It’s not a home run type stock, but it’s a single with a high batting average. Baseball analysts and portfolio managers agree that it is consistent performance that is the basis of a good result.
National Retail (NNN) has always been a fundamentally sound company, but only recently started trading at an attractive valuation. Going forward, I expect FFO/stock to grow steadily in the low to mid-single digits, which is a solid return at this price level.
I have always been critical of NNN as well as its retail-based triple net counterparts because they traded at a massive premium to diversified triple net REITs. It made no sense that retail triple nets were trading at such a premium when retail was otherwise trading at a steep discount to the industry.
Well, over time, industry triple networks like Gladstone Commercial (GOOD) and WP Carey (WPC) have significantly outperformed, and that value gap has at least partially corrected. Below are the 3-year and 5-year total return charts.
After being left behind, National Retail is now trading at an attractive valuation.
The company did nothing wrong to cause this underperformance. The market was just trading it, along with the other retail triple nets, at a crazy valuation. In fact, NNN continued its long-term trajectory of FFO/share growth.
This combination of weak market price performance and strong fundamental performance left NNN at a freshly cheap FFO of 15.2X.
This reduced valuation is even more important on a relative basis, as the broader market and REITs are now trading at higher multiples than before.
So, whereas NNN was trading at a premium to the average REIT, it now trades at around a 25% discount to the average REIT on a multiple basis.
This is a massive improvement in valuation and as a result this long standing NNN bear is turning bullish.
The triple net business model is inherently reliable because it involves accumulating a contractual revenue stream across many properties from many different tenants. National Retail takes this stability to the next level with its scale and some conservative practices.
NNN owns thousands of properties in hundreds of submarkets.
These thousands of properties are rented out to hundreds of different tenants on long-term contracts.
Things can and do go wrong as evidenced by the pandemic that has taken away quite a few retail tenants. However, due to the extreme geographic and tenant diversification, the portfolio as a whole continues to perform.
NNN’s occupancy rate is consistently in the high 90% range, currently at around 98%.
This diversified contract revenue stream results in very few upside or downside surprises.
It is simply a game of financial allocation.
The broadcast game
NNN buys properties at capitalization rates that exceed its cost of capital, with the delta increasing the bottom line. Cap rates have risen slightly, but even in a low cap rate environment, the gap is healthy.
In 2021, NNN acquired approximately $450 million in properties at an average capitalization rate of 6.5% and a lease term of 18 years.
It finances these acquisitions through a combination of debt and equity.
High quality corporate debt is very cheap and even at its reduced multiple, the cost of equity is around 6.5%.
This gives a blended cost of around 5%, net of a 150 basis point spread on acquisitions.
Each acquisition adds an additional FFO/share, resulting in a slow and steady increase in FFO/share. Consensus estimates call for an increase in FFO/share to $3.21 in 2024.
Because the source of growth has been constant for so long and revenue is contractual in nature, the error bars around the consensus estimate are significantly smaller than for most companies.
The triple-net business model simply works, and triple-net REITs have largely produced above-market returns over long periods of time.
The key as an investor is to enter at the right price. A few years ago, National Retail was overvalued, but today it is trading at a reasonable valuation.
Although the business model is inherently reliable, retail is not the most bulletproof industry. There have been a few hiccups along the way, such as NNN having AMC Entertainment (AMC) as a major tenant at 2.9% of rental revenue.
When the pandemic hit AMC became an immediate danger for failing to pay the rent owed to the REIT. This is one of those situations where it might be better to be lucky than good, as the army of Reddit Apes seems to have fully bailed out NNN’s most troubled tenant.
With the influx of capital into the meme stock craze, AMC was able to raise over $1 billion in stock at ungodly valuations.
This essentially free money has allowed AMC to significantly reduce its level of debt and make its rent profitable.
Never in a million years would I expect the stock markets to bail out such a struggling company, but the fact is, it happened and NNN was a major beneficiary.
As of today, almost all NNN tenants are paying their rent again and forward cash flow has now exceeded its pre-pandemic run rate.
This has long been the general pattern of triple net REITs in which they weather tough economic times like the pandemic or the Great Financial Crisis and come out the other side recovered and ready to continue growing.
This resilience is one of the reasons why triple net REITs have always been so popular with investors, but recently a new headwind has emerged that has caused a large sell-off in the sector: inflation.
The theory goes that inflation is bad for triple-net REITs because their long-term contractual revenue streams prevent them from realizing the benefit of inflation since they won’t be able to raise rent for tenants until the end of the year. expiry of these contracts. In addition, inflation will generally drive up interest rates, which could make financing them more expensive. Fixed income with higher interest charges would hurt the bottom line.
However, in practice, that’s not really how it works. Most triple-net REITs saw inflation coming and locked themselves into long-term fixed rate debt. This is especially true for NNN.
According to NNN filings, they recently:
- Issuance of $450 million principal amount of 3.000% senior unsecured notes due 2052
- Issuance of $450 million principal amount of 3.500% senior unsecured notes due 2051
- Weighted average debt maturity increased to 14.9 years
With almost entirely fixed rate debt pushed back by an average of 14.9 years, NNN’s cost of funding will actually be slower to increase than its ability to increase rents, as the weighted average remaining lease term is d about 10 years.
Thus, NNN is inflation-neutral or perhaps even slightly advantaged, as the duration of assets is shorter than the duration of debt.
With the market widely viewing triple nets as a bad place during inflation, many of them have become opportunistically cheap. Quite simply, the bark of inflation is far worse than its bite because REITs have done such a good job of eliminating fixed rate debt.
Balance sheet and balance sheet
The final element of NNN that makes it a particularly reliable company is that it maintains low debt ratios which have earned it an investment grade rating.
The diversification inherent in the business model mitigates any setbacks along the way and the ample liquidity of its healthy balance sheet provides the capital needed to deal with any issues that arise.
As such, NNN has been able to consistently increase FFO/share over time and dividends with it. It is part of the rare club of companies that have been steadily increasing their dividend for 32 years.
Although the track record is impressive, I want to add a note of caution here.
Dividend history is often overstated as a predictor of future dividend security. A 32-year history of dividend growth could signal the company’s intention to keep growing, but it’s the fundamentals that dictate the company’s ability to do so.
To determine future dividend growth, it is far better to look at FFO/share growth, dividend payout ratio and other potential cash flow drains.
National Retail basically seems pretty well positioned for dividend growth.
- FFO/share should grow thanks to a combination of favorable rental listings and acquisitions.
- Current payout ratio is 71% ($2.12 annual paid quarterly versus $2.97 FFO forecast for 2022)
- Minimal Capex due to triple net leases covering CAM and other costs.
To wrap up
With its now updated valuation, NNN looks like a solid investment. Between the 4.7% dividend and low to mid-single digit growth, I’d say expected returns are around 8% to 10% per year assuming a stable trading multiple.
I still prefer BON and WPC in the triple net space, but if the sector continues to sell on inflation fears, I would consider owning all three.