5% Dividend Yield From Postal Office Real Estate: Postal Realty (NYSE:PSTL)

Postal Realty Trust (PSTL) is an internally managed real estate investment trust (‘REIT’) that owns properties leased to the United States Postal Service (‘USPS’). The fragmented state of USPS properties makes PSTL an unlikely growth story with a hefty 5% dividend yield as a starting point. While the tenant concentration […]

Postal Realty Trust (PSTL) is an internally managed real estate investment trust (‘REIT’) that owns properties leased to the United States Postal Service (‘USPS’). The fragmented state of USPS properties makes PSTL an unlikely growth story with a hefty 5% dividend yield as a starting point. While the tenant concentration is a potential cause for concern, PSTL appears to be a worthy addition to any dividend growth portfolio.

Postal Office Real Estate

For those who are unfamiliar with postal office real estate, the USPS is a government entity whereas the underlying USPS properties are often privately owned. PSTL owns 666 such properties spread across 47 states, with a heavy concentration everywhere except the West coast:

(2020 Investor Presentation)

While it is tempting to put PSTL in the same league as triple net lease (‘NNN’) operators such as Realty Income (O), there are important distinctions to make. Typical NNN REITs like O leave the entirety of taxes, insurances, utilities, and maintenance expenses to the responsibility of its tenants. PSTL, on the other hand, is responsible for insurance and many components of maintenance expenses:

(2020 Investor Presentation)

USPS has proven to be a consistent and sticky tenant – lease retention rates averaged a high 97.9% over the past 10 years:

(2020 Investor Presentation)

The high lease retention rate is important considering that PSTL is facing significant lease expirations over the next 5 years:

(2020 Investor Presentation)

PSTL does not disclose comparable net operating income (‘SS NOI’), so I assume that its main growth lever is external acquisition. PSTL estimates that its footprint accounts for less than 5% of the 22,024 properties in the nation:

(2020 Investor Presentation)

Of the 400 properties managed by PSTL, the company retains right of first offer for 250 of those locations. This suggests clear visibility into the future growth pipeline. PSTL notes that it aims for acquisition cap rates between 7% and 9%. We can see the 2020 acquisition summary below:

(2020 Investor Presentation)

Based on its 94.6% NOI margin reported in the latest quarter, PSTL might earn $5.7 million in NOI from these acquisitions, for an estimated acquisition cap rate of 8.9%. The actual results will differ, but this back of the envelope estimation confirms that current acquisitions are projected to be within their acquisition cap rate range.

PSTL is targeting $100 million in acquisitions for 2020 which seems doable considering the footprint of PSTL’s managed property footprint.

Outlook For United States Postal Service

The reader may have some doubts regarding the financial strength of PSTL’s tenant in USPS. It is well known that USPS has been losing money for the past several years, but the story is far more complex than that. USPS is arguably mission-critical infrastructure for the United States economy, as it handles 48% of the world’s mail by volume. USPS added 1.3 million additional delivery points to its network in 2019. We can see below that rent accounted for only 1.3% of 2019 operating expenses, suggesting that there is little risk of USPS trying to cut costs by negotiating lower rents:

(2020 Investor Presentation)

There’s reason for optimism regarding the future outlook of USPS. E-commerce is expected to grow rapidly in the future, which should increase package volume as well as prices per package due to consumers’ increasing preference for speedy delivery:

(2020 Investor Presentation)

Regarding the fact that USPS has been losing money, the story is very complicated and seems political in nature. USPS actually was a highly profitable business prior to 2006, when it was required by the government to set $10 billion aside annually for health insurance plans (similar to a pension plan). We can see below that this immediately sent both net income and free cash flow negative in FY 2007. Free cash flow has actually been positive in recent years because USPS has been recording the $10 billion expense on its income statement but has not been setting aside that cash:

(Barron’s)

Should USPS be required to make these health plan payments? The answer is very political and hard to answer, but one thing seems clear: USPS appears to be fine financially aside from those payments. Considering that USPS has made 100% of rent payments even amidst the pandemic, there is no reason for immediate concern regarding USPS’ strength as a tenant.

Balance Sheet Analysis

Debt to annualized EBITDA stands at 6.2 times. PSTL has targeted a long term goal of 6.0 to 7.0 times debt to EBITDA. Because of PSTL’s small size, it has not had access to the unsecured credit market. As a result, it has financed acquisitions using its revolving credit facility, which carries a variable interest rate:

(2020 Investor Presentation)

While the actual interest rate is not so high, the revolving credit facility matures in 2023 and is inherently less flexible than longer dated unsecured bonds. Investors should look forward to PSTL making an entrance in the unsecured credit market scene over the next several years.

Valuation and Price Target

PSTL pays an annualized $0.82 dividend. Shares trade at a 5.4% dividend yield. The $0.205 quarterly dividend is amply covered by FFO of $0.23 per share and AFFO of $0.26 per share. Can we trust either metric?

We can see below that FFO ignores significant costs like recurring capital expenditures and lease amortization, while AFFO adds back equity-based compensation:

(2020 Investor Presentation)

My personal view is that we should determine dividend safety using “true” free cash flow, which in the case of PSTL is AFFO minus equity-based compensation. Under my definition, PSTL earns $0.20 in AFFO per share, which does not completely cover the $0.205 quarterly dividend. I still have confidence in the safety of the dividend because technically equity-based compensation does not take away from cash flow, even though it does produce more dividend-paying shares.

Shares appear to trade cheaply in light of rapidly growing cash flow. My 12 month fair value estimate is $20, representing a 4.1% dividend yield.

Risks

  • PSTL faces significant tenant concentration risk, as USPS is its only tenant. If Fedex (FDX) and United Parcel Service (UPS) are able to seize market share from USPS, then the company may face significant financial difficulties and may undergo a reorganization, which may lead to reduced lease rates. I anticipate any such developments to be gradual, as USPS retains the advantage of the largest footprint. However, as I stated above, I view USPS’ underlying financials as being quite solid and its net losses to be due to political reasons. I foresee any future changes to USPS’ business model to be related to the payment of the health insurance plans and view it unlikely for USPS to aim to reduce its footprint.

  • PSTL’s financial disclosures leave much to be desired. For starters, PSTL does not disclose SS NOI, nor leasing spreads. Perhaps PSTL will start disclosing these metrics in 2021, when we have a full year of public financial results for comparables. It would also be helpful if PSTL can disclose USPS EBITDAR coverage, which is the typical metric used to determine the financial strength of net lease REITs.

  • PSTL is still relying on its credit facility for financing, which has a very short duration and matures in 2023. In order for PSTL to accelerate its growth potential, it will likely need to earn an investment grade credit rating, which would enable it to issue low interest unsecured bonds. This may in turn lead to multiple expansion, at which point PSTL can more aggressively utilize its stock as currency. PSTL’s current debt structure means that it faces a potential debt wall in 2023.

Conclusion

At current moment, PSTL appears to present an attractive buying opportunity, as the company is still completing its aggressive growth pipeline. Despite public headlines, USPS has been a consistent and reliable tenant and PSTL may be able to further grow its bottom line through continued acquisition of postal office properties. PSTL’s leverage is reasonable, but the company will likely need to be embraced by the unsecured credit market before it is taken seriously by Wall Street. Shares have around 30% total return upside – I rate shares a buy.

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Disclosure: I am/we are long PSTL, O. 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.

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