EastGroup Vs. STAG Industrial: A Tale Of 2 Strategies

In a recent article, I argued that STAG Industrial Inc. (NYSE:STAG) is overhyped and overpriced. The article focused on an analysis of a property that STAG recently purchased in Cleveland.

While STAG bulls are clearly more numerous than bears on Seeking Alpha, the feedback was generally positive. My goal is not to persuade anyone, or tell them how to invest. My goal is to educate and share my research and knowledge. Hopefully, most people who read that article learned something that will aid them in making their investment decisions regarding STAG whether they are bullish or bearish.

This article is a follow-up that is designed to build upon the previous article. It is informative on its own merits, but I will be referring to the previous article several times and will not rehash details. So, I strongly encourage taking a moment to read the previous article.

In this article, I will be taking a look at a property of another industrial REIT, EastGroup Properties Inc. (NYSE:EGP). EGP is a much older industrial REIT, and while it has exposure to secondary markets, it takes a very different approach.

My goal is not to tell you which stock to purchase. I do not currently invest in either of them. By presenting a comparison from the building level up to the headline numbers, I hope to better inform readers about different REIT strategies. There is not necessarily one "better" or "right" strategy, but the strategies will experience different performances as market conditions change.

The property I am going to look at is Steele Creek Commerce Park VI. I chose this property because I believe it is a good representation of EGP's strategy, both the benefits and risks. The building is 137,120 square feet and had a total cost basis of $8.2 million. This compares to EGP's average of 130,000 square feet and $9 million cost.

The Location

The building I analyzed in the STAG article was located in Cleveland, which I characterized as

"The future for Cleveland is uncertain, but there is a strong argument that there is potential for growth. As far as STAG's markets go, Cleveland appears to be a promising one to experience a revitalization."

Charlotte is slightly further down the road. Coming out of the recession, industrial vacancy rates were in the double digits. Since then, vacancy rates have dropped to 4.5%, and new construction has been modest. Rental rates have climbed to $4.79.

A Colliers report predicts for 2017,

"We expect 2017 to continue the trend started in 2016 with demand from user space /owners which in turn will push pricing. Speculators/investors will have a difficult time finding product priced correctly to achieve yields that they have been accustomed to in years past."

Charlotte has a market similar to Cleveland and indeed many secondary markets, where strong demand is meeting an insufficient supply. Cap rates are compressing on existing properties, and rent is rising but not fast enough to match the growth of property prices.

Both Charlotte and Cleveland are likely to see rent and vacancy rates flattening in the next few years as new construction helps alleviate the lack of supply.

The big difference between the STAG strategy and the EGP strategy in terms of locations is one of focus. STAG takes a scattergun approach, or as Benjamin Butcher prefers to term an 'agnostic' approach,

"So we're, as I - one of my favorite terms is agnosticity. We continue to demonstrate our agnosticity as the market. We're looking broadly across certainly the top 60, maybe 70 markets to find transactions that will produce the best cash flow returns for our shareholders."

EGP, on the other hand, has a very targeted approach with 94% of its properties in 18 core markets among five states. EGP recently had its first acquisition in Atlanta, and in the first quarter conference call, Marshall Loeb offered some insight into how EGP views entering a new market, describing Atlanta as,

"...Sunbelt, high growth, land constrained market and it's also a big enough market will result we're not going to go there and buy a building or two over time and really get stuck, but there's enough activity in Atlanta that we could reach a million square feet and hopefully be self-managed and have someone in an Atlanta office maybe a year or change from now will see how our growth there goes will be patiently optimistic has kind of been our label for that market."

Certainly, when it comes to diversification, STAG is king, and it is not uncommon to find STAG buildings in the same markets that EGP focuses on. EGP, on the other hand, is very patient and enters a new market with the intent of ultimately developing a very strong presence.

The risks of concentration can be seen with the current issues that EGP is having with Houston. Once a very profitable market for EGP, large amounts of speculation construction have flooded the market and have led to increasing vacancy rates. Over 40% of the current vacancies that EGP has are located in Houston. Management has been dealing with this issue by pausing development in Houston and selling off some of the properties to reduce their exposure.

On the positive side, EGP does an excellent job maintaining high occupancy, in general. Despite the issues in Houston, as of the end of 2016, EGP had an occupancy rate of 97.3%. STAG's was at 94.7%.

The Building

(Steele Creek Commerce Park VI, marketing photo courtesy of JLL)

The largest difference between the two REITs are the buildings. STAG generally purchases fully occupied buildings, usually with some age, in locations that have already been developed.

EGP spends most of its capital on new buildings in areas that are undeveloped. It participates in speculative building as well as pre-leased build-to-suit.

The Good

Steele Creek Commerce Park VI is a 137,120 square foot warehouse with 30-foot clear height. With 50' x 56' column spacing, it is equipped for modern equipment and practices. Construction was completed in 2016, and as the name implies, it is the sixth building constructed in this development by EGP.

(Steele Creek Commerce Park, build VI under construction aerial courtesy of Mecklenburg County Assessor)

EGP has already purchased an additional 47.9 acres that it intends to develop as a third phase of Steele Creek Commerce Park. There is plenty of room to expand, and an area of new buildings should deter blight and command superior rents.

While the building does not have railroad access, like the STAG building in Cleveland, it does have the advantage of being only 2 miles from Charlotte Douglas International Airport. It also has close access to I-485, the belt around Charlotte.

And The Bad

The largest risk anytime you are building a warehouse is demand. These projects take years from conception to actually collecting a rent check. Over those years, things can change, and there is no guarantee that the space can be leased.

In this case, the building is currently 75% leased to Hearth & Home. With demand as high as it is in the region, EGP should not have an issue leasing up the remainder.

But what about Phase III? It will be years before those buildings will be hitting the market. At any point, demand could disappear, and at each step of the process, there are costs that cannot be recovered if things go wrong.

From this aspect, STAG is far more secure since the buildings it purchased are already leased. When STAG invests, it starts receiving a known rent instantly. When EGP starts construction, the payoff is well into the future, and rental rates or even if the building can be leased at all are uncertain.

The Tenant

Hearth & Home Technologies is currently leasing 75% of the building. Hearth & Home is the world's largest hearth manufacturer and is a subsidiary of HNI Corporation (NYSE:HNI). It is moving from its previous location in Charlotte, which was also owned by EGP. The move is an increase of 40,000 square feet from its previous space.

In the STAG article, I said,

"The main issue I see is that STAG leases to a lot of small to mid-sized businesses. It is a sector that is more turbulent and subject to change. Whether growing or downsizing, these businesses are going to see their needs change more frequently than larger corporations."

In my opinion, EGP shares this challenge with STAG. It is one of the reasons I am not crazy about holding a REIT investing in secondary industrial markets. However, the way it manages the risk is a bit different. With its concentration on areas and modern buildings, EGP is more likely to be able to provide an expanding tenant with an upgraded space.

Historically, EGP's retention has been in the 80% range. However, last year, it was only 70%, due to the difficulties in Houston. STAG's retention has been around 70% long term.

For STAG, the tenant is an integral part of deciding which properties to purchase. For EGP, the property is often built before a tenant is known. EGP focuses more on the fundamentals of its specific markets.

Headlines

As I have discussed before, I put my priority on the properties, not on the headline numbers. However, it is worth taking a look and comparing. Over the last five years, the companies have been at different stages. EGP is a mature company that has recovered from a recession. STAG is a young company that had its IPO after the recession.

Despite the large difference in age, STAG has grown quickly, and the two companies are similar in size. For purposes of consistency, all numbers are as of December 31st of the referenced year, taken from the fourth quarter supplemental or 10-K for each company.

The chart above illustrates FFO/share by year. As you can see, EGP bottomed out in 2010 and began to recover. By the end of 2012, the first full year of STAG operations, the FFO spread between the two companies was $1.85. EGP has grown at a faster rate, and the spread has increased to $2.44.

Going into 2017, EGP management is projecting FFO between $4.21 and $4.31. That represents an increase of 5-7%. STAG management has not offered any guidance on FFO, though after Q1, it is on pace for roughly 5% growth.

Dividend

A large difference between the two companies is the dividend. EGP yields 3.2% and STAG is currently yielding 5.3%. STAG also offers the benefit of monthly dividends. Certainly, having a higher yield and monthly payments are two common reasons for investors to be drawn to STAG.

Can STAG maintain a higher dividend while also providing capital appreciation? Since IPO, STAG has consistently increased the dividend. However, the rate of increase has been slowing dramatically.

EGP, on the other hand, had a flat dividend through the recession and began increasing it in 2012. While very modest at first, its three-year growth rate has increased to 4.59%. STAG has a similar three-year growth rate, but the growth is heavily weighted towards 2014. Investors should question whether the current small dividend growth for STAG is a new normal, or if it is a temporary hurdle.

The payout ratio is a measure of dividend safety; is a company well prepared to face difficulties without risking the dividend? In EGP's case, it now has had a conservative payout ratio and in the previous recession that protected the dividend. Instead of cutting the dividend, the payout ratio drifted up to 73%.

Since then, the payout ratio has decreased to 61%. This provides plenty of room for near-term dividend growth, as well as protection from any unforeseen turbulence. Typically, EGP raises its dividend for the September payout. With its low payout ratio and projection for solid growth, investors can expect another decent to raise this year.

STAG has not been through a recession (as a public company) and a payout ratio that has consistently been in the high 80s. It is unlikely that STAG could go through a recession and maintain its current dividend. In order to decrease the payout ratio, dividend increases will need to remain below FFO growth. It appears that management is aware of this risk and has been taking steps to increase the margin of safety.

STAG has been increasing its dividend twice per year, once in January and once in July. In 2016, it skipped the July increase and only increased it by one penny per year in January 2017. For 2017, the July increase will return for a total dividend increase of 2.4% this year.

Capital Structure

Both companies share similar debt numbers, with approximately one third of their enterprise value as debt. EGP has a higher proportion of its debt that is secured at 28% to STAGs 16%. Its interest rates are comparable.

What is very different is its reliance on equity. Since 2012, EGP has increased its outstanding shares by only 11%. Profitable dispositions help fund new developments, and EGP grows its asset base at a slower rate.

STAG has relied on share issuances, and management has indicated that it intends to rely heavily on equity to fund acquisitions in 2017. True to its word, STAG has already raised $203 million through its ATM program, adding 8.188 million shares since January.

Since IPO, STAG has had an extremely aggressive acquisition strategy, having spent $2.2 billion and plans to spend another $500-600 million on acquisitions in 2017.

In addition to its common shares, STAG also has two outstanding preferred issues, totaling 5.8 million shares. EGP has no preferreds outstanding.

The end result is that STAG has been growing substantially faster than EGP in terms of market cap and book value. In exchange, shareholders have been significantly diluted.

When assessing an acquisition, STAG shareholders should be mindful that a significant portion of that property was paid for through dilution. As long as share prices remain high, the strategy can remain quite effective. In more bearish environments, STAG may need to look for other options.

Conclusion

EGP and STAG share some similarities. They both operate in secondary markets and they both have exposure to smaller tenants. For industrial investors looking to diversify beyond, the primary markets dominated by large corporate tenants, these are two tickers worth looking into.

The two companies offer a very stark difference in strategies. Where EGP takes a concentrated approach, STAG takes a highly diversified approach.

EGP builds new buildings to modern specifications. STAG does not hesitate to purchase buildings that are decades old and may have functional obsolescence. EGP puts an emphasis on quality. STAG focuses solely on cash flow.

EGP will take the risk of committing capital to a project before tenants are found. STAG primarily purchases properties with leases in place, collecting rent immediately upon purchase.

EGP grows at a methodical rate, while STAG has been acquiring at a frenzied rate.

Right now, both REITs are priced above their averages as industrial REITs, in general, have been on an upswing. I have been long EGP in the past and am currently out as part of a portfolio strategy to reduce exposure to the industrial sector.

For those looking for a short-term investment, STAG is likely to provide a higher IRR due to the higher cash flow from the dividend. For those looking for a long-term investment, I believe that EGP will prove to have more durable growth.

Sources: Company SEC Filings, Google Maps, Colliers International, JLL, Mecklenburg County Assessor

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source : https://seekingalpha.com/article/4068608-eastgroup-vs-stag-industrial-tale-2-strategies

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