Modiv Inc.: High Cost Of Financing Leaves Little Scope For Expansion (NYSE:MDV)

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By Snehasish Chaudhuri, MBA (Finance).

Net lease real estate investment trusts (“REITs”) generally rely on their ability to raise low-cost capital to finance their growths. The large-cap REITs find it easier in a favorable macroeconomic condition. On the other hand, small-cap REITs find it difficult to raise capital, especially when rising interest rates make it difficult for such REITs to raise additional capital, which is a prerequisite for capacity expansion.

Modiv Inc. (NYSE:MDV) is one such microcap Net Lease REIT which has relatively high office & retail exposure and significantly higher debt. The covid-19 pandemic has adversely impacted the office and retail real estate market. MDV has been compelled to liquidate some of its office properties and utilize those funds to repay its existing debt. However, MDV’s common stock failed to attract investors, and the stock has been on a gradual decline since it was first listed almost 9 months back.

MDV Rents Out its Properties to Creditworthy Single Tenants on Net Lease

Modiv Inc. holds a commanding position within the direct-to-consumer commercial real estate product industry. The Company invests, directly or indirectly, in income-producing properties located in the US, which are leased to creditworthy single tenants under long-term net leases. In a net lease system tenants need to pay a base monthly rental amount plus some portion of the property’s operating expenses, usually real estate taxes, insurance, and maintenance. As these assets are let out to a single tenant, they usually are of high quality, and are rented by multi-national companies like Starbucks or McDonalds, who occupy these properties under a net lease agreement.

Modiv Inc. owns 44 net lease properties that are let out to almost 30 clients, with long-term lease agreements. These lease agreements generally specify a clause of committed rent increments, which ensure a steady revenue. Almost half of MDV’s properties are rented out to companies operating in general retail, automobiles, and healthcare sectors. Around 55 percent of the portfolio is leased to investment grade credit rated tenants such as Kia Corporation (KSE:000270.KS), Sutter Health, Costco Wholesale Corporation (COST), AvAir, FUJIFILM Holdings Corporation (OTCPK:FUJIY), 3M Company (MMM), Cummins Inc. (CMI), Northrop Grumman Corporation (NOC), Dollar General Corporation (DG), etc.

Modiv Inc. is Rebalancing its Portfolio and Reducing its Existing Debt

Modiv Inc. has various types of assets in diversified real estate segments such as office, hotel & hospitality, retail, industrial and self-storage. However, from last year, it has started reducing its office real estate portfolio and increasing its industrial property portfolio. During this year, MDV has sold multiple office properties and office exposure as part of total portfolio has come down from 35 percent to 30 percent during the past one year. On the other hand, MDV has acquired several industrial properties including a KIA dealership and the industrial exposure as part of total portfolio has gone up from 46 percent to 51 percent. The change in portfolio composition is expected to enhance the occupancy and revenue of this net lease REIT.

Equities make up about 53 percent of total capital, while various forms of debt account for the rest. More than 90 percent debt is on fixed rate, thereby taking care of MDV’s debt service costs during a period of rising interest rates. Over the past few quarters, MDV has been focused on disposing of office and non-essential retail properties, with a particular focus on minimizing exposure to assets that have a remaining lease of less than 5 years. This enables MDV to reduce its existing debt. It also helps this REIT to generate cash for reinvestment. However, the current level of high interest rates doesn’t leave much scope for Modiv Inc. to raise further capital. Thus, raising additional capital will attract a very high cost.

Modiv Inc.’s Price Growth and Dividend Yield Fails to Raise Optimism

Modiv Inc. was formerly known as RW Holdings NNN REIT, Inc. and was incorporated in May 2015. However, this net lease REIT was listed in the New York Stock Exchange (NYSE) only 9 months back, and started paying monthly dividends only from February 2022. The average yield so far has been 3.64 percent. Thus, it is not possible to take any investment decision based on its yield history.

However, the good thing is, MDV has recorded stable quarterly diluted adjusted funds from operations (AFFO) per share since 2021 – Q1 2021: $0.25, Q2 2021: $0.34, Q3 2021: $0.44, Q4 2021: $0.27, Q1 2022: $0.29, and Q2 2022: $0.35. So far, the dividends have been covered by its AFFO, and the changes in the composition of its portfolio of assets is expected to enhance the occupancy and revenue, and in turn these should positively impact the AFFO.

Modiv Inc. has low price multiples at present. A price to book value (P/BV) of 0.47 reflects lack of confidence on the part of investors, despite the fact that it generates stable AFFO. Price to cash flow (P/CF) of 6.27 and price to sales (P/S) of 1.92, also signals that the stock’s value has less to do with the current financial metrics of MDV. Investors, it seems, are more concerned about the future growth of this net lease REIT.

When the stock was listed on February, 2022, it recorded a day’s high of $89.99. Since the very beginning, the price is on gradual decline, and has come down to a level of $10. The stock is trading around $10 for more than a month, and it seems that the price may stabilize here. But no conclusion can be derived about its price movement, as the current financial metrics are not getting reflected on its valuation.

Investment Thesis

In my opinion, Modiv Inc. is taking the right steps with respect to rebalancing its portfolio and reducing its debt exposure. It has a stable AFFO, and is generating decent yield, although it’s too soon to comment on its sustainability.

Despite all these, MDV’s common stock has failed to attract investors. Investors might be assuming that the rising interest rates will make it difficult for this REIT to raise additional capital, which is a prerequisite for capacity expansion. As MDV is selling some of its office properties, and repaying its existing debt, there is valid reason to suspect the sources of future growth. All these factors are unlikely to change anytime soon. I, too, am not optimistic that MDV will be able to escape this cycle and earn a higher valuation from the market anytime soon, and suggest a hold or sell.

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