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This article was coproduced with Nicholas Ward.
Every day, we’re one step closer to a potential vaccine and/or effective therapeutic that can end the COVID-19 pandemic.
This disease certainly isn’t going to disappear overnight. But as we approach the light at the end of the tunnel, we continue to see investors become and more bullish on equities.
After a slight pullback in mid September, the major averages are once again approaching all-time highs. And while the REIT sector as a whole has lagged the broader markets, we are seeing many of the blue-chip REITs recover nicely.
The vast majority of the REITs we track were trading below our Fair Value estimates during the spring and summer. Yet today, we’re noticing more and more companies creep back up to those price targets.
In other words, the margin of safety is tightening.
Recognizing that, let’s compare and contrast two dividend aristocrats in the triple-net REIT space:
Both have increased their annual dividends for at least 25 years, making them two of only five real estate stocks on the U.S. dividend champions list.
Therefore, right off the bat, there’s a lot to admire.
(Source: Yahoo Finance)
The Realty Income and National Retail Properties Facts
Historically speaking, Realty Income has nearly always traded at a premium to National Retail Properties.
Both companies generate reliable dividend growth and strong, long-term returns for their shareholders. Yet O is widely viewed as being best in breed and therefore garners a higher multiple.
For the record, we believe that premium is justified.
Realty Income has provided shareholders with about 15% long-term annualized returns. Its 4.5% long-term dividend growth rate is more than double the target inflation rate – meaning that its passive-income purchasing power is protected from being eroded by inflationary forces.
And it has paid its monthly dividend for more than 600 consecutive months. What’s not to like here?
With that said, National Retail Properties is no slouch in the income-oriented metrics department either. Plus, it has a longer annual dividend growth streak: 31 vs. 27, since Realty Income didn’t join the NYSE until 1994.
Both increased their dividends by just a little bit this year. And we expect their 2020 and 2021 raises will be below average.
National Retail announced a 1% increase in July. And Realty Income has continued to provide slight monthly increases throughout the pandemic on top of the 2.2% raise it announced in January.
But “below average” and “just a little bit” is all that’s necessary to keep their records intact. So we remain impressed with both of these names and their abilities to navigate such unprecedented times.
Data-Driven All the Way
Realty Income comes out on top when it comes to shutdown-specific rent collection. It’s been providing encouraging monthly progress, culminating so far at 93.8% for September.
In this, it continues to outpace many of its peers and the averages for freestanding retail and shopping centers alike.
(Source: O Investor Presentation, page 9)
Realty Income also showed improving trends in terms of rent collection from its top-20 industries. And it included a chart highlighting how most of its locations are at least partially open for business.
(Source: O Investor Presentation, pages 8 & 10)
Throughout the pandemic, we’ve remained very bullish on it. There are still too many investors allowing fear to dictate their real estate decision making. But we prefer to let data drive our actions.
As shown above, at the end of September, 98% of Realty Income’s retail portfolio was open for business. This points to continued strong rent check collection into the future.
Rent checks equate to adjusted fund from operations, and AFFO equates to sustainable dividends. So logic points to this REIT continuing to offer compelling long-term value.
Members of management certainly agree. During their October presentation, they noted that the current AFFO yield spread relative to the U.S. 10-year bond yield was well above long-term averages.
(Source: O Investor Presentation, page 5)
This nearly 500 basis point spread implies that:
- The market is expecting about a 31% decline in AFFO – which isn’t likely considering how the company’s performance throughout 2020 has been stable. Besides, the current full-year analyst consensus estimate for Realty Income’s AFFO is $3.45, which represents 4% year-over-year growth).
- A 10-year interest rate of approximately 2.5% – which also seems unlikely in the short term due to the macro forces at play here.
There are much better conclusions to come to here.
Back to National Retail Properties
Using the previously-cited AFFO yield spread data, Realty Income arrived at a potential fair value price of $88 – much higher than our current price target of $61.75.
The thing is, we don’t simply use the yield spread data to reach our estimate. We factor in a wide variety of data metrics, which seem to indicate shares are trading slightly above fair value at the present.
This is why, even though we believe it’s a best-in-breed play in the net-lease sector, we rate it as a Hold.
Remember, quality is just half of the equation when making investment decisions. The other half comes from valuation, which brings us back to National Retail Properties.
It doesn’t have the iREIT iQ quality score that Realty Income does. But it does have a much more attractive valuation.
Let’s start out nonetheless by comparing the two companies’ quality metrics.
(iREIT on Alpha)
Rent collection continues to be the No. 1 priority for REIT analysts these days, and understandably so.
Unfortunately, National Retail Properties doesn’t provide monthly rent collection updates like O does. However, its second quarter report published in early August shows those numbers trending higher too.
For the second quarter, the company collected 69% of its rents and deferred another 21%. The former figure lags the Realty Income’s 86.5% by a wide margin. Yet, we’re pleased to see the deferral agreements, which seem to imply that NNN is on the way back.
NNN collected 84% of its July rent, showing an upward trajectory over time. Again, that lags O’s 92.5%, but it also opens up a better buying opportunity.
We can’t help but wonder if the market isn’t allowing fear to cloud its long-term judgment here about a business that’s faithfully raised its annual dividend for over 30 years.
The Good, the Bad, and the Unloved
When we look at National Retail Properties’ property portfolio, we see a lot of similarities with Realty Income. The chart below compares some of the largest industry exposures within their two portfolios, which aren’t necessarily very far apart.
Of course, there are notable differences. For one, roughly 8% of Realty’s portfolio is made up of grocery store assets. These are very safe properties to hold right now, and they’re notably absent from its peer’s holdings.
Then again, NNN has a higher exposure to convenience stores, which also are looking good. Besides, O leases to more drug stores, an industry that is suffering on the front end due to the continuing rise of e-commerce.
Both companies have mid-single digit exposure to movie theaters – which is probably our least favorite form of physical retail in today’s environment. Rent collection figures from that subset is likely to continue to struggle for the foreseeable future.
Along those lines, NNN also has much higher exposure to full-service restaurants and family entertainment assets. Its near 16% weighting there and about 10% to theaters and health/fitness assets combined haven’t done it any favors.
That’s why Realty Income is expected to generate 4% year-over-year AFFO growth this year, and the current analyst consensus estimate for NNN is -9% year-over-year.
Thankfully, this $2.54/share AFFO estimate still covers the company’s forward dividend rate of $2.08 by a wide margin. And that’s a large reason why we’re bullish about it at the moment.
Though it’s not the only one.
Show Me The Money
Prior to the shutdowns, National Retail Properties’ experiential retail assets were the exact type analysts loved to see. They wanted triple-net plays to diversify themselves to protect against the power of e-commerce.
In this regard, NNN was at the forefront of revolutionizing its portfolio, a wise move up until the unpredictable pandemic. We’re simply not looking to throw blue-chips under the bus so fast when they continue to provide safe dividends.
Realty Income used its AFFO yield compared to the U.S. 10-year yield to justify its current share price. Well, we’d like to use another spread to justify our “Strong Buy” opinion of NNN.
As we mentioned earlier, Realty Income has historically traded at a premium to National Retail Properties. O’s 10-year average p/AFFO ratio is 18.51x, whereas NNN’s is 17.11x.
Today, Realty Income trades for 18.47x, which is right in line with that historical average. But National Retail Properties trades for 13.84x.
That implies an almost 20% discount to its long-term average.
We understand that NNN’s short-term performance is concerning. Over the long term though, we still like it.
Certain industries it’s aligned with will continue to suffer in the short term. And we stand by our bearish article on EPR Properties (EPR). Many theaters probably will close, but we don’t predict a complete extinction of the net lease subsector as a result.
Moreover, we definitely don’t expect to see things like restaurants and gyms go the way of the dodo.
If National Retail Properties were to experience mean reversion in the coming years as the economy continues to improve, investors buying its beaten-down shares today will be setting themselves up to lock in very strong total returns.
(Source: FAST Graphs)
The pink line of the FAST Graph above represents National Retail Properties’ 10-year 17.1x AFFO average multiple. If analysts are correct about its ability to generate $2.64/share in AFFO next year – leading to a mean reversion by the end of it – investors buying in at $36/share would generate a 25.85% annualized rate of return over the next 14 months or so.
Even if it took until the end of 2022 for the multiple to expand like that, they would make roughly 18% annualized over the next 26 months. These are fantastic potential profits.
But the best part is that NNN currently yields 5.78%. So patient investors should be paid a handsome sum while they wait for growth to pick back up.
Oh. And one more thing along those lines…
All told, there are seven net-lease REITs including gaming landlord VICI Properties (OTC:VICI) in our Cash Is King Portfolio. That’s over 26% exposure in this highly predictable property sector.
Since we began it on March 16, shares have returned 35.25%. Compare that to Vanguard Real Estate Index Fund ETF (VNQ) at 6.15%.
Net-lease is clearly the place to be looking.
(Source: Sharesight – Cash Is King Portfolio)
Author’s note: Brad Thomas is a Wall Street writer, which means he’s not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.
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Disclosure: I am/we are long O, NNN, VICI, FCPT, WPC, STOR, SRC. 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.