Today’s market is tough.
Bond yields were already at historic lows that pushed traditional utility stock valuations to historic highs.
Other income-oriented equities like preferred shares and large REITs have also seen their share prices pushed up by lower-for-longer interest rates.
In today’s market, it is getting very difficult to find high quality conservative investments with a yield above 4% and even more difficult to find a monthly dividend-paying investment above 4%. What is an income investor to do?
One answer is to look for smaller, well-managed, fast-growing companies that are focused on returning a healthy share of their earnings to their shareholders. This article highlights one such company, Whitestone REIT (WSR, Financial).
Readers of some of my earlier articles will note that I published on Sure Dividend a series of articles on monthly dividend-paying REITs that started with "The Best Monthly Dividend Stocks."Â I didn’t cover Whitestone in that article because this small cap retail REIT had been flying under my radar. Now that I’m aware of Whitestone, it is time to take a long hard look at this relative newcomer to the group.
When selecting REITs for investment, it is important to look at the dividend yield through a qualitative (versus strictly quantitative) lens looking at the underlying risk-adjusted performance to ensure the overall metrics such as the balance sheet, diversification, earnings growth and payout ratios support continued growth of the REIT and its dividend.
Consistent with this approach, the investment thesis for Whitestone is presented in the following paragraphs and charts.
Whitestone in focus
Whitestone is a fully integrated real estate investment trust that owns, operates and redevelops community-centered properties. The company focuses on value creation in its community centers, concentrating on local service-oriented tenants.
Its diversified tenant base provides service offerings including medical, education, casual dining and convenience services. The company was founded on Aug. 20, 1998 as a nonpublicly traded REIT headquartered in Houston. Whitestone went public on Aug. 25, 2010 and is approaching six years of successful operation as a publicly traded REIT.
As of the end of June, Whitestone had a market capitalization of $420 million and owned 69 properties encompassing 5.9 million square feet with an average annualized base rent (ABR) of $16.05 serving 1,470 tenants.
Whitestone maintains a strong shareholder focus with the intent to manage its properties in the best interest of the company and its shareholders. Whitestone has focused its growth in the fast-growing Sun Belt cities of Phoenix, Houston, the Dallas-Fort Worth metropolitan area, Austin, Texas, and San Antonio. The figure below shows the population growth in the areas where Whitestone maintains its focus.
Source: WSR Website
Not only does Whitestone focus on fast-growing regions, it also focuses its investments toward fast-growing communities and neighborhoods within those regions.
The charts below show the local growth and income metrics for the local areas and neighborhoods where Whitestone focuses its property investments compared to its peers.
Source: WSR Website
In addition to focusing on higher per capita locales with higher forecasted growth in household income, Whitestone is selective in the properties it acquires. The chart below summarizes the property acquisition and review process that Whitestone utilizes.
Source: WSR website
The four charts above show, in summary, that Whitestone is targeting the sweet spots in the faster growing regions of the country and has a disciplined approach to property acquisition.
This approach should provide Whitestone with continued growth in rents, occupancy rates and acquired properties that should produce continued growth in funds from operations (FFO) and dividend payments.
Whitestone and retail REIT risk
I’ve written and commented previously that I don’t invest in small REITs or in general retail-anchored REITs because of the general headwinds from ecommerce. It is becoming easier every day to simply pop open your favorite search engine and find whatever it is you want at competitive prices on the Internet. I find myself shopping on the Internet more and more, and I’m one of the older generation. I can imagine that younger generations use the Internet even more than I do.
As a result of my dislike for traditional brick-and-mortar retail as investments, I have a high bar set for investing in retail-based REITs. Whitestone’s management has recognized the risk that ecommerce poses to traditional brick and mortar retail, and it has developed and implemented a strategy to minimize that risk.
Whitestone is selective in the tenants it chooses for its properties. Those tenants are heavily weighted with service providers like UPS (UPS, Financial), banks, insurance and medicine as well as restaurants and specialty retailers (drug stores, auto parts, coffee shops).
While this approach will not completely insulate Whitestone tenants from the ecommerce headwinds, it definitely mitigates the impact. When was the last time you ordered a double shot latte over the Internet?
The graphics below show Whitestone’s approach to tenant selection.
Source: WSR Website
As shown in the two figures above, Whitestone focuses on service providers to reduce the risk of losing tenants due to competition from ecommerce firms.
To a lesser extent, Whitestone’s strategy will also serve to mitigate the impact that a recession would have on its tenant base. While reduction in discretionary spending during recessions typically impacts restaurant revenue, the impacts on bank, insurance, health care and drug store revenue are significantly less. This makes the company fairly recession resistant.
I am impressed with Whitestone’s recognition of the ecommerce threat and its strategy to mitigate that threat. Let’s take a look at Whitestone’s recent performance.
How has Whitestone REIT performed?
Since it went public in 2010, Whitestone has performed well growing its revenue, net operating income (NOI) and funds from operations (FFO).
The chart below shows Whitestone has grown its financial metrics by 30% or more per year since 2010. Readers will note that the FFO/share has only grown 10% per year due to the dilutive effective of issuing more shares to fund property acquisitions.
For those readers not familiar with how REITs operate, issuing additional shares is a common practice to raise additional growth capital. As long as the REIT deploys that capital smartly and the acquisitions are accretive, the REIT also grows its FFO/share after dilution as is the case with Whitestone.
Source: Whitestone website
Whitestone’s early performance is impressive. Not many companies can grow NOI and FFO at 30%-plus per year. We can take a closer look at the growth in Whitestone’s financial metrics in the chart below.
Source: WSR Website
The above charts show that Whitestone has successfully grown its key financial metrics every year since the beginning of 2011, its first full year of operations. Readers will note that the gross assets chart above is not annualized for 2016 and only reports asset growth through the first quarter.
Whitestone, like most equity REITS, does not tip its hand on acquisition plans going forward, but we can expect additional asset growth in the second quarter through the fourth quarter. It is clear that Whitestone has been growing by property acquisition, but, in addition to acquisitions, Whitestone has also been increasing shareholder value through internal growth.
Source: WSR Website
The chart above shows that Whitestone has been successful at growing same-store (SS) NOI at 4.2% annually for the last 2¼ years.
While 4.2% doesn’t seem like a lot at first blush, SS NOI growth through higher occupancy rates and ABR increases doesn’t require much in the way of additional G&A costs, and therefore, the increase drops nicely to the bottom line.
Whitestone’s diligence in growing its assets and financials has translated into healthy dividend distributions to shareholders. The next chart shows total dividend distributions paid out versus FFO.
Source: WSR Website
It is important to fully understand the chart above. The yellow bars represent the total cash outlay in dividends to shareholders and the growth of the yellow bars over time represents the growth in the number of shares.
Whitestone has paid out a constant 95-cent dividend per month since its IPO which translates into an annual yield of 7.28% based on Friday’s closing share price of $15.67. The rising blue shaded area represents Whitestone’s growth in FFO. From the chart we also see that dividends paid out in 2011 and 2012 exceeded FFO (dividend payout ratio greater than 1.0). Whitestone’s dividends paid out were about equal to FFO in 2013 (dividend payout ratio equal to 1.0) and starting in 2014, FFO fully covered the dividend payments with room to spare (dividend payout ratio less than 1.0). The first quarter financial report shows Whitestone with a FFO dividend payout ratio of 0.81 (81%).
Expected future dividend growth
When an REIT goes public, it can choose to pay out a dividend rate that it can fully afford (payout ratio less than 1.0), or it can choose a dividend rate that it can grow into. Clearly, Whitestone chose the latter option and has now grown into the dividend it has been paying out for the last five years. So what can investors expect going forward?
My crystal ball is still cloudy, but it is a little less cloudy with Whitestone based on my experience with another REIT in a similar situation.
Physicians Realty Trust (DOC, Financial) is an equity REIT specializing in health care properties. Physicians Realty Trust went public in 2013 and, like Whitestone, chose to pay a dividend rate that it could not fully cover with FFO at the time of its IPO.
Like Whitestone, Physicians Realty Trust has steadily grown its revenue, NOI and FFO. Like Whitestone, Physicians Realty Trust has grown into its dividend rate and its FFO now fully covers its dividend with a current FFO payout ratio of 0.94 (94%). While there is no guarantee, it is expected that Physicians Realty Trust will provide its first dividend/share increase to shareholders in 2017.
Whitestone is likely to follow the same course as Physicians Realty Trust and, barring a new economic recession, Whitestone will begin raising the dividend paid on a per share basis.
But even if Whitestone does begin to raise its dividend, is Whitestone undervalued and investable at its current share price of $15.67?
Is Whitestone REIT undervalued today?
I’ve laid out above Whitestone’s past performance, but we also need to investigate the company’s current valuation to see if we would be getting a fair or maybe even a good deal.
Whitestone is currently priced at about $15.67 per share, and it has a 52-week high of $15.71 and a low of $9.44 so it is close to its high for the year. The recent release of the June Federal Open Market Committee meeting minutes and the loose monetary policy and the Brexit vote have all pushed the price of Whitestone and many of its peers up as investors run from higher risk equities to lower risk equities. But what about Whitestone’s valuation relative to its peers?
Source: Author
As seen in the chart above, Whitestone’s dividend yield is significantly higher than any of its peers at 7.3%. When we compare Whitestone’s Price/FFO (the REIT equivalent of P/E) with that of its peers, we see that Whitestone’s Price/FFO of 11.3 is significantly lower than its peers.
On an absolute scale, a Price/FFO of 11.3 is pretty cheap. Of the seven analysts that follow Whitestone, four rate it as a BUY, one rates it as OUTPERFORM and two rate it as a HOLD with a consensus fair value of $16.25 per share. Whitestone is cheap relative to its peers but because it is newer and smaller than its peers, the analysts covering Whitestone believe it is close to being fairly valued.
What are the potential risks of an investment in Whitestone REIT?
The potential risks of an investment in Whitestone are relatively low.
One area of potential exposure for Whitestone is carrying a not insignificant number of tenants with no credit rating. Some of the larger tenants (e.g. UPS, US Bank) have investment grade credit ratings, but many of Whitestone’s smaller tenants do not. This potential risk is partially mitigated by the strategy Whitestone has implemented in focusing its property investments in the growth and income sweet spots of the South and Southwest.
The second risk would be a general economic slump or recession in the U.S. An economic downturn would negatively impact Whitestone’s tenants and therefore Whitestone’s revenue and earnings. I’m not expecting to see a recession or significant economic downturn in the U.S. My expectation is for more of the same low interest rate and slow growth environment that we have had over the last few years. The recent Brexit vote pretty much guarantees loose monetary policy in the EU and the U.S. for the foreseeable future. With interest rates lower for longer, the probability of a recession in the U.S. appears very low.
The third potential risk is Whitestone’s debt load. Whitestone currently has a manageable but significant debt load resulting from borrowings to support its growth investments. The chart below is instructive for understanding Whitestone’s current debt load and what management intends to do over the next couple of years to address that debt load.
Source: WSR Website
Currently Whitestone’s Debt/EBITDA is 8.6x. This is rather on the high side. I generally consider a Debt/EBITDA ratio less than 8 to be OK and greater than 8 to be high. Whitestone is a wee bit over 8.
The good news is twofold. First, management has recognized that Whitestone’s debt is high and management believes it can lower that debt through same-store growth and higher occupancy.
Second, despite the high Debt/EBITDA ratio, Whitestone’s interest rate coverage is very good with a EBITDA/Interest Expense ratio of 3.1. A ratio of 3.1 indicates that Whitestone currently has more than sufficient earnings to cover its interest expense.
Wrapping it all up
Whitestone is a fast-growing small-cap retail REIT that focuses its property investments in high growth areas with above average family incomes and above average income growth and pays monthly dividends.
Since its IPO in 2010, it has performed very well. The current dividend is a generous 7.28% with a FFO payout ratio of 81%. Risks of an investment in Whitestone are reasonably low and Whitestone’s debt, while a little on the high side, is quite manageable with its healthy interest coverage ratio.
I’m definitely sold on investing in Whitestone, but I’d like to get my entry point at a price under $15 to give me a little margin under its 52-week high. Hopefully, the market will cooperate and give me that $15 price point.
(Published July 11 by Dirk S. Leach)
Disclosure: I am not long any of the stocks mentioned.
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