Triple Net Lease REITs And The Income Investor: A Cash Flow Analysis

by: Bruce Miller

Summary

Several Triple Net Lease REITs have paid years of reliable and growing dividends.

Triple Net Lease REITs can be the most boring equity investment for reliable income.

Triple Net Lease REITs should be a staple of the income investor's portfolio.

Triple Net Lease REITs are probably the most boring equity investment contrived by man. Their revenues from 'tenants' can be as regular as rain in Seattle, dividends grow as slowly and steadily as dandelions in your lawn and with the right management, they can weather recessions better than most. As an income investor, I spend most of my time keeping tabs on companies that grow their dividends sufficiently to make up for the fixed income of preferred stock and (rarely) long maturity bonds I hold in our income portfolio, which allows the annual distributions from it to keep up with inflation. Triple Net Least REITs generally don't provide outsized dividend growth, so I look to those I hold to at least keep up with inflation over the years I hold them.

Triple Net Lease REITs are simple in their structure. The REIT looks for properties that are often held by companies who wish to maintain their brand through their buildings structure, colors, layout and control over these physical features...but the company wishes to free-up the equity tied up in their property by selling the title to the REIT, make lease payments to the REIT (a sort of sale lease-back) and maintain the property to their liking, including paying their own insurance, property taxes and maintenance. This means the Triple Net Lease REIT has two primary concerns in finding such properties: ensure the 'tenant' has the business and management that will be able to sustain lease payments through various economic conditions and to make sure the right mix of debt, equity and minority interest is used to finance the buying of such properties. As is always the case, those REITs who do this well make it look easy. It isn't easy.

So how well does this group of equity REITs sustain and grow its dividends to those of us who rely on them to provide our retirement household income? To study this, I first had to come up with a list, and for Triple Net Lease REITs, this is not easy, as I don't think there is one. So I simply searched the archives of several online REIT discussion forums until I came up with a list of 17 such REITs. I then reduced this to REITs that had at least 5 years of dividends that had grown over this period, although they did not have to grow the dividend each year. This left me with 8 Net Lease REITs: (NYSE:NNN), (NYSE:O), (NYSE:WPC), (NYSE:EPR), (NYSE:ADC), (NYSE:GOV), (NYSE:LXP) and (NYSE:OLP).

Gathering the Data:

I collected all cash flow data from company financial reports as shown on Morningstar, with occasional corrections from other web sites or the company's quarterly or annual shareholder report. With the exception of historic dividend growth data, I used the past 10 quarters of data (which I'll refer to as 10Q), calculating ratios using a rolling 4-quarters of data to smooth out the peaks and troughs typical of quarterly reporting. I use only GAAP numbers in performing ratios for trending, with the primary source of data being the company's statement of Cash Flows (SCF), which I explain in my past article on how to use the SCF. This analysis will report on 6 key cash flow metrics I feel are important in measuring a company's ability to sustain and grow their dividend into the future. It is important to note that no single metric or even group of metrics will always predict a company's future dividend paying ability. But by considering all important measures, the income investor can get a much better picture of the company's willingness and ability to sustain and grow their dividends going forward.

The players, their current yields and historic dividend growth rates:

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And a chart comparing their historic dividend growth.

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Note that the dividend growth rates of several of these tend to vary over the years.

Interest expense as a percent of [CFFO + Interest Expense]

This metric is important because interest expense is generally a fixed cost to most companies that cannot be managed away during an economic decline. Also, the higher is this expense relative to Cash Flow from Operations (CFFO), the greater the negative impact on company cash flows during times of rising interest rates when the company must replace maturing debt.

In my experience, any company with an interest-to-[CFFO + Interest] ratio greater than 30% will have a tough time raising their dividend, as too much of the company's operational cash is being paid in interest. However, equity REITs tend to be fairly heavily capitalized and must distribute most of their cash as dividends due to the rule that they must distribute at least 90% of taxable income in order to maintain their REIT status. Thus, REITs tend to hold more debt than do other industries. But over the years, I've found that those who keep their interest expense less than 25% of CFFO tend to have better dividend growth.

Dividend to CFFO Payout Ratio

Revenue minus operational expenses (the expenses of running the business) will leave net Cash Flow from Operations or CFFO. I order the next use of cash to be the paying of dividends, preferred dividends (if any) paid first. The percent of the CFFO consumed by the dividends will determine how much of the CFFO remains to be used towards investing activities.

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This chart shows, over the past 10 Quarters, the high, low and Trailing Twelve Month, or TTM, percentage of the CFFO that is paid in dividends. Clearly, the lower this percentage, the higher percent of CFFO that remains to be used towards investing activities. I've found that those REITs with payout ratios consistently exceeding 85% to 90% of CFFO have a tough time raising the dividend. Operational cash is the only sustainable support to dividend growth. Certainly, dividends can be paid with cash from the sale of assets, cash held in reserve or from borrowed dollars or dollars raised by the sale of company stock, but only growing operational cash will sustain the growth of the dividend.

10Q Return on Investments to CFFO

Cash Flow generated from (used by) investing activities, referred to as CFFI, represents the net amount of cash a company raises from the sale of, or uses to purchase, investments...primarily Capital Expenditures or CapEx. These ongoing investments are what provide for company growth. As a company purchases investments, more revenue will come to the company's 'Top Line' and then those new revenue dollars should travel through the company, paying the added operational costs of the new investment and eventually the residual amount will show up as CFFO after all operational expenses are paid. To measure this, I calculate the slope of the CFFO growth line over the past 10 Quarters as the average growth per year, and divide this by the average annual net investments made over that period.

The drawback to this metric is it does not consider investments made prior to this measurement period and that the changes in CFFO are due to added CFFI. But clearly, if a company spends $500MM on new investments over a 10 Quarter period, it would be reasonable to expect to see an increase in CFFO DUE to this investment...else why make it?

10Q CFFO-to-Revenue measure of "Managerial Efficiency"

For every dollar that comes into the REIT as Revenue, how efficiently will management manage that dollar to control expenses part of the dollar must pay for, such that after all operational expenses, a significant part of that dollar remains with the company as CFFO. This is called "Managerial Efficiency", and is simply the CFFO dividend by the total revenues.

This ratio will vary by industry, and will depend on how much in operational expenditures the company makes to sustain its operations. But from my experience, REITs whose ratios are consistently greater than 60% generally provide stronger dividend growth.

Conclusion

In response to my past article on cash flow analysis of 8 Industrial Stocks that may provide long term reliable dividends, I received several personal messages on SA that kindly asked me if I would mind providing my own recommendations on the stock's whose cash flows I've analyzed. Okay, I'm happy to do that, but please keep in mind, this is only one person's observation and also don't forget, that no one metric or even set of metrics can predict with accuracy what management will do with their company's future dividend. Rather, this information should be used collectively to provide the best 'picture' of the stock and its dividend reliability. So with that in mind...

I've held NNN and O for the past 12 and 14 years, respectively, and I track their CF metrics regularly. These are my top choices based on the above metrics. Although not always on top of the group in a given metric, their CF metrics are consistently at or above the average of this group. And their ability to sustain and grow their dividends through the 2008-09 economic recession demonstrate management's commitment to the dividend. At about 6% of my income portfolio's income, I'm not looking to add to my holdings of Triple Net Lease REITs right now. But if I were, this is the priority ranking I would use in my selection:

ADC and EPR look favorable to me, with ADC my favorite. Both have good 1, 3 and 5 year dividend growth and both offer an attractive current yield in the 5.5% to 6.5% range. EPR took a 23% dividend cut in 2009 but fundamentals since have markedly improved, with the exception of the 10Q CFFI return to CFFO, which is a concern. ADC took at 22% dividend cut in 2011 that may, like EPR's dividend cut, understandably repel some income investors. However, I think ADC has markedly improved fundamentals, particularly being careful of debt obligations.

An iffy REIT here would be LXP. Interest expense is a bit high and managerial efficiency is not very good. Return on CFFI to CFFO and payout ratios look good, two measures I consider to be fundamental to dividend growth. Although historic dividend growth has been good, the slowing of it to about 1% over the past year does not inspire confidence. I think I'd hold off on LXP until its dividend growth returns.

The REITs I would not consider are GOV, OLP and WPC. With the exception of Interest expense-to-CFFO ratio, all of GOV's metrics are near the bottom of this group, and it has not grown its dividend since October of 2012...and management seems to take pride in this! OLP is below the average in all of the above metrics and has the highest interest expense-to-CFFO ratio which probably concerns me the most. I tend to put more weight on this metric, as an economic slowdown and an increase in vacancy would lead to the interest expense becoming a major fixed operational expense that would likely lead to a dividend cut. I exclude WPC due not only to its intolerably high payout ratio, high interest expense and lowest measure of "Managerial Efficiency" of the group, but because it is very hard to read its financials. One of the features I like about equity REITs is financials, they are usually easy to read and 'dogs' like GOV are easy to spot. WPC has a strong dividend growth history, which makes it attractive, but it is growing its dividend with not enough or barely enough operational cash to fund it. Instead, funding appears to have come from asset sales. And the sudden jump in CFFO in 2Q14 appears to have come from about a $2B all stock buy-out of properties added to WPC's balance sheet without affecting the SCF (Morningstar's SCF for WPC over the past 10 Quarters shows no sale or redemption of company stock on the SCF in the Cash Flow from Financing Activities (or CFFA) section). And CFFO since that jump in 2Q14 has been flat despite adding another $1B in new debt to fund new CFFI. It's as though management is shuffling around properties in clever ways and pulling transactional cash out on occasion without anyone really minding the store. Now, in fairness, there may be some rational reason for this, or, this may be a shenanigan...I don't know. But I don't think I'd risk my investment dollars to find out, at least until CFFO starts comfortably covering the dividend.

I hope this provides some assistance to those considering adding a Triple Net Lease REIT to their income portfolio, despite their boring nature.

Disclosure: I am/we are long O, NNN.

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.