It seems as though nothing has been spared from the market carnage. Postal Realty (NYSE:PSTL), due to its post office leasing contracts with the Federal government, is largely immune to macro changes so its fundamentals are still strong, but its market price has fallen with everything else. At this now lower price point, I think it is once again quite opportunistic.
In particular, I think there are 3 aspects of its business that are getting overlooked.
- Over-equitized heading into market crash
- Re-leasing opportunity – mark to market with inflation
- AFFO vs FFO compared to peers
Cash pile is looking great right about now
I was a bit grumpy when Postal decided to issue a boat load of equity in November. Specifically, they issued $83 million worth of shares at $17 per share on 11/15/21.
Noting that even after the issuance PSTL has a market cap of about $300 million, it was quite massive.
The issuance was technically accretive in the long run in that once they get it fully invested in properties the cap rate on acquisitions is likely to exceed the dilutive cost of the capital. So, it was not a bad issuance necessarily, but I thought the accretion to FFO/share could have happened much faster if they instead broke that into multiple smaller issuances closer to the time at which the capital would be deployed.
See what happens when a big chunk of equity is issued and then it takes a while to put together the acquisitions that the company operates in an over-equitized fashion until it gets deployed. This shows up in the data as debt to total capital dropped well below 20% in 4Q21.
This is not an efficient level of leverage in that it is not minimizing cost of capital. PSTL has access to rather cheap debt and its equity is fairly expensive. Somewhere around 30-40% debt to total capital is a much more efficient level, even on a risk-adjusted basis.
This over-equitization has been leaving money on the table for the past few months.
However, that whole analysis changes with the market crash. After the market’s freefall, companies are finding it much harder to raise capital so it would potentially be difficult to match fund fresh equity raises with acquisitions.
Given this new information, Postal’s giant equity raise during the good times looks prescient. I’m not sure if it was a case of Andrew Spodek (their CEO) having precognition or if they just happened to issue and then got lucky that it turned out to be the right move.
Either way, this cash hoard is about to pay dividends to PSTL as they get to continue to execute on their accretive acquisition pipeline while much of the rest of the market has to slow down.
Given the sharp rise in interest rates, I suspect that will keep cap rates relatively high in the postal property space. Cap rights were already in the 7s for PSTL, and they might rise to around 8% if the Fed keeps doing what they are doing.
With its extremely low leverage, PSTL is positioned to buy as much as $100 million of post offices without issuing any more equity. That would simply take them up to a more normal leverage level.
At cap rates of 7.5-8%, this would be incremental annual NOI of $7.5-8 million. Netting out $4 million of interest expense assuming a 4% cost of debt that is incremental accretion to FFO of $3.5-4 million.
That is about a $0.20 increase to FFO/share at the midpoint.
Why I think the market is missing this info
The analyst consensus is calling for steady growth at PSTL, but at a more moderate pace.
They have PSTL going from $0.97 in 2022 to $1.07 in 2023.
I think this is wrong.
See 2022 is a trough year due to timing of the dilution from the massive equity raise. PSTL had already crested $0.25 quarterly in 2021 but simply got knocked back down heading into 2022 from that November issuance.
I think the analysts are calling for the ~$100 million of acquisitions to be financed with a blend of equity and debt but they are missing that the equity component is already in the numbers.
Since they are coming from this point of over-equitization it means the acquisitions can and should be financed entirely with debt to get back to a more normal level of leverage. Since debt is significantly cheaper than equity, it means the spread between ROIC and WACC is closer to 350-400 basis points rather than the more normal 200 basis points that the analysts seem to be factoring in to their FFO estimates.
Thus, from the acquisition side alone, I think PSTL will blow by the consensus analyst estimates. The market tends to follow the street, so I don’t think the higher FFO/share I’m estimating is priced into the stock.
Further, there is significant upside to FFO from organic growth.
Mark to Market Opportunity
PSTL has significant lease roll-over in the next few years.
Leases with the post office are significantly different than most commercial real estate leases. The government tends to sign flat leases rather than the normal escalators.
During the lease term this is clearly a negative, but when the lease rolls it is rolling from that flat level rather than an escalated level. Thus, the new lease factors in the cumulative inflation of the entire duration of the previous lease term. If it was a 5-year term which is fairly typical for post offices, the new lease will be higher by approximately 5 years of inflation give or take a bit for other mark to market forces.
Well, for the leases coming due in 2022, 2023 and 2024, 5 years of inflation is a huge number. I would anticipate lease roll-ups in the vicinity of 20% with perhaps a bit more for the 2024 rolls and a bit less for the 2022 rolls.
Between the primarily debt financed acquisitions and significant organic lease rate growth, I think PSTL will beat consensus FFO/share estimates by a significant margin.
Valuation – PSTL’s FFO goes further than that of peers
Neither FFO nor AFFO is a perfect earnings metric for REITs, and we usually have to make a couple adjustments to get to a clean number.
FFO is nice because it is NAREIT defined, so companies cannot sneak things in there. However, it is notably lacking in its accounting for tenant improvement and leasing commission costs (TI and LC).
AFFO is better in this regard, because it accounts for maintenance costs such as TI and LC. However, it too has problems because it is not a defined metric and companies can throw in unclean things.
For most REITs there is a gap between FFO and AFFO due to the TI and LC. The gap is enormous in office where these expenses are as much as 20% of revenue, but still quite prevalent in Postal’s industrial sector. Note below that the average industrial REIT trades at 30.1X AFFO.
In contrast, the sector trades at 26.2X FFO.
The FFO multiple is significantly lower because FFO is significantly higher than AFFO due to TI and LC.
Postal Realty is the exception. The government renews its post office leases at a very high rate around 98% whereas most of the sector has retention of about 50-70%. So, this means there is a lot less leasing to do and the post office also generally doesn’t require TI or LC to renew their leases.
As such PSTL’s AFFO is actually a bit higher than its FFO/share. This means that PSTL has a higher quality of FFO in that it does not lose a chunk to TI and LC.
Despite this advantage, it trades at a steep discount at 16.7X ($16.18/ $0.97) while the average industrial REIT goes for 26.2X.
I find this to be an opportunistic multiple given the growth PSTL has ahead from both acquisitions and roll-ups on renewed leases.
PSTL also looks attractive from a NAV standpoint with NAV around $18.25
Wrapping it up
Postal is still quite small so there is some risk inherent to that, but I think its size is also a plus in 2 potential ways.
- As PSTL crosses about $600 million it will be added to REIT indexes and the associated ETFs which tends to cause a flux of new buyers.
- It is a bite size acquisition making it a potential M&A target.
Overall, PSTL strikes me as undervalued and well positioned to handle this environment.