“We believe the value proposition is the durable income coupled with preservation of capital.” – Nicholas Schorsch, CEO of American Realty Capital
American Realty Capital (ARC) has been a disruptive force in the private REIT industry. Historically, private REIT offerings were littered with conflicts of interest, high fees, and no liquidity. ARC set out to change the game by creating more transparency and aligning management’s incentives with their shareholders. Their first multi-billion dollar offering, which we wrote about back in February last year, closed in the summer of 2011. Nine months later, ARC established a new precedent when they went full cycle with the offering by creating a liquidity event and listing the shares on the NASDAQ. Unlike other private REIT managers who sit on a portfolio of illiquid assets for years in order to collect their management fee, ARC built their compensation structure so that they would be highly incentivized to “find an exit” at the best possible price. With the success of their first major offering, ARC has grown at an incredible rate and now offers an entire suit of funds ranging from commercial real estate to mid-market business lending to collateralized loans. They have continued to improve their business practices by listening to their shareholders and in return, their shareholders have entrusted them with their capital.
We too are fans of ARC, although we haven’t been afraid to criticize some of their decisions in the past, based on their track record and commitment to shareholders. Last week I had the opportunity to go out to NY to learn more about a couple of their latest offerings including their flagship strategy being offered through ARCT V (American Realty Capital Trust Five). The flagship strategy has always focused on single tenant, commercial real estate properties located on the “corner of Main and Main,” which are backed by corporate credits (as opposed to mom and pop stores or franchisees). Most large retailors (e.g. Walgreens, Payless, Jack-In-The-Box, etc.) feel the best use of their capital is to invest it back into their businesses. As such, they don’t want to lock it up by owning the real estate for their stores. One way that they can unlock this capital is to sell the property to a company like ARC and immediately enter into a long-term lease obligation with the purchaser. This is a win-win for both parties as ARC is able to create a portfolio of “durable income” investments with 100% occupancy and their tenants are able to redeploy their capital back into their business to help it grow.
Today, ARC faces a couple unique challenges that were not really an issue when it rolled out its first flagship fund in ARCT back in 2007-08. For one, the economy has recovered from the depths of the financial crisis and as such, the price of real estate has gone up. This is best illustrated by the average capitalization rate (similar to the interest rate on a bond) ARC has locked in on each of their flagship strategy funds as illustrated below.
The decreasing cap rate is indicative of the fact that real estate prices are rising faster than rents. This in and off itself isn’t a bad thing as cap rate compression is indicative of an improving economy, which historically has been a tailwind for real estate. The 7.7 cap rate for ARCT V still translates into a 7.0% yield on the purchase price (commission waived) for our investors, which is fantastic in today’s yield starved environment. ARC is aware of the changing fundamentals and is finding it harder to close deals at favorable prices. They have already announced that there will not be an ARCT VI and that the company will instead focus its attention on other areas of the commercial real estate market where they see the most value. The fact that ARC was willing to cut off a profit machine of continually rolling out new funds around the flagship strategy speaks very highly of management’s commitment to their shareholders.
The second biggest change since the first ARCT fund was launched has been the speed at which ARC has been able to raise capital. It took ARC around 4 years to raise the capital and close the first ARCT fund. In contrast, ARCT V is expected to close by the end of the month, less than six months after opening. Deploying a mountain of capital comes will its own set of challenges. I was able to speak with two representatives from different companies that actually sell properties to ARC. They had plenty of praise for the ARC management team and how they conduct business. Their one caution was that ARC seemed to be way more driven by quantifiable statistics (e.g. cap rate, credit rating, etc.) than other intangibles such as location. We bring this up to simply point out that the original story of buying property on the corner of “main and main” has most likely drifted a bit due to a hotter real estate market and ARC’s need to deploy capital quickly. That being said, ARC is still highly incentivized to get the build a portfolio that will demand the highest price when they go to market, and the best way to do that is to assemble a diverse basket of high quality properties.
One thing ARC has done to accommodate the rapid inflow of new funds is to focus their attention on buying entire portfolios that meet their investment criteria versus assembling the portfolio one property at a time. One example is ARC’s recent $2.2 billion purchase of Inland Real Estate Corporation’s portfolio. The offering was originally for $3.5 billion, but ARC was able to negotiate favorable terms which allowed them to cherry pick the assets that were the best fit for several of their funds. The blended portfolio was purchased at right around a capitalization rate of 8.0. ARC was able to lock in the higher than market cap rate (lower price) because they had ample cash to close the deal and a team of analysts to streamline the due diligence process.
Even though ARC has gone through some growing pains, we are still comfortable recommending an allocation to this fund for our clients after having the chance to review ARC’s investment process, closed deals, and current pipeline. The biggest value-add for ARCT shareholders in the past has been ARC’s ability to buy assets in the private market at a discount to what they trade at in the public markets. By creating liquidity through listing the shares or selling the portfolio to a larger, publically traded REIT, ARC has been able to generate capital appreciation of 30% - 40% within 12-18 months of the fund’s closing. Although there is no guarantee that ARCT V will follow in these same footsteps, we think there is a good chance that similar returns can be achieved. In the case where something derails the opportunity to find a quick exit, we are still comfortable holding a diverse portfolio of high quality, single tenant, triple net lease, commercial real estate which generates a 7% yield.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.