My last post talked about my purchase of Lexington Realty Trust (NYSE: LXP) during the financial crisis. I sold most of my shares when they recovered, but I still hold a few. I have it on my radar and have watched it drop over the last several months. It looks interesting again.
My Basic Thesis on LXP
My basic thesis for this company is that funds from operations are going to be in the $1.00-$1.10 range and that any price under $7.00 per share allows for a payback period of just over six years.
Another way to look at it is by valuing the assets. Book value is not a good indicator for REITs because depreciation is a continual drain on assets at the same time that those assets could actually be increasing in value. Just basic back of the envelope valuation would look at NOI in the most recent quarter of $88 million annualized to about $353 million. Apply a capitalization rate of 7.5% to this income and you get an asset value of $4.7 billion. This is $1.3 billion above where property assets are held on their balance sheet. Adding this on to their book value would indicate a market value of equity of $2.8 billion, or $11.35 per share.
When I first started my analysis, Lexington Realty Trust was trading for just over half of their true equity value. In addition to this, they currently pay an annualized dividend of $0.68 per share. The current yield on this payout is approximately 8.3%, and they have indicated that they have excess cash that could be deployed to a dividend increase or to share buybacks over the coming year. All of this would be great for investors. If investors could get shares at around $7.00, returns would be 25% per year when factoring in dividends.
With all of this said, my biggest weakness as an investor is falling for a story. I tend to find what I want to find when I am doing research. It’s time to dig a little deeper.
My History with Lexington Realty Trust
My past analysis of Lexington can be found on Seeking Alpha. I first wrote about the company in 2009 when it was $5.00 per share. I followed up on it in 2010 when it was $6.25 per share. I bought and sold the company several times coming out of the financial crisis. It is a fairly easy company to understand and value. Looking back, my stressed analysis was pretty much spot on back then.
A Summary of Lexington Realty Trust
Lexington Realty Trust is focused on single-tenant, triple-net leased office and industrial buildings throughout the United States. As of year-end, they had 215 properties across 40 states. Their portfolio is 97% leased. Their investment focus is on properties that have long-term leases, typically 15-20 years. The obtain the majority of their portfolio through sale-leaseback transactions and build-to-suit projects.
In the past, they have held their properties on a long-term basis. Their current strategy is to sell properties that they consider non-core with 10 or more years left on the lease. This allows them to achieve favorable sale prices. Proceeds are then reinvested in new sale-leaseback transactions or build-to-suit projects.
Focusing on single-tenant properties does present some risks. It is often very expensive to convert a single tenant office building into a multi-tenant office building. Lexington is able to mitigate these risks due to their scale and their diversification. They have also developed experience in dealing with these situations to achieve favorable outcomes.
The long-term leases to credit tenants on a triple-net basis produces very predictable results. Expenses are covered by tenants, reducing Lexington’s exposure to increases in expenses due to inflation. Inflation is the tenant’s risk to take in Lexington’s business model. However, they are often able to achieve rent growth due to rent steps in leases. Long-term leases may not allow Lexington to push rents higher very often, but with this sacrifice comes stability of cash flow. This makes the company easier to understand and easier to value.
To purchase a single-tenant building requires an acceptance of risk. Without scale and diversification, this becomes a binary risk that most investors are not willing to take. Because of their scale, Lexington is able to purchase properties at more favorable capitalization rates than investors in multi-tenant properties are likely to achieve. Lexington can capture this cash flow, and by extension, their investors.
Lexington has also developed a reputation for sale-leaseback transactions and built relationships with their tenants over many years. This leads to favorable build-to-suit opportunities.
Finally, real estate by its very nature has certain barriers to entry. Each property is unique and provides certain benefits to the tenants in occupancy. Combined, these benefits produce some nice cash flow for the company and its shareholders.
Risk of Investing in Lexington
The two primary risks of investing in Lexington consist of leasing risk and financing risk.
Since the financial crisis, Lexington has done a good job focusing on leasing risks. The average lease term has grown from 6.9 years in 2012 to 12.6 years today. This greatly mitigates leasing risks at Lexington. This extension prevents quick rent growth in rising markets, but provides for a very stable and predictable income stream that also reduces management costs. In their supplemental information, Lexington provides a nice summary of lease expirations. Expirations do not cross 10% in any one year until 2025.
The other side of leasing risk is the potential for lease defaults. Only 34.5% of their revenue comes from investment grade tenants, while over half their tenants are unrated. One thing to consider here is that single-tenant leases likely mean that the property is fairly critical to the tenant occupying the space. However, the lack of investment grade tenants does pose a risk. This risk is mitigated largely through diversification. A significant recession, however, could push tenants into defaulting on leases and contracting their business. This risk would be compounded by market conditions that could reduce future leasing prospects for the short to intermediate term.
Their properties are 96.8% occupied in total. They have been above 95% occupancy since 2011.
One of the beneficial aspects of investing in real estate is the ability to use other people’s money. It allows real estate investors to generate leveraged returns. Lexington’s secured debt totals $891 million, or 22.3% of their total capitalization. Their goal is to continue to unencumber assets to create more balance sheet flexibility. They also are focused on maintaining their investment grade rating.
Their current financing structure offers some opportunity. Almost $150 million of mortgage debt matures in 2016, but the weighted average interest rate is 5.8%. The debt markets are not in a great place today, but Lexington should be able to improve on this interest rate. Next year offers a similar opportunity with a weighted average interest rate of 5.6%. Expect Lexington to reduce these rates by at least 1% overall in the coming year, producing more cash flow for shareholders.
Lexington is focused on managing their debt effectively and avoiding significant spikes in debt maturities. During the financial crisis, several REITs faced the prospect of having significant debt maturities in years where their was no financing available. This could always happen again, but the prospects for this in the near term appear unlikely. This is something to pay attention to over the coming years. Lexington has done a good job in staggering debt maturities to limit any significant spikes in debt maturities.
Having survived the financial crisis, Lexington’s management team has focused on avoiding some of the pitfalls identified when financing ceased. They have focused on their strategy and have leveraged their expertise in the single tenant space. They have also made very rational decisions with regard to share buybacks and deploying capital. If anything, management has been a bit too conservative. I prefer them to err on the conservative side. FFO has been consistent and is slowly growing. This predictability allows for great visibility into the business and the valuation of the company.
After the recession, Lexington has demonstrated fairly stable and improving performance. There is not a lot of growth here, but the company is fairly easy to value for someone familiar with commercial real estate.
I believe that $11.50 per share is a fairly conservative estimate of value for shares of Lexington Realty Trust. Management agrees that shares are undervalued based on recent share repurchases. I will look to add below $7.00 and sell above $13.50. Now is the time for patience. I missed a pretty good price about a month ago, adding only a small number of shares.
Valuing a REIT is a little different than valuing most companies. This analysis does illustrate the importance of knowing the value of a company and its assets. It allows an investor to have clarity on when to buy or sell. If Lexington once again falls below $7.00 per share, it will be an opportunity to achieve almost a 10% yield with a projected rate of return of over 25% for a three year hold. This is a nice threshold for me. If there is more market volatility, it could provide an opportunity to trade in and out of the company to achieve greater returns.
Disclosure: Dan owns shares of Lexington Realty Trust (LXP)