A gaming analyst has downgraded shares of gaming real estate investment trusts VICI Properties and Gaming & Leisure Properties from a buy to hold as a reflection of the economic climate and its impact on mergers and acquisitions.
Deutsche Bank’s Carlo Santarelli said GLPI and VICI have been downgraded “as rate environment and accretion impacts are likely to linger.”
Santarelli said that since the inception of the two REITs, Deutsche Bank has recommended them, given the stability of their tenants, growth opportunities inherent in the acquisition landscape, and their respective valuations relative to other REITs, which he noted have generated less reliable cash flows and had “more considerable risks” inherent in their tenant base.
“We continue to view the gaming REIT complex as possessing many favorable aspects when compared to other REIT verticals and we believe the stability of the tenant cash flows are virtually unrivaled, as evidenced during the COVID shutdowns,” Santarelli wrote in a note to investors. “That being said, given current valuation, a more challenging M&A landscape, and increasing financing costs, which are likely to drive slower AFFO (adjusted funds from operations) growth, we are downgrading shares of GLPI and VICI to hold from buy.”
Santarelli said it’s important to point out that the downgrade doesn’t change their view on the businesses or stability of the cash flows, “but rather the broader climate, its impact on M&A activity and deal accretion, and valuation multiples we believe are full and unlikely to expand materially in the near to medium term.”
In addition, given refinancing activity in 2024 and 2025, Santarelli said they expect AFFO growth to further decelerate. The absence of mergers and acquisitions activity has resulted in “more limited accretion” in recent transactions, he added.
“We have lowered our target multiples for both GLPI and VICI and as such, our price targets are lower,” Santarelli said. “Our GLPI target stands at $52, down from $60, while our VICI price target goes to $34 from $39.”
Deutsche Bank doesn’t expect either of the REITs to miss forecasts, since the “checks will continue to arrive.” Santarelli reiterated that the bigger issue is the rate environment and valuations, along with the mergers-and- acquisitions landscape.
“We’ve been a bit perplexed by the rate environment and its impact on the gaming REITs as valuations have not just held up well. They’ve expanded despite the cost of capital migrating higher. Based on the trading multiples, one could be led to believe higher interest rates are a favorable dynamic. The gaming REITs have traded at about 13.5x forward AFFO during periods in which the 10-year exceeded 3%, while trading at 10.0-11.5x forward AFFO during periods in which rates ranged from 0-3%.”
Santarelli said they don’t think this dynamic lends itself “to multiple expansion as a likely outcome.” In addition, “Given limited prospects for meaningfully accretive mergers and acquisitions,” Deutsche Bank doesn’t see material upward revisions to AFFO as likely.
“While the expansion of the AFFO multiple as rates have expanded has been an interesting dynamic, it is not necessarily unique as market multiples have expanded,” Santarelli said. “Where we struggle a bit more with respect to valuation is the shrinking of the spread between the 10-year and the respective dividend yields.”
Since the arrival of COVID, the spread has continued to tighten as rates continue to rise. At current levels, GLPI is trading at about a 200-basis-point premium versus the 10-year yield compared to an average of 430 basis points since 2018.
VICI is trading at about a 100-basis-point premium versus the 10-year yield compared to an average of about 280 basis points since 2018.
“To put this tightening of the spread in perspective at current levels, applying the respective average spreads between the dividend yield and the 10-year would value GLPI at about $35 (-28% from current levels), while VICI would be valued at about $23 (-27% from current levels).”
Santarelli said they have long believed that given the more durable and diversified tenant portfolio, a less economically sensitive gaming business, and the barriers to competition within the gaming industry, “gaming REITs should and would eventually reach valuation parity with other more established REIT asset classes.”
While Santarelli said they believe the premium is justified, they don’t think the gaming REIT asset class “is likely to command a meaningful premium relative to the peers as the relative valuation case no longer serves as an element of the bull case.”
While AFFO growth via escalators, along with debt reduction, has been healthy for VICI and to a lesser extent GLPI, “step-function growth has been a product of acquisitions over the years, ” Santarelli said.
For several years, deal accretion, while not the only barometer of a high-quality transaction, has hovered in the 4% to 5% range, Santarelli said. Despite REIT equity multiples expanding, rising financing costs, increased competition, and fewer available portfolio deals of scale have forced the gaming REITs to become more resourceful.
“These factors have all contributed, to varying degrees, to what has been more tempered accretion in recent transactions,” Santarelli said. “At this juncture, we struggle to see how this changes materially in the near term, given the current landscape.”
Future refinancings are likely to hamper AFFO growth, Santarelli said.
On a first-quarter EBITDA run-rate basis, GLPI financial leverage stands at 4.9x, while VICI financial leverage stands at 5.9x. Over 2024 to 2025, GLPI has $1.25 billion of unsecured notes due, which equates to about 20% of its first-quarter 2023 end gross debt. VICI has $3.1 billion of unsecured bonds due, representing 18% of its debt capital stack.
“Given current pricing of the respective debt instruments, we anticipate refinancing activity to be a net drag on AFFO over the course of 2024 and 2025, barring a meaningful shift in interest-rate policies and debt capital markets,” Santarelli said.
Deutsche Bank estimates a 6% cost of debt for both GLPI and VICI on the refinancing of the notes due in 2024 and 2025 and that interest expenses would absorb roughly 42% of the organic AFFO growth for GLPI and 32% of the organic AFFO growth for VICI. VICI gets an added benefit from organic AFFO growth stemming from CPI-lined escalators.
Santarelli said while there are several drivers to 2024 AFFO forecasts and 2025 refinancings are likely to have a bigger impact on interest expense given the debt stacks, “it is hard to see the impact of the likely higher interest expense in consensus forecasts at present. As such, we believe refinancing activity could serve as a headwind to current consensus forecasts for 2024 and 2025.”
