Interview With Chris Volk, Former CEO Of STORE Capital
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Interview With Chris Volk, Former CEO Of STORE Capital
You may remember that our largest holding used to be a REIT called STORE Capital (STOR):
We accumulated a large position during the early days of the pandemic and earned a large gain when it eventually got bought out by private equity.
One of the main reasons why we invested so heavily in STORE was its unique business model which had the potential to deliver above-average returns with below-average risk.
It was unique in that it would target net lease properties that were occupied by smaller middle-market companies and it would originate its own deals via cold calling efforts.
The lack of competition for these assets allowed it to pick up assets at much higher cap rates and with faster rent escalators, at discounts to replacement cost, and it would then structure stronger leases to make up for the lower credit quality of its tenants.
This approach was very successful as you can see in the charts below:
At the time of our investment, the CEO of the company was Chris Volk, who is considered by many to be one of the most influential net lease investors of all time. He has taken 3 net lease REITs public and each of them generated significant outperformance under his leadership.
Recently, I had the chance to talk with him and I asked him a bunch of questions about some of our favorite net lease REITs. Our conversation included:
Essential Properties Realty Trust (EPRT) - our single largest holding
Agree Realty (ADC)
NNN REIT (NNN)
VICI Properties (VICI)
Realty Income (O)
Among others...
Below, you will find the transcript of our conversation and towards the end, I also discuss my main takeaways.
But before I get to it, I have two side notes:
(1) In case you haven't already, I strongly recommend that you order his new book, The Value Equation, on Amazon. I read it when it first came out and think that it is one of the best business books on the market. You can learn more about it by clicking here.
(2) Chris Volk told me that he plans to expand his social media presence in 2024 and would be happy to connect with more individual REIT investors on LinkedIn. You can connect with him by clicking here.
Transcript of Interview with Chris Volk
1) STOR used to be our largest holding, but when it got bought out, we reinvested the proceeds into EPRT and it remains our largest net lease holding to this day. My understanding is that you also hold a position in EPRT. How do you think that EPRT compares to STOR?
Well, they say that imitation is the finest form of flattery! We started STORE in 2011 with the backing of Oaktree Capital, the state of Arizona retirement system, and added Texas Teachers and Illinois Teachers in a later private round of capital raising. Goldman Sachs subsequently led our 2014 public offering, with our founding equity holders exiting less than six quarters later with a return exceeding 20%. That kind of performance will generate interest!
EPRT was formed the quarter after the profitable exit of our founding shareholders with financial backing from Eldridge Industries and went public about two years later. Their strategy to hold profit-center real estate leased to middle market companies was similar to ours, as was their disclosure and their prospectus. Their CEO previously served as President of Spirit Finance (now Spirit Realty Capital), which I co-founded in 2003. Their Chief Operating Officer was someone I hired at our very first net lease company, Franchise Finance Corporation of America (FFCA), and who later joined our executive team at Spirit. Their Chairman was briefly my boss at GE Capital after we sold FFCA to GE in 2001. So, you can say we shared a lot of the same DNA. I liked our strategy at STORE and so hold a position in EPRT.
2) EPRT seems to be getting slightly smaller rent escalations in its leases than STOR did. Do you think that this is simply a case of them buying safer properties, or do you think that there is another reason that could explain the disparity?
EPRT probably gets hurt at the margin with their strategy of sticking to smaller individual real estate investments. Their average investment per location has averaged somewhere in the area of $3.5 million, which is low.
For sure, it means that there is little being done in the way of industrial and manufacturing real estate investing, which approximates 3% of their book. But the difference as you note will be small. For sure, the lease escalators they and other net lease companies will be able to get today will be better.
3) It seems that EPRT is putting greater emphasis on acquiring small, highly fungible net lease properties that are easier to release in case of tenant issues. They seem to be skipping some of the larger specialized assets like Bass Pro Shops, etc. Would you agree with this assessment?
I was willing to take the risk of making some larger per property investments in concepts we believed in. That decision raised our average per property investment to closer to $5 million. But diversity is so important. When we created STORE, we looked to have less than 1% exposure to more than 80% of our tenants. EPRT follows this formula, with their largest tenant not much more than 3% of revenues.
4) Realty Income today is probably the most popular net lease REIT among retail investors. One big reason for this is its long track record of paying monthly growing dividends. Is there a reason why STOR decided to pay quarterly dividends instead? It seems that paying a monthly dividend has the potential to help a net lease REIT reach a higher valuation multiple, which is very beneficial for external growth.
I have never been a believer that monthly dividends made that much of a difference to valuations. Early on, when Realty Income became the first company to take this path, becoming the “Monthly Dividend Company,” they were dominated by retail shareholders. Many years on, as an S&P 500 company, Realty Income’s shares are more than 80% controlled by institutional investors who are far less likely to care about the frequency of dividend payments. Obviously, there is some expense savings in being a quarterly dividend company. And really, having quarterly distributions means that a company can reinvest its cash for two more quarters and hopefully add some incremental return in the process. It’s not much, but every little bit helps.
One observation I would make is that the holders of REITs have changed a great deal over my career. We took FFCA public in 1994 and were the largest net lease REIT until our 2001 sale to GE Capital. During that period, and when we started Spirit two years later, institutional investors were dominated by the so-called “REIT Mafia,” who were basically REIT-dedicated investors having a real estate valuation mindset. Even when we were taking STORE public in 2014, the very notion that we might trade at an AFFO premium to established Dividend Aristocrats like O or NNN was near heresy.
Of course, this real estate bias did not exist anywhere else. A newly minted company like Shake Shack could well trade at a P/E multiple greater than McDonalds because investors in other sectors paid up for growth and total return expectations. NAV is the ultimate rear view mirror indicator because you’re being paid for what you have and not for what you will have. Not only that, but valuing companies based on NAV presumes that there is a correlation between NAV and return, which is a fallacy. Non-dedicated REIT shareholders see this and their observations are finally showing themselves in REIT valuations. This is why EPRT, with no investment-grade tenants and no monthly dividend is presently trading at an AFFO multiple premium to O. By the way, I should note that I also have a personal position in O.
5) You have previously explained in articles on Seeking Alpha how investors can attempt to estimate the growth prospects of net lease REITs by taking into account a number of factors such as their rent escalations, payout ratio, leakage, etc. But one factor that I have not seen you discuss is how the size net lease of a REIT affects its external growth prospects. Do you think that a large size is a big disadvantage?
First, it’s important to point out that well-run net lease REITs should nearly always trade at a premium to their equity NAV. After all, their shareholders benefit from asset diversity, economies of scale and the use of more efficient leverage. In addition, shareholders benefit from management and acquisition teams that can deliver a third way to grow returns beyond those of simple real estate ownership. I will elaborate on that later. To my way of thinking, REITs should do even better than this: buying properties investors generally would not see at cap rates they might not get and with leases superior in quality to those they might use. You do all this and your odds of trading at better than NAV start to get very good.
All real estate portfolio ownership has growth that comes from two sources: tenant rent increases and reinvested cash flow. When starting a REIT, it is important to get this right at the outset because it is so impactful to the growth you can eventually deliver. Conversely, if you get it wrong and have a large balance sheet, it becomes almost impossible to alter the challenging business model you have locked yourself into.
When we took STORE public in 2014, our dividend payout ratio was nearly 70% at the start. Likewise, we were conscientious about the importance of having high escalations, so STORE had the highest escalations of any company I ever led. When we did the math, and disclosed it to investors, the combination of rent increases and retained reinvested cash could deliver north of 5% annual growth. At the time of our IPO, our yield was in the 5% range, so this meant we had a shot of delivering a 10% investor return without issuing new equity to buy a thing. It was also insurance against the problems faced by a large balance sheet. The denominator effect would not impact us much as we got larger.
Trading at a premium to NAV enables external growth, or the ability to issue new equity at a higher AFFO multiple than our investment AFFO. In doing this, our shares would be diluted, so we had to share our existing AFFO with our new shareholders. But, if we could invest the equity proceeds into real estate having a lower AFFO multiple at cost, then we would be able to pay the new shareholders their dividends without eating into the money otherwise meant for our existing shareholders. Meanwhile, the existing shareholders would benefit from their dominant share of the AFFO investment spread, which would deliver added growth beyond just rent bumps and reinvested cash. We call that external growth.
Having been instrumental in guiding three net lease REITs, I learned the importance of getting the business model right at the outset. The trap you can otherwise fall into is an over-dependence on external growth, which is where size and the denominator effect can be damaging. I believe it’s very possible for net lease REITs to be formed having solid business models at the beginning that provide insurance against the perils of size.
6) Some net lease REITs have begun to expand into new property sectors as they grow larger. As an example, Realty Income recently invested in some data centers. But historically, it seems that the market has rewarded REITs for being highly specialized and punished diversified REITs with lower multiples. Would you be indifferent to net lease REITs investing across many property sectors, or would you prefer them to focus on one specific segment of the net lease market in an ideal situation?
When we listed our very first REIT, FFCA, we were 100% invested in a pool of more than 1,000 chain restaurant properties. Later, we began to expand into convenience stores, truck stops and automotive parts and services establishments. As the first net lease investment-grade company, I recall having to explain in detail our tenant base expansion to the rating agencies that covered us and the shareholders who invested with us. By the time we formed STORE, I had long come to a conclusion: restaurants, convenience stores, truck stops and auto parts and services companies are not asset classes. They were all part of a much larger asset class: profit-center real estate.
In an abstract sense, net lease companies do not own real estate. Their main assets are long-term contracts, which are backed by real estate. They only truly own real estate when tenants become insolvent and relinquish their properties or when tenants elect to not renew their leases. In this sense, whether a property is a cost center (think offices, bank branches, and distribution centers) or a profit center makes a large contractual difference. The underwriting and evaluation is simply not the same.
Interestingly, data centers can either be cost or profit centers. They are cost centers when they are held by companies for their own system requirements and they are profit centers when they are built to allocate processing and data storage for a fee to companies requiring cloud-based operations. Basically, they can be the data equivalent of self or cold storage.
Net lease REITs are each formed with missions and core competencies. This means that the array of real estate uses of the properties they hold is less important than whether those assets are expected to have a long-term relevance and whether the assets fit within the REIT’s stated mission. We took care to define our asset class and then proceeded to successfully invest in a wide array of profit center properties across the country.
7) VICI has previously made the argument that most net lease properties like Dollar General convenience stores are not built to last longer than a few decades. They may then need to be torn down and rebuilt. On the other hand, VICI's casinos are built to last forever and their tenants are required by their leases to reinvest a percentage of their revenue back into the properties each year. Do you view this as a significant advantage for specialized net lease properties like the casinos owned by VICI?
Well, I believe the comment is probably somewhat rhetorical. For sure The Venetian Casino in Las Vegas is built to last longer than a chain restaurant or a Dollar General store. But we have provided many twenty-year leases on chain restaurants that were twenty years old. These assets simply require periodic remodeling, which can happen every five years or so. If you are running a consumer-facing business and do not keep your property up to date, your business will suffer.
I have held stock in VICI since its listing. They invest in profit center real estate that our companies would not do because of its size and different financing implications. But behind their leases are substantial companies having large equity capitalizations and balance sheets. And their ownership of the very assets that give their tenants their ability to be in business means that VICI’s shareholders are at the front of the bus when it comes to their priority. How can you not like that?
8) You have previously explained that you believe that properties occupied by IG tenants are typically overpriced relative to non-IG tenants because there is far more capital chasing a limited number of assets, credit can change, and the leases of IG tenants are typically weaker. However, ADC has had great success focusing on IG properties and they argue that the best real estate is typically leased to strong IG-rated tenants since it results in lower cap rates and this maximizes their value. If the real estate is better located, it could then enjoy better prospects over the long run. Would you have any counter to that?
In the interest of disclosure, I am an ADC shareholder and have long been an admirer of Joey Agree and his team. ADC has an advantage of still being a relatively small company, which means they can pursue their investment thesis having less concern about the denominator effect as they load up on some attractive real estate having more elevated lease rates than in years past. I like their tenant base and am happy with their exposure to Walmart, which is their largest tenant. In addition, their roughly 12% exposure to ground lease assets makes them almost a hybrid between SAFE and a more traditional net lease REIT. Finally, the company has historically been the least levered REIT in the net lease arena. So, the Agree team has worked hard to assemble a bunker of a net lease company.
With all that said, if I were running STORE as a public company today, I’d be happy to bet Joey that our portfolio would outperform his based purely on its cost. Not only would I bet in favor of larger unlevered returns, but I would bet that we’d have a better Sharpe Ratio as well, allowing us to produce higher returns for each unit of volatility. On a levered cost basis, I would bet that we’d deliver even better risk-adjusted performance, since our unsecured ratings and cost of borrowings were similar to ADC and we deployed sightly higher leverage. Until STORE’s privatization in February of this year, it was the only net lease company to employ a two-pronged liability strategy, having access to AAA and A+ rated non-recourse secured ABS borrowings, while having the bulk of its assets unencumbered which supported a corporate unsecured rating. This enabled STORE to have the lowest leverage against its unencumbered assets (about 25%) of any net lease REIT, which provided our shareholders with added insulation from risk.
I believe net lease real estate leased to investment-grade companies tends to be mispriced, which is why I’d be willing to make the above bet. Hence, I elected to adhere to our diverse portfolio comprised of profit center real estate leased to non-rated tenants. To me, it is inconceivable that I could not create alpha against a portfolio of assets leased to investment grade tenants having materially lower gross returns (lease rates plus bumps).
9) You are a big proponent of investing in net lease properties. Are there any other property sectors that you like more than others?
I like many of the REIT sectors, but I am an adherent to the importance of business models. Companies can have solid business models and then get bid up so high that they have less investment appeal. This is why my REIT investments have been highly centered in the net lease space, where both the lease rates and operating profit margins remain among the highest and the AFFO multiples are among the lowest. I like industrial, single family residential and data center assets, but the valuation discrepancy has been palpable. My REIT holdings even include a few non-traditional companies like Lamar Advertising (LAMR) and Iron Mountain (IRM).
10) Finally, are there any specific REITs that you think have particularly interesting business models that you would like to highlight?
No, but I’d like to make an observation regarding net lease companies. When we’d conduct our investor day presentations at STORE, I’d typically conclude by preparing a highly simplified 5-year model. One of the questions would be, “What happens in period of high interest rates or inflation?” For us at STORE, I concluded that our returns, given stable annual investment activity, would likely remain the same – somewhere in the 10% to 12% area. We effectively created a solid company with a stable absolute return profile. If the ten-year yield were to rise, our new leases would likely capture about half that increase. Since we were 40% levered to cost and our incremental debt costs would rise, this would mean that the portfolio return attributes for shareholders would be about the same. Importantly, our annual retained cash flow, together with asset sales proceeds, would generally exceed our debt maturities, meaning we would not have the drag of having to roll our debt at higher costs. Any new borrowings layered on would be financing new assets at more elevated yields.
One of my observations from leading three public net lease REITs is that this sector tends to be wrongly seen by investors as being a hybrid bond investment. All you have to do is mention long-dated lease maturities and flashes of bond duration risk fly into people’s heads. Only investors are not buying bonds. They are buying stocks having shorter duration than that of Berkshire Hathaway. And our five-year model clearly illustrated that returns do not need to degrade as rates rise. But perception can be reality, so net lease companies tend to trade off mostly on fears of higher rates, together with interest rate volatility. But once rates stabilize and investors become comfortable with a better ability to predict the future, then net lease REITs rebound. This is why I have been happy to build net lease positions as the Ten-Year has touched 5%. We delivered a 19% compound investor return to the shareholders of Spirit Finance between 2003 and 2007 when the Ten-Year averaged 4.5% and lease rates for middle market companies were not much different from the investments STORE originated between 2011 and 2021.
Takeaways
Chris Volk is a strong believer in EPRT, which is very encouraging given that he is one of the best net lease investors of all time. This confirms our belief that EPRT is a good replacement for STOR. It is a similar, but slightly improved version of it.
Individual investors like monthly dividends, but this is counter-productive as it leads to higher costs for the REIT, which shareholders are ultimately paying.
REITs should trade at a premium to their net asset value. This has historically been the case during most periods, but they are today still priced at large discounts, which is exceptional. This means that you get the benefits of real estate with the added benefits of liquidity, diversification, limited liability, professional management, etc. at a discount.
Internal growth has far more value than external growth because it is much more predictable. It is not dependent on the mood of Mr. Market. Therefore, REIT business models that can achieve a stronger internal growth rate are likely to outperform over the long run.
Chris Volk owns some shares of Realty Income, but from my previous conversations with him, it seems to me that his position is very small and he owns it mainly because he serves as a consultant to the company.
He likes VICI Properties a lot as well. The quality of its leases and properties is exceptional.
He views Agree Realty as a "bunker of a net lease REIT", but he is almost certain that STOR, and therefore also EPRT, will outperform over the long run.
The business model of a REIT matters more than its property sector.
Net lease REITs are far more resilient to rising interest rates than the market appears to understand.
Closing Note
You can read our investment theses on EPRT, VICI, and ADC by clicking the links below:
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Sincerely,
Jussi Askola
Analyst's Disclosure: I/we have a beneficial long position in the shares of all companies held in the CORE PORTFOLIO, RETIREMENT PORTFOLIO, and INTERNATIONAL PORTFOLIO either through stock ownership, options, or other derivatives. High Yield Landlord® ('HYL') is managed by Leonberg Research, a subsidiary of Leonberg Capital. All rights are reserved. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. The newsletter is impersonal and subscribers/readers should not make any investment decision without conducting their own due diligence, and consulting their financial advisor about their specific situation. The information is obtained from sources believed to be reliable, but its accuracy cannot be guaranteed. The opinions expressed are those of the publisher and are subject to change without notice. We are a team of five analysts, each contributing distinct perspectives. Nonetheless, Jussi Askola, the leader of the service, is responsible for making the final investment decisions and overseeing the portfolio. We do not always agree with each other and an investment by Jussi should not be taken as an endorsement by other authors. Past performance is no guarantee of future results. Our portfolio performance data is provided by Interactive Brokers and believed to be accurate but its accuracy has not been audited and cannot be guaranteed. Our portfolio may not be perfectly comparable to the relevant index. It is more concentrated and may at times use margin and/or invest in companies that are not typically included in REIT indexes. Finally, High Yield Landlord is not a licensed securities dealer, broker, US investment adviser, or investment bank. We simply share research on the REIT sector.