Postal Realty Trust: Growth Strategy Appears Dilutive (NYSE:PSTL)

Introduction

Postal Realty Trust, Inc. (NYSE:PSTL) boasts a dividend yield of 6.06% and recently increased their dividend for the eleventh consecutive quarter since their IPO in May 2019. They are an internally managed real estate investment trust (“REIT”) focused on acquiring properties leased to the United States Postal Service (USPS). Having a stable, government-backed tenant with a high retention rate is a key reason an investment in PSTL is a worthwhile consideration.

In a sense, PSTL can be viewed as a conduit to government financing. You could invest in the 10-year Treasury directly and earn 3.125%, or invest in a landlord that derives rental income from a government-backed entity and earn substantially more. The USPS pays their bills on time and rarely relocates. The USPS can trace its roots back to 1775, a year before the founding of the U.S. They have the largest physical and logistical infrastructure of any non-military government institution. There are more USPS retail locations in the U.S. than McDonald’s and Starbucks combined. And, their infrastructure is critical to our growing eCommerce needs.

Sources: https://about.usps.com/who/profile/, Financesonline.com, Statista

There are some risks: the number of retail postal locations have decreased in the past decade; and the use of e-mail and online billing have reduced first-class mail volume. Still, it is hard to imagine a world without the need for the USPS. PSTL’s leadership team is well-seasoned, and sourcing favorable locations and terms that the USPS would consider leasing long-term appears to be within their area of expertise.

Source: PSTL 10-K 2021

Fragmented Industry and Growth Strategy

PSTL is the largest owner of properties leased to the USPS, with about 5% of market share. The next 20 portfolio owners combine for about 11% of market share. The industry is fragmented and there is potentially a long runway for growth and consolidation which will benefit PSTL. However, expansion could be expensive, since most USPS landlords are single-property landlords, and for PSTL to negotiate acquisitions with individual landlords across the country would be time consuming. Nevertheless, as long as PSTL can tap into debt markets at favorable terms relative to single property landlords, there are potentially accretive deals to be had. And PSTL’s ability to tap into debt markets will be based on operating metrics and management’s ability to execute a well-defined strategy.

In 2021, PSTL acquired 239 properties bringing their total investments of real estate properties to 966 as of the end of 2021. For the period ending May 6, 2022, PSTL has acquired 74 more properties.

Source: 2021 Annual Report, Q1 2022 Supplemental

Is PSTL Stock Cheap?

PSTL does not have a long track record, so in forming an opinion of value, the following are potentially relevant:

In January 2021, 3.25 million Class A common stock was priced at $15.25 per share in a follow-on offering.

In November 2021, 4.25 million Class A common stock was priced at $17 per share in a follow-on offering.

Please also take a look at Table 1, which shows the gross real estate less debt per share and the net real estate less debt per share for 2020 and 2021.

Table 1: Gross and Net Real Estate (Less Debt) per Share
	2020	2021
Gross real estate less debt	$ 17.46	$ 18.48
Net real estate less debt	$ 15.57	$ 16.96
Average share price	$ 14.61	$ 18.40

Source: Author’s calculation, PSTL 10-K 2021, Q1 2020 to Q4 2021 Supplemental

The share price today appears undervalued, which is not surprising given the current macroeconomic environment.

Lease

The majority of PSTL’s leases are modified double-net leases, whereby the tenant is responsible for utilities, routine maintenance and reimbursement of property taxes and the landlord is responsible for the insurance, roof and structure. There are some repairs and maintenance that fall on PSTL. Property maintenance-related payroll would also fall on PSTL.

The lease term is typically five years, and the current weighted average lease term is four years. This may seem short for a lease, but this is more a reflection of how the USPS does business than anything else. From 2012 to 2018, the historical weighted lease retention rate is 98.8%. In 2021, PSTL collected 100% of the rent due.

Peeling back from the surface, there is an issue with the leases that requires further analysis. The leases with the USPS provide for fixed annual rental payments without annual rent escalators. With rental revenues fixed, while property operating expenses are subject to inflation, there will naturally be some margin compression as the lease moves through time. When the lease gets renewed at the end of the term, there is presumably a wider than normal releasing spread. Unfortunately, PSTL only went public in 2019, so we do not have the benefit of getting a clear view of how wide the releasing spread is and if it makes up for the fact that there are no annual escalators during the term of the lease.

A related issue worth considering is that the going-in cap rate might not be as attractive as it looks if there is cap rate compression as time goes by. An 8% going-in cap rate is not the best reflection of the actual cap rate for the length of the lease, as an example.

From a theoretical point of view, if there are no lease escalators built in, then where exactly would organic annual dividend growth come from? The growth in dividends has to come from somewhere. If there is margin compression because of fixed rental revenues while property operating expenses are subject to inflation, then what growth rate can dividend growth-oriented investors expect? In a general sense, a REIT that has built-in lease escalators of, say, 2% and has some leverage in their capital structure might be able to support a 3% to 4% annual dividend growth rate, for example.

The CEO in the recent earnings call explained that the shorter lease term actually helps because PSTL is able to “mark to market” the lease every four or five years. However, there is still a question of whether the mark to market will make up for the four or five years in which rent stays the same and operating expenses fluctuate. And if they are able to secure a releasing spread that makes up for the lost rent escalator then it would probably be “mark to premium-to-market” which would require people at the USPS to agree to such terms. This is not something an analyst can readily accept without a lengthy track record to support the claim.

Source: PSTL 10-K 2021, Q1 2020 to Q4 2021 Supplemental, https://postalrealtytrust.com/

Dividends

We have a mismatch. There is not a clear theoretical link of how a sustainable annual growth rate in dividends will be achieved. And yet, we have the fact that there has been an increase in dividends for every quarter since the May 2019 IPO.

Ultimately, dividends come from AFFO and FFO, which come from NOI, which come from rental revenues. Please look at Table 2, which highlights the weighted average rent per square for the last nine quarters.

Table 2: Weighted Average Rent per Square Foot
	2020	2021	2022
1st Quarter	$ 9.83	$ 8.62	8.34
2nd Quarter	$ 9.87	$ 8.75
3rd Quarter	$ 9.94	$ 7.92
4th Quarter	$ 8.55	$ 8.22

Source: Q1 2020 to Q4 2021 Supplemental

Table 2 does not paint a picture of an accretive growth strategy. The weighted average rent per square foot has declined as compared to the previous quarter in all periods presented. There also appears to be a general trend towards a declining weighted average rent per square foot.

This is potentially a cause for concern and requires further scrutiny.

The point of growth is to derive benefits from scale. As a company grows, the unit costs decrease relative to sales. Let’s us take a look at some year-over-year metrics that could potentially shed some light. Please take a look at Table 3.

Table 3: Selected Metrics (in thousands)
	2020	2021	YoY Growth
Total revenues	$ 23,315	$ 38,276	64%
Real estate taxes	$ 3,095	$ 5,399	74%
Property operating expenses	$ 1,924	$ 3,987	107%
G&A	$ 8,230	$ 10,643	29%
Shares outstanding	7014	13689	95%

Source: PSTL 10-K 2021

The year-over-year comparison does not paint a favorable picture. While more seasoning is needed to make a comprehensive assessment, it is difficult to be reassured when the growth of real estate taxes and property operating expenses exceed the growth rate of total revenues for a young company.

Please take a look at Table 4, which highlights FFO and AFFO per common for the past five quarters.

Table 4: FFO, AFFO, and Dividends per Share
	Q4 2020	Q1 2021	Q2 2021	Q3 2021	Q4 2021
FFO per share	$ 0.26	$ 0.21	$ 0.25	$ 0.25	$ 0.24
AFFO per share	$ 0.28	$ 0.27	$ 0.26	$ 0.27	$ 0.25
Dividend per share	$ 0.2175	$ 0.2200	$ 0.2225	$ 0.2250	$ 0.2275
Dividends/AFFO	78%	81%	86%	83%	91%

Source: Q1 2020 to Q4 2021 Supplemental

Table 4 shows a increasing AFFO payout ratio at the end of the period compared to the beginning. This is one measure of dividend safety that is heading the wrong direction. There is a second mismatch here: usually when a company is on a growth trajectory, even a REIT, they try to retain as much capital as they can, within certain REIT-related limits. Here we have a company that is on an aggressive acquisition timetable, and yet their dividend payout exhibits an increase.

Dividends Relative to Treasuries

Earlier the article pointed out how PSTL can be viewed as a conduit for government financing. We could invest in risk-free treasuries or invest in a landlord that has the U.S. government as a tenant and earn substantially more yield. This is not the complete picture, because in the latter investment there is a sort of middleman in the form of PSTL which is the entity that we entrust with our capital. For minority investors we are subject to the ability of the “middleman” to execute their strategy. In this regard, the spread of the dividend yield to U.S. treasuries could be insightful. Basically, the narrower the spread, the less margin of safety the investor has in the management’s ability to execute an accretive strategy. The wider the spread, the larger the margin of safety the investor has. Given their limited track record, the prudent investor should be looking at a wider margin of safety.

Please take a look at Table 5.

Table 5: PSTL Dividend Yield Spread to the US 10-Year Treasury
	PSTL Dividend Yield	10-Year Treasury	Spread
2020 First Quarter	5.55%	1.37%	4.18%
2020 Second Quarter	5.12%	0.69%	4.43%
2020 Third Quarter	5.89%	0.65%	5.24%
2020 Fourth Quarter	5.64%	0.86%	4.78%
2021 First Quarter	5.35%	1.34%	4.01%
2021 Second Quarter	4.66%	1.59%	3.07%
2021 Third Quarter	4.67%	1.32%	3.34%
2021 Fourth Quarter	4.85%	1.53%	3.32%
2022 First Quarter	5.04%	1.95%	3.09%
Average	5.20%	1.26%	3.94%

Source: Author’s calculation, Q1 2020 to Q4 2021 Supplemental, https://fred.stlouisfed.org/

As the reader will note, the spread in general is narrowing. The average spread of the last three quarters is narrower than the first three quarters presented. This is not surprising given the current macroeconomic environment. Nevertheless, the fact is that the spread is narrower today than the average. There is currently less of a margin of safety relative to the 10-year treasury than only two other of periods presented.

Conclusion

There are two points I wish to conclude on: Firstly, the shares of PSTL could be undervalued currently if you consider the follow-on offerings in 2021 and the gross and net real estate (less debt) per share. I am of the opinion that we are in a bear market and many companies, including those with a dilutive growth strategy, seem undervalued.

The second point is that, for a long-term, dividend-growth oriented investor, it is difficult to support a bull thesis. It is probably best to sit this one out until a longer track record is established.

The dividend coverage is deteriorating. The weighted average rent per square foot has been declining. Property operating expenses and real estate taxes have been increasing faster than total revenues. In terms of the U.S. 10-year treasury, an investor would be paying more today for the stock than the historic average would warrant. I believe these factors support a sell recommendation.