Tuesday, May 20, 2014

When it Comes to Dividends, is it Really About How Big You Are?

Being a big company has its benefits, but there's also negatives. So while legendary real estate investor Sam Zell highlights the need for scale in the real estate investment trust (REIT) world, it doesn't mean that every REIT should strive to be a giant.

The case that proves the Zell
When it comes to REITs, the business model is pretty simple. Buy property, rent it out, pay 90% of earnings to shareholders. But, that last one means that REITs have to constantly come to the public markets for new equity and debt capital if they want to grow. It's much easier for large companies to get attention on Wall Street, which is why Zell expects small players to get gobbled up by bigger ones in the future. The small fry, he suggests, won't be able to compete effectively for growth capital.

American Realty Capital Properties (NASDAQ: ARCP  ) is probably the poster child for this idea. The triple net lease landlord came public in 2011 with a portfolio of around 60 properties. It wasn't even a small fry compared the industry's largest player, which, at the time, owned over 2,500 properties. American Realty Capital raised around $100 million in its IPO.

Today, American Realty owns over 3,700 properties. It's market cap is $2.6 billion and it's swimming with bigger fish now -- what a change a few years makes. However, the swift ascent seems to have the market concerned. After peaking at over $17 a share, the stock now trades at around $13.

ARCP Chart

Too big, too fast
The reason is potential indigestion. American Realty Capital Properties got so big by gobbling up other triple net lease players. If American Realty can pull off the get big quick approach, the recent yield of around 7.5% is a great buying opportunity (the other big players yield around 5%). If not, a dividend cut isn't out of the question.

And, sometimes, being small is actually a good thing. Take, for example, Whitestone REIT (NYSE: WSR  ) . This company operates a portfolio of roughly 60 properties in Texas, Arizona, and Illinois. That said, it only has one property in Illinois, so it's really focused around just two markets.

Whitestone's specialty is buying local strip malls that are in disrepair or that have fallen out of favor. It fixes them up and turns them into what management calls "Community Centered Properties," a term Whitestone has trademarked.

Essentially, Whitestone takes jalopies and turns them into race cars... well, maybe station wagons is more to the point. That's because these strip malls house things like grocery stores, hair salons, and dry cleaners. The types of businesses you visit regularly. Strip malls are, actually, a great asset class if you like boring and reliable.

Although Whitestone remains a tiny player with an around $300 million market cap, revenues have gone up in each of the past three years. The rent roll has increased from about about $35 million in 2011 to over $60 million last year. And being small is a big benefit, because turning a single property around can still lead to material improvement on the top and bottom lines.

(Source: Ecksemmess, via Wikimedia Commons)

On an operational front, it would it be hard for Whitestone to call itself "Community Centered" if it owned thousands of properties spread across 50 states. But it would be even harder to keep growing using the same fixer-upper model. In this case, small and nimble Whitestone is benefiting from fishing in ponds that are too small for the big players.

Opportunity, but don't be blinded
Sam Zell is correct that big REITs have better access to capital. He's also correct that consolidation is likely in the REIT world, American Realty Capital proves that point. However, that doesn't mean that being big is the only way to make money. Whitestone REIT is a good example of small being beautiful.

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