Retail Opportunity Investments: M&A Is Likely
This article was coproduced with Wolf Report.
Do you recall our last article, over 4 months back at this point, on the west-coast-focused REIT Retail Opportunity Investments Corp. (NASDAQ:ROIC) where we reviewed and added a stake in the West Coast shopping center REIT?
While it can’t compare in scale or in safety to some of the REITs we write about more often, such as Agree Realty (ADC) and Realty Income (O), this company still warrants at the very least your attention.
Despite strong fundamentals and a portfolio that we argue practically makes certain a degree of outperformance or stability in the future, the company has not outperformed since the last article.
It has, in fact, dropped slightly, meaning the yield is now even better than before.
To call it a failure is a bit of a stretch.
The company is moving up and down in terms of valuation, and it’s our view that there’s a clear undervaluation at play here that makes the upside significantly attractive in terms of multi-year rates of return over time.
In addition, we view ROIC as a prime-time takeover target!
Also, as we’ll show you, this company typically actually trades at far higher multiples but has gone down to what we can almost consider a discount here.
Let’s see what we have here.
ROIC – The weakness is there – and this REIT remains a “BUY”
Now, as we said in the first article – ROIC isn’t a class leader – and our investments are primarily in just that – class leaders and businesses with both fundamentals and upside.
While ROIC has some of the fundamentals part down, it does have a BBB- credit rating which we would characterize as “so-so.”
However, from another perspective, if the company is actually “safe,” this marks the potential for a very attractive entry point with plenty of outperformance potential.
ROIC has a portfolio lease rate, as of the end of the last fiscal year and before Q1 2024, of 97.7%.
This isn’t as perfect as some of the net lease REITs we cover, but it’s good for what it is, and it’s very good for being a shopping center landlord.
Why is that?
Because ROIC is the largest grocery-anchored Shopping center REIT with a West Coast exposure.
You know from our previous articles that we’re careful with West Coast exposure – this is not our favorite geography to invest in.
But good companies can overcome potential risks in any geography, provided that the price is right.
So why ROIC?
A well-established portfolio of grocery-anchored shopping centers.
Grocery anchors ensure stability, and the company’s properties are in the heart of various areas, typically the affluent areas in its geography.
The company is apt at selecting leading metro markets that have high barriers to entry, and they pick tenants that focus on basic consumer goods and conservative services, with minimal concentration on one single tenant.
What makes this company different from other similar REITs?
- A stable portfolio with almost 98% leased, which is the highest amongst its closest peers.
- 96% lease rate or above, for over a decade running, including during COVID, which is unmatched by peers.
- The company has a diversified West Coast portfolio with the highest exposure in L.A at 28%, but relatively nice diversification beyond that.
- Tenants are superb, with 82% of ABR coming from daily necessity, service, and destination tenants
- Management is very apt at qualitative execution and consistently leases twice as much in space per year as is about to expire – again, a very good metric.
- The company has very good metrics despite a BBB-. 57% equity and 43% debt are good, with well-laddered maturities. Only the best of the best in this business really have significantly better than this.
If you’re curious exactly where the company’s assets are located, they’re all over the West Coast – but they have things in common.
They’re all densely populated communities with affluent demographics and above-average household income.
New construction in these areas is extremely limited, and there are very high barriers to entry to these areas.
Now one thing to consider is if you’re not convinced by Cali/West Coast investing.
If you’re not, then you might want to avoid this.
We say that the best REITs and best companies out of any area are very investable, and this is the case here as well.
Rexford Industrial Realty (REXR) is another good example of an above-average business in a below-average or somewhat worrying geography, that we believe will outperform and therefore invest in.
23% of this company is groceries, another 8% is drugstores/dental/medical, with 6% fitness and 5% financial.
The company also has a solid subset of restaurant exposure – both to full service, fast food, and fast casual, together about 22%.
So, 45% is some sort of grocery or eating/restaurant service, and 94% of the top 10 tenants’ annualized base rent, or ABR, is from daily-necessity retailers.
The company’s by far largest customer is Albertson/Safeway, but only at 5.6%, with the second being Kroger at 3.3%.
Below that, it’s all below 1.5% of the total ABR.
2023 was the first year that the company’s Anchor lease rate wasn’t a perfect 100%.
It went to 99%.
This was worth some attention, but not a decline worth what the company stock price has been dropping for a bit more than a month now.
The company’s lowest lease rates are found in the non-anchored segment as might be expected, but it’s actually above the 2020 level at 96% still here.
Again, a testament to the quality here.
So why is the company down so much?
Because, as we see it, the risk-free rate and current macro.
Unfortunately, ROIC has a history of trading at a relatively significant premium.
If we look at adjusted funds from operations, or AFFO, these premiums can at times go up to 23-24x, which is very high, but at one time not that long ago was justified for what the company offered.
We’ll look at these premiums in a bit – but first, let’s look at just how good the company’s finances are at this time.
The 2023 results were good.
The company increased results by 3.7% on a same-store NOI basis, with record-high activity for leasing, and a 22.2% increase in same-space cash rent on new leases, dispelling any notions that the company needs to “discount” its space in order to get clients in there.
The company also paid down debt, and 96.6% of the company’s gross leasable area is completely unencumbered by the year-end time.
Let’s look at the valuation for this business.
ROIC – Why ROIC will drive returns at this valuation
The company’s valuation is somewhat higher here than the lowest point when we wrote about the business last.
At this time, ROIC has a valuation of around 16x P/AFFO with an AFFO growth estimate of around 4% annually for the next few years.
This is neither terrible, but nor is it superb.
It’s so-so.
On a normalized basis, the company typically trades at 20-21x P/AFFO – but as we said in the last article, we would prefer to discount this somewhat down to at least 19x despite no historical average period going below the 20x P/AFFO average – rather, they go up to around 23-24x P/AFFO if you look at longer term-periods, indicating a high conviction both for the management as well for the portfolio and the business model.
What we would perhaps consider the most negative is the company’s failure to hit targets.
The company has a 45% miss rate negative on its forecasts, and this is with a 10% MoE. This is noticeable in an area, where we typically have 90%+ accuracy to lean back on – but not with ROIC.
That’s our logic for discounting the company at a decent amount here, and why we wouldn’t go higher than 19-20x here – that and the fact that there are plenty of better-graded REITs available that probably should be on your list above this particular one.
However, the upside exists.
The adjustments to forecasts as of 1Q have been only a cent lower in AFFO for 2024 (Source: FactSet). At a 19-20x P/AFFO, this company manages a 14-16% annualized RoR, and at below 21x, the company is close to 20% annualized here.
So, depending on what you’re looking for, and depending on what sort of risk tolerance you have and your other investment exposures, this might be of some interest to you as an investment.
The main problem with investing in ROIC is simply the fact that there are objectively better businesses available at either better valuations, better yields, better upside, or a combination of all of these things.
It’s not a bad opportunity, but we’re simply in an environment where despite no longer being at a crash-level valuation for many REITs, there are still excellent investments out there.
That’s why we invest in this after we’re done with businesses like O and ADC, which as we see things, are objectively better, safer, and better priced.
That was the case in our last article, and that is still the case today.
Looking at valuation, we would say as we said in the last article, that ROIC warrants at least a price of $15/share.
This is despite the valuation being somewhat down from our first target, and 9 analysts following the company currently averaging at around $14.5/share. (Source: S&P Global.)
Out of those 9 analysts, only 3 consider the company to be any sort of “BUY” here – they consider many other alternatives here to be objectively better, is our interpretation of the data here.
ROIC is a good and qualitative company.
Not the highest buy – but it’s still a worthy investment meeting our target of a 15% annualized.
Having mentioned REXR, we will take a look at that business as well to explain to you why we recently doubled our position in the geographical region.
For now, this is our 2024E thesis for ROIC.
Thesis
- ROIC, or Retail Opportunity Investments Corp, is a REIT out of the West Coast with an investment-grade credit, over 4.5% yield, and a portfolio that’s attractively exposed above all to grocery anchors. The company’s solid performance speaks in favor of investing in this business as it navigates the challenging macro we find ourselves in.
- While we would not call this company the first investment anyone should make, ROIC offers meaningful diversification for those already invested in other companies, or those wanting higher West Coast exposure with a doubled-digit potential combined upside from yield and reversal.
- Given management’s solid track record and the company’s fundamentals and upside, we rate ROIC a “BUY” here, and would give the company a target of at least $15/share.
Remember, we’re all about:
1. Buying undervalued – even if that undervaluation is slight, and not mind-numbingly massive – companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.
2. If the company goes well beyond normalization and goes into overvaluation, we harvest gains and rotate my position into other undervalued stocks, repeating #1.
3. If the company doesn’t go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, we buy more as time allows.
4. We reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.
Here are our criteria and how the company fulfills them (italicized).
- This company is overall qualitative.
- This company is fundamentally safe/conservative & well-run.
- This company pays a well-covered dividend.
- This company is currently cheap.
- This company has a realistic upside based on earnings growth or multiple expansion/reversion.
The company isn’t cheap, but it has a high enough upside to where we will say that this is a solid “BUY.”
Takeover Target!
In 2006, Kimco Realty (KIM) agreed to acquire Pan Pacific Retail Properties Inc. for $2.9 billion.
This deal allowed Kimco to beef up its portfolio by acquiring Pan Pacific’s 138 properties on the West Coast. A Morgan Stanley REIT analyst estimated the capitalization rate — ROI for the first year of ownership — on this transaction to be 6.3%.
Pan Pacific was formed by none other than Stuart Tanz, who is also the CEO of ROIC.
Currently, ROIC trades at an equity yield of 6.2% compared with KIM’s equity yield of 6.0%.
Given KIM’s balance sheet strength ($780 million of cash and full availability on $2 billion revolver) and cost of capital, we believe KIM should pursue M&A related to ROIC.
KIM has successfully integrated Weingarten Realty and RPT allowing the dominant shopping center REIT to continue consolidating high quality shopping centers.
Given the pricing for ROIC, we believe that KIM should pounce!
Data Duel
(I hope you’re enjoying our new “data duel” feature. Let us know your feedback please. Thank you).