respectively.
Another way for cap rates to increase is if asset prices come down. Asset prices coming down may seem like a positive development for an acquirer such as STAG, but it could also put a dampening effect on STAG’s stock price as their current portfolio will potentially be valued less.
Finally, operating performance would be impacted. About 17.4% of their debt principal balance has a maturity date on or before June 2025 which implies meaningful refinance activity in the near term. Additionally, interest expense for the first six months of 2023 was 29.3% higher than the comparable period in 2022. Debt was only 12.88% higher during the period by my estimate. If more of the pie is going to fixed income holders, there is less available for equity investors.
Let us look into the operating performance in more detail.
Operating Performance
Please take a look at Table 10 in which we compare the per share metrics for the first six months of this year with the first six months of 2018.
| Table 10: Selected Operating Metrics (per Share) | ||
| 6 month ending June 2018 | 6 month ending June 2023 | |
| Total Revenue | $ 1.64 | $ 1.88 |
| Cash NOI | $ 1.28 | $ 1.46 |
| Adjusted EBITDAre | $ 1.15 | $ 1.35 |
| Core FFO | $ 0.89 | $ 1.12 |
Source: Q2 Earnings Supplements for 2018 and 2023.
Looking at the metrics, it appears that even with the current inflationary environment, STAG’s performance is better than it was in the first six months of 2018. This is the sort of five-year performance you would expect from a REIT in a stable interest rate environment. In 2018, the 10-year treasury was hovering around 2.90% and it is at 4.24% today. Let us look at this in more detail.
The metrics presented in Table 10 are per share metrics for the first six months of the respective year. Let us look at the share count* growth from 2018 to 2023. To maintain consistency, the share count is as of the second quarter of each year not year-end. Please take a look at Table 11.
| Table 11: Share Count as of Q2 of the Respective Year | ||
| Year | Share Count (thousands) | Growth from Prior Year |
| 2018 | 102,893 | 14.8% |
| 2019 | 123,931 | 20.4% |
| 2020 | 151,692 | 22.4% |
| 2021 | 163,397 | 7.7% |
| 2022 | 182,256 | 11.5% |
| 2023 | 183,412 | 0.6% |
Source: Q2 Earnings Supplements from 2017 to 2023.
*Share count growth in this article refers to weighted average common shares, units and other dilutive securities on a fully diluted basis.
Share count growth showed an increasing trend from 2018-2020 and then dropped to about a third of the pace in 2021 and then showed an increase in 2022 and then slowed to a crawl in 2023. My first impression from overall cadence of share issuance is that management is adroit in issuing shares and units when the environment is favorable.
The second impression is that the miniscule growth in share issuance in the first half of 2023 is not sustainable. REITs are not able to retain earnings to a meaningful extent so they have to issue shares regularly to fund growth. The slow share count growth in the first six months of 2023 is probably a reflection of the unfavorable market conditions that exist in acquiring assets. When a healthy spread exists between the cap rate and the cost of capital, that would be an opportune time to issue shares and fund growth. There is another dimension to this which may be of potential concern to investors.
Because the per share data for the first six months of 2023 as presented in Table 10 does not reflect the historic pace of share issuance as we have seen from Table 11, investors should contemplate on how accurate the performance comparison between the two time periods really is. Had share issuance continued at its average pace in the first six months of this year, the period comparison would probably favor the 2018 performance. Additionally, while management strategy of holding back on share issuance until a balance between cap rate and cost of capital is sensible, it may portend an accelerated pace of share issuance with its dilutive effect.
Conclusion
When the fixed income instrument of an issuer can offer a return that exceeds the dividend yield and growth rate, the investment thesis of the stock has to be revisited. In revisiting the worthiness of the investment, we have raised some questions as to the timeliness of an investment in STAG’s stock:
Firstly, there is an imbalance between the cap rate and the cost of capital. Investors should consider waiting until a positive spread is restored and value creation is demonstrated by figures. Secondly, if and when cap rates adjust upwards, there could be downward pressure of real estate asset prices. STAG’s current portfolio would be potentially valued less which may negate some of benefit of the cap rate improvement. Thirdly, the per share performance in the first half of 2023 is not reflective of performance under the normal pace of share issuance. When share issuance resumes at its historic pace, operating metrics may compare unfavorably to past periods which may dampen stock prices. Lastly, as debt matures and requires refinancing, increased interest expense will make it less likely that future dividends can grow at an attractive clip.
Prudent investors should consider foregoing an investment in STAG at the current time.
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