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STORE Capital Corporation (STOR)

STORE Capital (which stands for Single Tenant Operational Real Estate) is a relatively new triple net lease REIT, having gone public in 2014. However, the company is led by an experienced management team that has built three previous triple net lease REITs (tenants pay all taxes, maintenance, and insurance costs). STORE's management has collectively invested over $16 billion in more than 9,200 properties, generating strong returns for shareholders along the way.
Source: STORE Capital Investor Presentation
Today STORE owns over 1,900 properties leased under long-term contracts (average remaining lease is 14 years) to 397 companies in 104 industries. Its occupancy rate is 99.6% and 98% of its leases are triple net, creating a high-margin (EBITDA margin 90%) and recurring source of revenue.
Source: STORE Capital Investor Presentation
STORE’s rent is derived from a number of different industries:

  • 67% services (restaurants, daycare centers, fitness centers, movie theaters)
  • 18% retail (located in retail corridors and focused on experiential types of businesses, including furniture stores, home goods stores, hunting and camping outfitters, and hobby centers)
  • 15% manufacturing (primarily located in industrial parks and focused on companies making everyday necessities such as playground equipment, medical devices, aerospace components, and memory foam products)

Business Analysis

There are three key attributes that every REIT needs to be a good long-term high-yield dividend growth stock.

The first is a quality management team, with experience in disciplined capital allocation and good risk management skills. This is because the triple net lease industry is one in which a REIT will buy a store from an existing tenant, and then lease it back under a long-term (10 to 20 year) contract with annual rent price escalators baked in. These are usually tied to inflation and give a REIT some cash flow protection should inflation accelerate in the future.

Of course, if a tenant's business falls on hard times, then the cash flow-to-rent ratio might also decline to potentially dangerous levels. In such a scenario a tenant may default on its rent, or even go out of business entirely. That would leave the REIT on the hook for maintaining the property, including paying property taxes and insurance costs (negative cash flow properties).

Fortunately STORE's management team is very good at managing risk. For example, the average tenant's cash flow-to-rent ratio is 2.6 and has remained stable over time. This indicates that the company's tenants are generally performing quite well and are more likely able to afford the average 1.8% annual rent escalators built into STORE's leases (one of the highest rates in the industry).

Importantly, management estimates that approximately 75% of the lease contracts it holds to be of investment-grade quality, further demonstrating the quality of STORE's tenants. When combined with STORE's conservative payout ratio (more on that later), this focus on contract quality should really help protect the dividend over time. 

The second key to a good REIT is a business model that generates secure and recurring cash flows from which to pay predictable dividends. On this count STORE also leads many of its rivals, thanks to several factors.

First, the company has the industry's longest average remaining lease term, at 14 years. And despite its relatively small size, the REIT also has the most diversified portfolio, with just 12% of its rent coming from its top five tenants. In fact, STORE's single largest tenant makes up just 3.4% of its cash flow.
Source: STORE Capital Investor Presentation
STORE's cash flow stability also benefits from the fact that its properties are leased out to tenants in no less than 104 industries, meaning the REIT has minimal exposure to any single industry (full service restaurants are its biggest exposure at approximately 13% of base rent).
Source: STORE Capital Investor Presentation
The third component of a quality REIT is its ability to grow profitably over time. Specifically, its ability to make acquisitions that are accretive to adjusted funds from operation (AFFO - the rough equivalent of free cash flow for a REIT).

REITs must legally pay out 90% of taxable income as dividends. This means that they are able to retain far less cash flow than most companies with which to grow their businesses. Thus REITs are frequently turning to debt and equity markets to fund their growth.

Whether or not that growth is profitable, however, depends on two things. The REIT's cost of capital, and the cash yield on new properties (call the "cap rate"). If the company's weighted cash cost of capital (taking into account retained AFFO, debt, and new equity sold) is not lower than the cap rate, then a REIT's marginal cash flow from new properties won't cover its higher interest and dividend costs.

In other words, the REIT will grow for growth's sake only, but AFFO per share will stagnate or decline. As a result, the dividend becomes less safe over time and is less able to be safely increased. 

Fortunately STORE Capital has a very strong growth capability thanks to one of the industry's lowest costs of capital, ranging between 3% and 5% in recent years. As you can see, STORE's cost of capital is well below its lease rates, providing a stable and profitable spread.
Source: STORE Capital Investor Presentation
The company's low cost of capital is a function of two main things. First, management has been highly disciplined about how quickly it grows the dividend.

This allowed the REIT to have a 70% AFFO payout ratio in 2017 (most triple net lease REITs pay out 80% to 90% of AFFO as dividends). That's not only a very safe payout ratio, but it also means that the REIT is retaining 30% of its cash flow with which to reinvest in growth projects. As a result, STORE is less dependent on debt and equity markets.

In fact, STORE Capital's relatively large amount of retained cash flow, when combined with the highest rental escalators in the industry mean, that its capable of growing AFFO/share organically (without new property acquisitions) by at least 5% a year.
Source: STORE Capital Investor Presentation
The other reason for STORE's low cost of capital is the REIT's cheap borrowing costs. This is thanks to management's disciplined use of debt. For example, the REIT's leverage ratio (net debt/EBITDA) is 5.7, slightly below the industry average of about 6.0. Management has a long-term goal of maintaining its leverage ratio between 5.5 and 6.0, which is why it has such a strong credit rating (BBB).

The company's investment grade credit rating helps STORE to borrow money on very long terms (locking in its cost of capital) at an average interest rate of 4.6%. Recently the REIT further increased its access to low cost debt by extending its revolving credit facility to 2022 while also expanding it by $600 million (to $1.4 billion). This means that STORE's liquidity (cash + remaining borrowing capacity) now stands at $1.1 billion, sufficient to cover all of 2018's planned growth.

That's important because STORE has a very long growth runway. In fact, management has located $12 billion worth of potential acquisitions, 85% of which are in service or non-retail sectors. And that pipeline is just a drop in the bucket because there are currently over 200,000 single occupant properties that have a combined value of $3.3 trillion. That's compared to STORE's $5.9 billion asset base, which means that the REIT has about 0.2% market share in its industry.

STORE is both highly aggressive in its growth, but also highly disciplined. For example, in 2017 it made net purchases of $1.1 billion in new properties at an average cap rate of 7.8% (3.5% above its cost of capital). This drove 4.3% AFFO per share growth and allowed the REIT to raise its dividend by a healthy 7%.

For 2018, management expects $900 million in net acquisitions at 7.8% cap rates, driving about 6% AFFO per share growth. That should allow for another 5% to 6% dividend increase this year.

Given the market's fragmentation, management's experience, and the company's relatively low cost of capital, STORE seems likely to continue generating mid-single digit AFFO per share and dividend growth over the long term. 

When combined with its generous yield, STORE Capital could potentially be an interesting option for conservative investors to consider. Even Warren Buffett has signed off on the company as STORE is Berkshire Hathaway's only REIT investment.

Key Risks

While STORE is undoubtedly a very well-run and high-quality REIT, there are still some challenges it may face in the future.

STORE's impressive growth rate of the past may not be sustainable over time, for example. For one thing, as its property portfolio increases in size, it's harder to move the needle and maintain strong growth rates of 6% to 8%.

That's especially true given how disciplined management is with its acquisitions. Approximately 80% of STORE's purchases are from management's deep ties in the industry, and thus sourced through its business-to-business (B2B) connections.

In other words, STORE's industry-leading profitability is because management is able to locate excellent deals, with quality tenants, at attractive prices (above average cap rates). However, there is likely a limit to how many of these great deals STORE can come up with, especially since cap rates have been declining steadily for years.

That's because property prices have been steadily rising due to the second longest economic expansion in history. Low interest rates also helped inflate commercial property prices, making it harder to find attractively valued properties to purchase.

The good news is that rising interest rates should help to push up cap rates over time. However, remember that what matters to all REITs is the profitability of each purchase. In other words, rising rates, while pushing up cash yields on new investment, will also mean higher borrowing costs and potentially greater costs of capital.

Therefore, STORE's profitability on new investments might take a dip (slowing AFFO per share growth) if its costs of capital rise faster than cap rates. That might happen if fickle equity markets, which are currently very bearish on REITs, raise STORE's cost of equity too much.

Another thing to consider is that STORE's heavy focus on service-oriented tenants might serve as a double-edged sword.

On one hand, STORE’s tenant base is largely immune from current industry challenges (the decline of brick-and-mortar retail). However, in a recession, discretionary spending at businesses like restaurants and movie theaters can fall significantly.

These kinds of properties are also usually more specialized and can take longer to find new tenants if existing ones fail. This is why triple net lease REITs like STOR usually sell about 1% of their properties each year.

Rather than pay to refurbish an empty property (which is generating negative cash flow because of maintenance, insurance, and tax costs), a triple net REIT will sell empty properties to reinvest the capital into new properties with healthy tenants and brand new long-term leases. In 2017 STORE sold 55 properties for $267 million, netting a $40 million profit.

However, the amount of property dispositions can be volatile and fluctuate with the economy, as well as other factors (local property markets). In years when dispositions are very high, cash flow growth can slow or even potentially fall.

If a REIT's AFFO payout ratio is low enough, like STORE's, such periods are unlikely to put the dividend at risk. However, the short-term hiccup in growth means that dividend growth can come in lower than investors expected and the share price can suffer.

Closing Thoughts on STORE Capital

Before Warren Buffett bought his stake in the company, not many investors had heard of STORE Capital.

While the relatively young REIT is still far from earning the label of a blue chip, its disciplined management team, industry-leading profitability, healthy balance sheet, low cost of capital, and solid dividend growth potential mean that STORE Capital could be a worthy high-yield investment to keep an eye on for a diversified income portfolio.

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