We’ve long wondered why, when Warren Buffett decided to invest in a REIT, he went with STORE Capital (NYSE: STOR), instead of the more popular real estate income (NYSE: O). To understand why we analyzed the two companies’ business models, their strengths and weaknesses, and whether Buffett had made the right choice.
The first thing we need to understand is that these two companies, although both are in triple net lease, have very different business strategies.
Realty Income is focused on the lowest possible cost of capital and isn’t afraid to pay top dollar for high quality portfolios with high credit quality tenants. It is primarily focused on delivering high risk-adjusted returns and boasts a beta to the S&P 500 of around 0.5. It has modest but very consistent dividend growth, which has averaged 4.4% since 1994, making the company one of the aristocrats of the S&P 500.
STORE Capital, on the other hand, focuses on making acquisitions with a high capitalization ratio, and instead of relying on formal credit metrics, they focus on profitability at the unit level. He boasts that his portfolio has a weighted average 4-wall fixed charge coverage ratio of 4.6x. The company’s dividend has increased at a CAGR of 6.2% since its IPO.
In summary, the Realty Income strategy attempts to minimize its cost of capital by maintaining a very high credit rating and delivering consistent results to its investors. In fact, it is one of only seven US REITs to have two A3/A- ratings or better. On the investment side, he simply buys high-quality portfolios with quality tenants. He can make good offers for these portfolios because his cost of capital is so low. On the other hand, STORE Capital’s strategy is to do the hard work of carefully underwriting each location, ensuring that it is highly profitable, even if the parent company is not. He focuses on the characteristics of each location and his strategy is to buy properties with high capitalization rates.
The strengths of Realty Income
Realty Income’s main strengths are its low cost of capital and, from an investor perspective, its consistency. It was one of the few S&P 500 REITs to increase its dividend during the 2020 Covid crisis or post positive earnings that year.
A significant advantage of the business is its size, which allows it to spend a smaller percentage of its rental income on general and administrative (G&A) expenses. Property income spends only ~4.9% on G&A, while the net median of rental peers spends ~9.3%.
Low property income
Realty Income’s main weakness is its reliance on low cost of capital. If investors lost confidence in the company or the stock price fell significantly, it would no longer be able to buy low-cap portfolios on an accretive basis. This could also happen if the rating agencies significantly downgrade the company’s credit rating, thereby increasing the cost of capital on debt and probably the cost of equity as well. Realty Income must therefore be extremely careful not to lose its high credit rating.
STORE Capital Highlights
STORE Capital’s main strengths are that it is able to acquire properties at high capitalization rates that continue to perform well through its huge underwriting effort at the property level, and that it targets very long leases. . As seen below, the average vesting cap rate for Realty Income has averaged around 5.9%, while STORE Capital has averaged around 7.8%. Therefore, they are on opposite sides of the spectrum when it comes to net lease REITs.
STORE Capital also has longer leases than Realty Income, with the former averaging 17.1 years and the latter 12.5 years.
The weakness of STORE Capital
The main weakness we see with STORE Capital is that it relies on companies that are generally unrated or do not have an investment credit rating. This means that errors in its underwriting can have serious consequences. In other words, it relies on its own due diligence and betting on specific locations more than the parent companies themselves.
Balance sheet strength
Both companies have strong balance sheets, with a debt to EBITDA ratio of around 6x, we’re not too worried that they can raise funding at decent rates.
They also have similar interest coverage ratios, with both having a ratio multiplied by interest earned greater than 2x.
Both companies have pretty decent industry diversification among their tenants, generally favoring non-discretionary, low-cost, retail, and non-commercial tenants. This protects them from some of the changes retail is going through, like the greater penetration of online shopping.
One of the main differences we can see between the two is that Realty Income is a bit more grocery-focused, while STORE Capital has full-service restaurants as its primary industry, with early childhood education as its second most important industry. Our biggest concern with Realty Income industries is “theatres”, while the one we’re most concerned about with STORE Capital is “health clubs”.
Buffett started investing in STORE Capital in 2017, and since then the total return has been similar for the two companies. We can’t really say at this point if Buffett erred in choosing STORE Capital over Realty Income.
Going forward, we are more optimistic about STORE Capital as it currently has a higher dividend yield, its AFFO payout ratio is lower and has been growing its dividend at a faster rate.
STORE Capital is also currently trading at a more attractive valuation based on EV/EBITDA, and close to its 5-year average, while Realty Income is trading at a much higher EV/EBITDA, even relative to its own average. over 5 years. Importantly, STORE Capital has underperformed in recent months as many investors worried about the departure of its CEO and co-founder Christopher Volk.
Dividend yields tell a similar story, with STORE Capital currently yielding around 1.2% more and performing above its 5-year average, while Realty Income is performing below its 5-year average.
The most likely reason why Buffett chose STORE Capital
STORE Capital seeks to purchase buildings below replacement cost and invest in properties with above traded market yields and returns. These strategies provide the business with a margin of safety, and we know that Buffett is a big fan of margin of safety investing, just as Professor Benjamin Graham taught him.
Realty Income and STORE Capital are high-quality REITs worth considering in a portfolio. Each has its own business strategy with corresponding strengths and weaknesses. We prefer STORE Capital’s strategy of carefully underwriting at the property level and trying to buy below replacement cost over Realty Income’s low cost of capital strategy, but both have provided investors with good returns over the years. So far, it’s unclear whether Buffett erred in choosing STORE Capital over Realty Income, as total return performance over the past five years has been similar. Going forward, we believe STORE Capital should outperform Realty Income given the lower valuation it is trading at.