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STAG Industrial (STAG)

STAG Industrial (STAG) is a small but fast-growing industrial REIT that owns over 350 properties leased to more than 300 tenants in 37 states. The vast majority of its single-tenant properties are warehouses (88% of rental revenue) and light manufacturing (9%) facilities.
Source: STAG Industrial Investor Presentation
STAG's primary focus since its 2011 IPO has been buying warehouses in secondary markets (which have between 25 million to 200 million square feet of industrial rental space) such as Spartanburg, South Carolina; Milwaukee, Wisconsin; or Charlotte, North Carolina. Secondary markets account for 50% of rental revenue.

However, in recent years management has also been getting more aggressive in purchasing properties in 34 larger primary markets (over 200 million square feet of rentable industrial space) such as Chicago and Philadelphia. Primary markets account for 42% of rental revenue.

Business Analysis

Industrial REITs can be a way to gain exposure to the overall strength of the U.S. economy, since their tenants do well when the economy is growing (as it is now).

STAG Industrial specializes in free standing or single tenant warehouses or light manufacturing buildings, most of which are located in smaller, but faster-growing markets. This is by design, because since STAG Capital was founded in 2003 (precursor to the REIT which IPOd in 2011), management has determined that commercial real estate investors have been mispricing these kinds of properties.

Specifically, most commercial real estate investors believe that primary or super primary markets have higher, more stable occupancy and stronger pricing power (higher rents), which makes them worth paying more for.

STAG believes that secondary market fundamentals are actually far more attractive than what Wall Street is giving it credit for. For example, during the Great Recession occupancy in secondary markets held up just as well in primary markets, and rents actually fell less.

This is because in smaller cities there is less available industrial rental space, meaning tenants have less alternatives to move to. Or to put it another way, when there are less warehouses in a city, existing tenants have higher switching costs and are generally more willing to remain in place and pay higher rents (or at least demand smaller rental concessions during a recession).
Source: STAG Industrial Investor Presentation
STAG's goal has been to build a nation-spanning empire of secondary market industrial properties that are diversified across city, industry, and individual tenants.

For example, no single city, industry, or tenant represents more than 10%, 14%, or 2.6% of its rent, respectively. Of its tenants, more than 85% have revenues in excess of $100 million, and around 27% maintain an investment grade credit rating. Staying diversified and attempting to focus on larger, healthier tenants helps stabilize STAG's cash flow.
Source: STAG Industrial Investor Presentation
STAG also wants to be one of America's fastest-growing REITs, with a goal of expanding its property portfolio by 25% a year.

Management believes this is achievable because it's targeted markets represent about $250 billion of assets, of which it currently has 1% market share. In other words, STAG appears to have a very long growth runway ahead of it.
Source: STAG Industrial Investor Presentation
But that doesn't mean that STAG is trying to grow for growth's sake. Management is highly disciplined in the properties it buys, generally only acquiring just over 1% of properties it considers, making sure that the cash yield on a new property is greater than the firm's cost of capital. 

                               STAG Industrial 2016 Acquisition Selectivity
Source: STAG Industrial Investor Presentation
Management has proven to be highly skilled at not only allocating capital well (in 2017 the cash yield on new properties exceeded its cost of capital by 3%), but also at being disciplined with its use of external financing.

Specifically, STAG retains about 20% of its adjusted funds from operations, or AFFO (similar to free cash flow for a REIT), giving the dividend somewhat of a safety cushion and importantly providing the business with much needed low-cost growth capital.

From a leverage perspective, despite growing at a ferocious pace, STAG finished 2017 with a net debt/EBITDA ratio of just 5.0, far below the industry average of 6.0. The REIT also maintains strong interest coverage and fixed charge coverage ratios, which combine to earn the company a solid BBB credit rating from Fitch.

This helps the REIT to borrow cheaply (average 3.5% interest rate) to fund its growth projects and also helps ensure that the dividend isn't put at risk by dangerous amounts of debt.

Overall, STAG Industrial appears to be a well-run, fast-growing industrial REIT. The company pays a generous monthly dividend and appears to have decent long-term growth potential to compound its payout at a mid-single digit pace.

However, interested investors need to understand the risks facing STAG before trusting its management with their money.

Key Risks

While there are strong trends benefiting industrial REITs, such as the fast growth of e-commerce and accelerating economic growth, investors need to understand several risks associated with STAG.

First, the underlying thesis that secondary markets will hold up equally well as primary markets has not yet been tested, at least not while STAG has been a publicly-traded REIT.

Given the firm's short history as a publicly-traded company, investors don't yet know how the REIT's occupancy, retention rates, or cash flow will perform during the next economic downturn. Remember that industrial REITs are cyclical, because their tenants' businesses closely track the health of the general economy.

Investors also need to be aware that STAG's recent pace of growth may be set to slow, and thus the company might not be able to achieve its stated 25% portfolio growth target (which has resulted a fast-growing share price). For example, management's 2018 guidance calls for only about $450 million in net acquisitions compared to $545 million in 2017.

The reduced acquisitive growth target is largely due to two factors. First, management is finding less reasonably priced properties, since cash yields on new properties across the industry have been falling. The good news is this allows management to opportunistically sell some properties at attractive returns.

However, it also means that STAG's disciplined approach to purchasing good properties at good prices may become more challenging. In fact, for 2018 the REIT expects cash yields on new investments to come in around 7%, down from 7.4% in 2017, 7.9% in 2016, and as high as 9.2% in 2010. 

Compressing cash yields also mean that more money is now targeting secondary markets as well (the hunt for yield), which suggests that STAG could be facing more competition in its niche over the coming years. 

And with higher borrowing costs and a lower share price (higher cost of equity), the gross yield on new investments (cash yield on new property minus cost of capital) is likely to fall from 3% in 2017 to just 2.3% in 2018. 

In other words, the same strong economic growth that is causing the industry to boom is causing property prices to rise, making highly profitable growth harder to come by. This is especially true now that STAG is targeting more primary markets and extending its average lease duration (more cash flow stability).

This seems like a wise long-term decision, one that will position the REIT to achieve stronger retention rates (about 70% on expiring leases in recent years). In fact, in 2018 STAG expects to achieve about 75% retention, thanks to its focus on increasingly higher quality properties in more desirable markets. 

STAG is essentially positioning itself well ahead of the next correction, but at the cost of less profitable properties which will likely cause cash flow per share to grow slower than in the past.

However, this leads to two further considerations. STAG's dividend growth has been historically weak, as its fast pace of equity issuances (to raise growth capital) has caused ongoing share dilution to slow the rate of AFFO per share growth.

The firm's AFFO payout ratio has been coming down in recent years and is likely to continue to do so. However, the more cyclical nature of industrial REITs means that investors may have to wait a few more years to see the REIT achieve the kind of long-term 5% dividend growth analysts think it is capable of.

And that's assuming we don't get a correction in the meantime, which could cause cash flow per share to drop and force management to keep raising the payout at a snail's pace.

Then there's the issue of rising interest rates, which might hurt STAG's growth in two ways. Management has said it expects rising long-term interest rates to raise cash yields on new properties, but only after a lag of six to 18 months.

In the meantime, the REIT's share price has been significantly lowered from its earlier highs, raising its cost of equity and making it less profitable to fund new property purchases with freshly sold shares.

This is why STAG plans to depend more on debt in the short to medium-term, bringing its leverage ratio (Debt/Adjusted EBITDA) up from 5.0 at the end of 2017, to about 5.5 in 2018. Keep in mind that the average industrial REIT has a leverage ratio of 6 and management's long-term target range is 5.0 to 6.0.

So this increased use of debt is not necessarily a concern, though the REIT's plan to extend its bond duration through the use of five to 10 year unsecured notes could cause its average interest rate to climb from its current 3.5%. This would further compress the REIT's gross yield on new properties. 

In other words, while interest rates generally don't affect REIT growth rates over the long-term, in the short-term a sudden spike in costs of capital means that cash flow growth and dividend growth can slow.

Closing Thoughts on STAG Industrial

Industrial REITs can be attractive long-term high-yield income growth investments as part of a well-diversified portfolio. STAG Industrial’s strong experience in more niche and highly profitable markets means that it has the potential to pay generous and moderately growing dividends.

However, investors need to keep in mind that this industry is more cyclical than most in the REIT sector, with lower retention rates and more volatile cash flows that can result in lumpier and less dependable dividend growth. 

And because of the company's short track record in only positive economic conditions, STAG Industrial might not be appropriate for highly conservative investors who seek more proven and defensive investments. 

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