Warren Buffett Recognized The Value Of Avoiding Toilets, Trash, And Taxes

As a free-standing net lease developer in a prior life, I always recognized the value of collecting rent checks from tenants, especially when they kept me away from the “3-T’s.”

That’s right, I built buildings and leased them back to a variety of companies that occupied stand-alone buildings, such as Advance Auto Parts, Sherwin Williams, and Blockbuster Video (I also leased stores to Payless Shoes – sad to see them closing down so many stores).

Oh yes, back to the 3-T’s, which stands for toilets, trash, and taxes.

You see, when you own real estate in which the tenant is responsible for ALL expenses – like fixing toilets, trash removal, and property taxes – it becomes relatively easy as a landlord, because all you have to do is collect a rent check. Duh, that sounds so easy.

Back in June 2017,  Warren Buffett’s firm, Berkshire Hathaway, recognized the secret of “3-T” investing and scooped up $377 million to own a stake (roughly 9.8%) in Store Capital (STOR). I wasn’t too surprised by this move, because I knew that the Triple Net REIT sector was an attractive and highly durable property sector. In fact, I upgraded Store from a BUY to a STRONG BUY just a month or so before Berkshire Hathaway entered the scene , and since the (Berkshire) investment, shares have increased by around 60% ($32.46 at yesterday’s close).

Our Strong Buy ratings signify our highly bullish stance on a REIT , targeting returns in excess of 25% in 12-18 months. And, back in the summer of 2017, we recognized the wide margin of safety with Store – and so did Berkshire Hathaway.

More recently, Store Capital has become soundly valued, and though we’re still bullish – increasing our position in the REIT this past December, we’ve adjusted our rating, from STRONG BUY to BUY.

To get more information about the company’s business model and its “flight to quality” attributes, I reached out to Store’s CEO Chris Volk. “Store” is an acronym for “single tenant operational real estate,” and is a core position in my Forbes newsletter’s Durable Income Portfolio. (A version of this interview appeared in the February issue.)

Brad Thomas: Store Capital is unique in the way it acquires net lease properties. Can you describe this differentiation?

Chris Volk: We operate an intricate business with a growing customer base of more than 430 tenants who lease more than 2,250 properties across 49 states (as of 12/31/18). Each quarter, we are capturing and evaluating thousands of financial statements, making strategic portfolio decisions and touching over a quarter of our customers. Roughly 40% of our general and administrative costs are associated with new business development and we have more relationship managers and a deeper credit evaluation team than anyone I know. We close 30 to 40 transactions every quarter, maintain an average transaction size of less than $10 million and achieve average transaction flow of well more than $100 million monthly. At the same time, we are profitably selling off 3% to 5% of our real estate portfolio annually.

Thomas: What is Store’s capital structure?

Volk: Leading net lease companies have historically relied solely or predominantly on a capital mix of unsecured corporate debt issuance and equity. Store has elected to have more capital structure diversity. We are rated BBB, BBB and Baa2 by Fitch Ratings, Standard and Poor’s and Moody’s, respectively, with about 60% of our real estate holdings unencumbered. But we also have our Master Funding conduit, which is a flexible secured borrowing source that now gives us access to AAA and A+ rated note issuance. Today, the Master Funding conduit provides the most competitive borrowing costs, but we are really focused on the benefits of diversity and flexibility that make such borrowing sources so complementary.

The result is that we have a better laddered maturity schedule, better debt repayment optionality and therefore less interest rate sensitivity than we would have, were we to rely solely on corporate unsecured borrowings. Master Funding also allows us to deliver far better unsecured debt ratios than we could have at any corporate credit rating.

Over time, I believe that this mix of highly rated, complementary borrowing sources will deliver us more competitive capital costs. With the advent of our inaugural AAA note issuances in 2018, enhanced capital costs efficiency is already evident.

Thomas: Store has more than doubled its pipeline of opportunities to $12 billion since its IPO. What is Store’s investable universe and growth prospects?

Volk: The market for profit center real estate exceeds $3 trillion. We set out to address the middle market sector of this market, which numbers in the tens of thousands of companies. Our median tenant has around $50 million in revenues, which is not really that small. Our weighted average dollar is invested in real estate leased to tenants having about $800 million in revenues.

Our tenants are obviously real estate-intensive and tend to be bank-dependent, which means they lack attractive means to finance their real estate. In Store, they have found a solution to improve the efficiency of their real estate capital, while also improving the flexibility of their company.

Both of these benefits stand to make their companies more valuable, which is why Store has been investing more than $100 million monthly, on average, since 2015. There is no way that we or anyone else can corner this market; it is simply too big. So, the size of the market and the demand by companies for efficient capital, offer Store the potential for sustained growth.

Thomas: Our February newsletter focus was the potential of the next recession. As I review Store’s categories of operators, I get somewhat nervous with casual dining and family entertainment. Also, can you address your company’s education exposure?

Volk: Recessions hurt any business and any stock. That said, it is important to keep in mind that we are always making investments that presume three or more recessions during the primary lease terms, which range up to 20 years. Our location lease coverage median after overhead has held in at just over 2:1 since we started the company in 2011. To put that coverage in terms of investment risk, our tenants would have to suffer sales declines in the neighborhood of 30% to 40% before the location profits would be insufficient to pay us.

Certain discretionary spending sectors may be deemed to have greater sensitivity, but we still have significant margins for error. Keep in mind that the same restaurant tenants you are talking about endured the Great Recession in 2008 and 2009.

As to education, we have no charter schools and have not made an investment in post-secondary education since 2015. Our major education exposure is centered in early childhood education, which is a space we continue to like.

Finally, and this is important, we receive about 80% of our rents from tenants we have less than 1% exposure to. Our top tenant at the end of 2018 is less than 3% of revenues and our top ten tenants do not comprise much more than 18% of revenues. So, while we can be expected to have issues with non-performing tenants from time to time, which is part of the business we are in, that exposure should be generally non-correlated and should not detract from the investment grade performance characteristics of the portfolio.

Thomas: Store has grown its AFFO nicely over the last several years. Do you expect to see continued growth in a similar range? Also, what’s your normalized payout ratio range?

Volk: At the moment, we have a dividend payout ratio of slightly less than 70%, which enables Store to have among the leading sector abilities to invest that free cash flow into new assets and allow our shareholders improved prospects for internal growth as a result of greater return compounding. Our aim is to continue to have amongst the most highly protected dividends in the sector. Growth ranges vary, but this ability to retain cash, coupled with sector-leading rent increases averaging 1.8% annually, should allow us to target AFFO per share growth in the range of 5% to 7% for some time to come.

Thomas: Even with the volatility in 2018, Store generated a return of 13.6%. Given the more recent pullback in the Fed’s rate policies in 2019, what are you expecting in terms of performance?

Volk: 2018 marked our fourth consecutive year of double-digit investor return performance. Since 2015, our returns have exceeded the S&P 500 and MSCI U.S. REIT Index (RMZ) for one-, two-, three- and four-year periods, as well as since our November 2014 IPO. We’ve achieved this exclusively through financial performance, since our AFFO multiple at the end of 2018 was slightly below the AFFO multiple at the beginning of 2015.

In other words, we did this with a median dividend yield of 4.6%, coupled with AFFO per share growth over the past four years of 34% and sector- leading dividend growth of 32%. We see no reason why we should not aspire to similar performance for our shareholders in 2019.

Thomas: On a personal note, I know you enjoy wearing bow ties. What’s your favorite one and why?

Volk: My first one. It was given to me by my daughter around the time we started Store Capital.

Readers of this column seeking our current “Strong Buys” just ripe for the picking – along with our March feature about A-Rated REITs, and updates on our model portfolios, can subscribe today to our monthly newsletter, Forbes Real Estate Investor. No other publicly available publication covers REITs so well – and so affordably. The new issue’s out Friday. Make yourself a subscriber – just click here. 

DISCLOSURE: I am long STOR

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