How 'Serial Issuers' Of Debt And Equity Win: Morgan Stanley, Darden And Triple-Net REITs

On Thursday, Morgan Stanley analyst John Glass and his team published "Restaurants and REITs" to help investors understand the rationale behind the June 23 announcement by Darden of its "OpCo/PropCo" REIT strategy.

Darden is contributing 430 store locations (almost entirely Olive Garden) to a PropCo, which will then lease the locations back to Darden under triple-net leases. In addition to monthly rent, the OpCo will be responsible for paying the operating expenses, including taxes, insurance and almost all maintenance costs.

Related Link: Is Darden's REIT Announcement A Recipe For Success?

Net-Lease REIT Portfolio Diversity

Most triple-net REITs are diversified by tenant, industry type and across multiple geographies in an attempt to protect against changes in consumer preferences and maintain high occupancy during all economic cycles.

The Darden REIT Is A Choice

The REIT spin and sale-leaseback of 75 more individual stores is calculated to generate approximately $1 billion to Darden, which it intends to use to deleverage its balance sheet.

However, this is a very different scenario than retailer Sears Holdings Corp SHLD, which is cash-strapped and continues to hemorrhage huge sums on a quarterly basis. Tapping into the real estate assets on the Sears balance sheet through its Seritage Growth Properties SRG REIT was essentially a matter of survival.

Notably, Darden shares already pay investors a very competitive dividend, currently yielding 3.1 percent.

Red Lobster Haunts Darden

Darden activist hedge fund Starboard Value was vehemently against the transaction, as not being in the best interest of Darden shareholders, and successfully spearheaded the election of an entirely new board of directors.

The current Darden Opco/PropCo REIT strategy is an attempt to create additional shareholder value, since net-lease REITs trade at higher EV/EBITDA multiples than most restaurants.

Net-Lease REITs: Tenant Concentration Risk

However, many ARCP shareholders were not pleased with the high concentration of Red Lobster assets, the increase in exposure to restaurants in general and the reduction in percentage of investment grade tenants.

One plus for the Darden REIT is that its OpCo tenant has an investment grade rating, which is not the case with Sears or Red Lobster.

Morgan Stanley Trims Darden Valuation

Morgan Stanley expects the Darden REIT shares "to trade at a 10–20 percent discount to the group on an FFO multiple basis. This would translate to 11–13x FFO or 12–14x EV/EBITDA."

This is a reduction from initial estimates in the 13x–17x EV/EBITDA range, resulting in a new Darden price target range of $63&ndash$77, down from $63–$79 for the combined OpCo/PropCo.

Darden REIT Questions

There are major investor questions that have yet to be addressed:

• Lease Terms: So far, Darden management has mentioned very conservative rent coverage levels of approximately 3x, but that remains to be seen.
• Growth Strategy: Darden has indicated that it may pursue 1031 exchanges in an attempt to diversify, but Glass feels this would also require acquisitions and strategic dispositions.
• REIT Management: In order for net-lease REITs to grow, they are "serial issuers" of debt and equity, which in turn requires investor confidence to be successful.

Restaurant REIT Possibilities

Morgan Stanley noted that Bob Evans Farms Inc BOBE has recently announced its intention to pursue a REIT spin or sale-leaseback of its real estate.

Related Link: Should McDonald's Spin Out A McREIT?

McDonald's Corporation MCD has the largest portfolio of owned real estate worldwide and was the subject of a hedge fund presentation back in March, which suggested that its real estate was potentially worth $25 per share. However, McDonald's current management is not keen on the idea.

Morgan Stanley's Valuation Takeaway

"A combination of factors drive valuation in the Triple-Net REIT sector. On a relative basis, valuation is typically determined by a combination of the (1) external growth outlook, (2) perceived portfolio quality, (3) portfolio diversification and (4) leverage. On an absolute basis, interest rates and expectations are also an important valuation driver," Glass concluded.