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National Retail Properties (NNN)

Founded in 1984, National Retail Properties (NNN) is one of America's oldest triple net lease, or NNN, REITs. The company follows a "sale-leaseback" model in which it will buy a property from an existing tenant and then rent the property back to the former owner under long-term (10 to 20-year) contracts.

Triple net lease contracts require the tenant to pay for insurance, maintenance, and property taxes. National Retail Properties thus serves purely as a landlord, collecting a highly recurring stream of rent from which it pays its generous and growing dividends. These leases also have annual rental escalators built in (currently about 1.5% a year) that are based on a formula partially indexed to inflation.

National Retail owns nearly 2,700 properties in 48 states, leased to more than 400 tenants in 38 industries. Its largest concentration is in convenience stores (18.3% of rent) and experiential industries such as restaurants, entertainment centers, health clubs, auto service shops, and theaters.
Source: NNN Investor Presentation

Business Analysis

In order to be good dividend stocks for conservative income investors, REITs such as National Retail Properties rely on three main factors to generate high, safe, and steadily rising payouts.

The first is a very predictable business model, characterized by a a highly diversified portfolio of properties leased out to financially strong tenants.

For example, National Retail's top 25 tenants generate just 59% of its annual rent, and no single company represents more than 5.2% of its annual revenue. More importantly, the weighted average rental coverage for its largest customers is very high, with an operational cash flow-to-rent ratio of 3.6.

Even after all fixed costs are factored in, meaning maintenance, insurance, taxes, and other overhead costs, the cash flow of its average top tenant is 2.3 times greater than the rent they pay. These rental coverage ratios have generally been very stable over time, indicating that National Retail's tenants are not suffering nearly as much as other retail industries, such as malls and department stores.
Source: NNN Investor Presentation

As a result, National Retail Property's occupancy (currently close to 99%) has never fallen below 96.3% in the past 14 years and has remained far greater than that of the average REIT's over time.
Source: NNN Investor Presentation

The second important thing for REIT investors to focus on is the quality of the management team. This is important because these are the people making the long-term capital allocation decisions that let a REIT grow, and thus make sustainable dividend increases possible. 

In the case of National Retail, the average executive has 19 years of experience. This means that they have strong industry-specific expertise, including an ability to source new acquisitions from private parties rather than public markets. Private transactions (70% of the company's historical deals) are more profitable, with cash yield or cap rates averaging 7.8% compared to 7.4% for publicly-listed acquisitions. 

However, one of the most important concepts for REIT investors to understand is cost of capital and its effect on a REIT's growth prospects. 

Remember that REITs by law must distribute 90% of taxable net income as dividends. As a result, REITs must pay out the majority of their cash flow rather than reinvest it into growing the property base. 

That's why almost all REITs frequently tap the debt and equity markets for growth capital by borrowing debt and selling new shares. In order for a REIT to be able to grow profitably, its weighted average cost of capital must be below the cash yield it earns on new properties, which was close to 7% for National Retail Properties last year.

The company's higher than average cap rates are not just due to management sourcing a lot of its deals privately, but also the REIT's underlying business model. Specifically, National Retail Properties is interested only in free-standing properties, which have no anchor risk (unlike shopping centers or malls). 

By owning single-tenant properties, tenants are unable to pool their bargaining power together to try and reduce their rent. National Retail’s main street locations also provide a strong market for replacement tenants and rent growth over time.

In addition, management mostly rents to tenants who do not have investment grade credit ratings, which allows for better pricing and rent growth. Their lack of ratings doesn't necessarily mean that these are riskier customers. For example, credit rating agencies like S&P charge $100,000 to $500,000 a year (depending on the business) to rate a client, which is why many businesses forgo this expense. 
What National Retail focuses on instead is partnering with strong businesses in good markets, with solid fundamentals. Since each tenant's business is highly localized (to that specific high traffic area), most tenants are unlikely to move stores and risk losing customers when it comes time to renegotiate a lease. 

To put it another way, consumer-focused retailers face more switching costs than an office or industrial customer because they are more location-driven; they don’t want to risk disrupting their established customer base to save a bit on rent, resulting in stronger renewal rates.

This is why over the past decade National Retail Properties has averaged an 88% lease retention rate, which has been even higher in recent years. In fact, since 2014, the company's average renewal rate has increased and its lease recapture rate (new rent/old rent) has risen to 103%.
In other words, National Retail's tenant base not only appears to be doing quite well, but it is largely locked into the company's properties. As a result, they are more willing to pay higher rents (with annual escalators tied to inflation) and thus provide the REIT with excellent cash flow predictability.

While earning a healthy cash cap rate on its properties is very important, the final competitive advantage National Retail has is on the cost of capital side of the equation. Thanks to its conservative balance sheet, created by below average leverage and a high interest coverage ratio, the REIT has a BBB+ credit rating with a stable outlook from S&P.

This helps the company borrow very cheaply, at a 4.4% average interest rate with 7.2-year average bond duration. National Retail also has an untapped $900 million revolving line of credit (about 3% interest) that can be expanded to $1.6 billion at its request.

In addition to cheap debt, National Retail Properties enjoys a lower cost of equity (as represented by AFFO yield on new shares) than most of its rivals. This is due to the company's impeccable track record of 28 straight years of dividend growth. It's also thanks to the stock's track record of low volatility (72% less volatile than the S&P 500 over the last five years) and somewhat defensive nature (outperformed market by 11% during the financial crisis).
Source: NNN Investor Presentation

Thanks to these low costs of debt and equity, the REIT's average cost of capital is about 4.5%, which sits comfortably below the 6.5% to 7% average cash yield the company earns on each new property it purchases. As a result, National Retail should be less vulnerable to a spike in interest rates, which would increase the cost of debt capital. 

Thanks to this healthy cash yield spread, National Retail also enjoys a wide range of growth opportunities. The total size of the single tenant retail property market is estimated to be in the $1 trillion range, but the company's total assets are just $7.1 billion, providing plenty of room for future growth via acquisitions. The retail property market is extremely fragmented as well (most of the company’s properties are $2 million to 4 million in size), resulting in less buyer competition because it’s harder to scale in this market.

Overall, National Retail Properties' combination of a cash-rich business model, a conservative management team, above-average profitability, a well-diversified portfolio, and one of the best dividend growth records in the real estate sector appear to make it a solid long-term company.

Key Risks

There are four main risks to consider before investing in National Retail Properties. 

First, the retail environment is seeing meaningful disruption thanks to the increasingly popularity of online retailers such as Amazon (AMZN). 

In fact, Credit Suisse estimates that 25% of U.S. malls (about 275 locations totaling 1 billion square feet) will close in the next five years. National Retail Properties has done a good job in terms of "Amazon-proofing" itself thus far, thanks to its focus on single occupancy properties, which are rented out to convenience and experience-oriented tenants. 

However, there is a risk that even some of these tenants might eventually come under pressure, as Amazon plans to eventually offer things like free two-hour delivery for its Prime members, further increasing its convenience appeal. 

In addition, some of National Retail's properties can be specialized, such as gyms, banks, or movie theaters. This means that should a tenant fail (or not renew it lease), finding a new tenant may not be easy or will require expensive redevelopment costs. 

This is why triple net lease REITs such as National Retail generally turnover some of their properties each year (usually 10% to 20% the volume of new acquisitions). Basically, because vacant properties generate no rent and also require the REIT to pay for maintenance, taxes, and insurance, it often makes more sense to just sell the property than let it be a drain on the REIT's finances. 

However, if future retail disruption does become severe enough, then even though National Retail can adapt its portfolio over time to new thriving industries, the rate of new net property growth (and thus cash flow share growth) might slow. That in turn could result in even slower dividend increases. 

Besides potential disruption from e-commerce, it's worth repeating that many of National Retail’s tenants are non-investment grade businesses, which are ostensibly riskier that investment grade tenants in the event of a recession.

Management targets this group because it allows for better pricing and rent growth. The company also believes that tenant credit ratings can be a fleeting factor, and there is always room for tenant credit improvement.

Fortunately, National Retail’s results during the last recession (87% of prior leases were renewed in 2009 and 101% in 2010), the company's consistently high occupancy rates, and the fact that over half of National Retail’s rent is from public companies of those with rated debt reduce some of the concerns here. 

While most retail tenants will be impacted by an economic downturn, National Retail’s industry diversification provides some protection as well. For example, convenience stores (its largest industry exposure) would likely perform relatively well during the next recession.

Another risk factor is one that seems initially counterintuitive. REITs usually do best in a strong economy, because tenants that are thriving can afford higher rents (why REITs can actually be a good long-term hedge against inflation).

However, during long periods of prolonged economic expansion, property prices can rise, meaning that cash yields (cap rates) decline. In other words, new investments can become less profitable, and thus make it harder to grow adjusted funds from operations (AFFO) per share (and dividends) as quickly.

For example, in the chart below you can see that cap rates usually fall as the economic cycle ages, resetting to higher levels during a recession. The length of the current expansion has caused cap rates to decline from 9.5% to 6.9%.
Source: NNN Investor Presentation

Since National Retail has a very disciplined approach to acquisitions, the company might not be able to find enough profitable deals to keep up its recent growth rate. In fact, management expects $400 million in net property acquisitions in 2018, down from $600 million in 2017 and representing 4% AFFO per share growth (from 6% in 2017).

With the economy apparently accelerating, it might be several more years before National Retail can benefit from a resetting of higher cap rates and thus position itself for stronger growth rates that investors have come to expect.

Finally, no risk analysis would be complete without a discussion about interest rates. There is a common believe that REITs are highly interest rate sensitive, because in the last eight years, the lowest interest rates in history have made them "bond alternatives."

Or to put it another way, yield-starved investors have chosen low-risk REITs like National Retail Properties over risk-free U.S. Treasury bonds out of sheer necessity. Now that long-term rates are rising (largely due to higher inflation expectations), REITs have become highly rate sensitive, meaning that as Treasury yields rise, REIT yields are rising too (and thus their share prices are falling).

The concern is that if U.S. economic growth continues to be strong, then rising wages will drive higher inflation, causing interest rates to rise further and pushing REITs further into the red.

For investors with short time horizons, such as retirees following the 4% withdrawal rule, this is indeed a risk that may need to be planned for. The good news is that over the long term, REIT rate sensitivity tends to be cyclical and mean reverting. In fact, research shows that over the last 45 years there has been no correlation between REIT total returns and long-term interest rates.

This is because the same higher inflation (usually caused by strong economic growth) that causes long-term rates to rise means that many REITs can raise rents faster and thus grow AFFO per share and dividends faster than inflation over time.

In other words, long-term investors with well-diversified portfolios probably don't have to worry about rising rates hurting the growth prospects or dividend safety of an investment in National Retail Properties, especially considering the company's financial strength.

Overall, management’s conservatism reduces most of the diversifiable risk the company faces. It seems unlikely that any one industry, customer, or geography could permanently impair the company’s long-term earnings potential or jeopardize its dividend.

Closing Thoughts on National Retail Properties

Many triple net lease REITs enjoy a business model that is tailor-made for generous, secure, and steadily-growing dividends, and National Retail Properties is no exception. 

The company has proven itself among the best in its industry thanks to its conservative and disciplined management team, strong balance sheet, mostly "e-commerce proof" tenant base, meaningful diversification, and ability to grow its payout in just about any economic and interest rate environment. 

Therefore, National Retail Properties seems like a reasonable candidate to consider as part of a well-diversified portfolio for a lower-risk source of high-yield income. 

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