Real estate has historically been a popular way to build and preserve wealth. However, buying, owning, and managing rental properties can be highly complex.
That’s why real estate investment trusts (REITs) offer a far simpler, more liquid way for regular investors to profit from this valuable industry.
Of course, REITs are also a highly specialized sector, one with many proprietary metrics that need to be understood to successfully navigate this high-yield industry.
Let’s take a look at National Retail Properties (NYSE:NNN), one of the best high-yield stocks here trading near a 52-week low, to see why if it has what it takes to help long-term income investors build their wealth and income over time.
Founded in 1984 in Orlando, Florida, National Retail Properties is one of America’s oldest triple net retail REITs. Its diversified property portfolio of 2,543 stand-alone stores is spread out over 48 states and leased to over 400 tenants across more than 30 industries.
While the rise of e-commerce giants like Amazon (NASDAQ:AMZN) has devastated certain retailers, specifically in the apparel and mall sectors, National Retail’s tenants have very little direct exposure to this long-term secular trend.
In fact, National Retail leases none of its stores to apparel brands and has the vast majority of its properties leased under very long-term contracts (average remaining lease is 11.4 years) to tenants that either offer experiences or are relatively Amazon resistant, such as financially sound (i.e. strong rent coverage ratios) convenience stores, restaurants, and fitness centers.
National Retail’s base of tenants is also nicely diversified, further reducing its risk. You can see that its largest tenant (Sunoco) accounts for 5.4% of total rent, and its top 10 tenants generate a reasonable 35% of rent. The company’s tenants are also in good financial shape overall with a weighted average rent coverage ratio of 3.8x.
These factors have allowed National Retail Properties to enjoy some of the highest and most consistent occupancy rates (never below 96.4% since 2003), which results in very stable cash flow and highly secure dividends.
National Retail Properties would be a member of the dividend aristocrats list if it was large enough to be in the S&P 500 Index. This is impressive considering that there is currently only one REIT that is a dividend aristocrat, and National Retail actually has the 4th longest consecutive annual dividend growth streak in the industry.
Not surprisingly, this remarkably consistent growth has resulted in impressive total returns over the past quarter century. In fact, National Retail Properties has greatly outperformed not just the S&P 500 and the vast majority of its REIT peers, but several other major benchmarks as well.
Of course past performance is no guarantee of similar results in the future. However, there are plenty of reasons to be optimistic that National Retail Properties will continue to generate solid total returns in the years to come.
That’s because the business model is what’s known as triple net lease, meaning that the tenant pays all maintenance, insurance, and property tax costs. National Retail just owns the properties, which it leases to high-quality businesses for 15-20 year contracts with annual 1.5% rental increases to offset inflation.
Better yet? The company’s management team is very good at getting clients to renew their leases at the same or higher rent, creating incredibly consistent (thanks to well-spaced-out lease expirations) recurring cash flow from which to fund the steadily growing dividend.
When leases are up for renewal, you can see that National Retail has rarely had to discount its leases or make substantial improvements to its properties to get tenants to stay (thanks to its triple-net leases, the company doesn’t have to “buy” higher rent with capital investments because tenants are on the hook for maintenance).
National Retail has achieved these strong results for several reasons. First, the company intentionally owns properties with no anchor or co-tenancy issues. 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.
Finally, consumer-focused retailers also 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.
However, a high-quality, diversified property portfolio is just the beginning to National Retail’s success. In addition, management is constantly looking for new properties to acquire at highly favorable terms. That means acquiring properties for above average capitalization rates (operating net income/property price).
In fact, thanks to great industry connections by its experienced management team, National Retail Properties gets most of its acquisitions from off-market private deals, which have higher cap rates and cash yields.
That in turn explains why NNN’s average cap rate over time has been above the REIT average. As seen below, National Retail has enjoyed an average cap rate of 7.7% since 2010.
While the cost of debt for most REITs is currently cheap, National Retail Properties appears to be well positioned to continue earning a positive spread on its acquisitions if interest rates begin to rise thanks to its healthy cap rate.
As a result, National Retail Properties has enjoyed not just high and improving profitability over time, but also some of the best margins and returns on shareholder capital in the industry.
This very high profitability, especially the adjusted funds from operations (AFFO) margin, which shows how much of the company’s revenue is converted into AFFO (the REIT equivalent of free cash flow and what funds the dividend), is due to two main factors.
The first is National Retail Properties’ growing economies of scale, meaning that its administrative expenses are being spread across a steadily larger portfolio of cash-producing assets.
The other is management’s disciplined approach to acquisitions. Specifically that means only buying new properties if their cap rates are sufficiently higher than the REIT’s weighted average cost of capital (WACC).
That ensures that, despite a rising share count over time, courtesy of the REIT business model in which the vast majority of cash flow is paid out as dividends and growth is funded by external debt and equity capital, the company’s AFFO per share steadily rises over time.
The fact that National Retail Properties’ return on invested capital (ROIC) is greater than its WACC is very important because it signals that management is actually growing shareholder value over time rather than merely acquiring new properties as a form of destructive empire building.
Taken all together, NNN’s high-quality property portfolio, geographic and tenant diversification, conservative management team, low cost of capital, and diverse sources of recurring cash flow explain its highly secure and steadily growing dividend.
Management’s conservatism reduces most of the diversifiable risk that National Retail appears to face. It seems unlikely that any single industry, customer, or geography could permanently impair the company’s long-term earnings potential.
However, it is still worth mentioning 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.
This risk factor is not a big concern based on National Retail’s results during the last recession (87% of prior leases were renewed in 2009), consistently high occupancy rates, and overall mix of tenants – over 60% of National Retail’s rent is from public companies of those with rated debt.
While most retail tenants will be impacted by an economic downturn, National Retail’s industry diversification provides some protection. For example, convenience stores are its largest industry exposure at 17% of rent and would likely perform relatively well during a recession.
NNN’s stock also outperformed the S&P 500 by 16% in 2008, perhaps providing some support to this theory. Regardless, economic weakness would not impair the company’s long-term earnings power.
However, there are two additional risks to understand before investing in National Retail Properties.
First, National Retail Properties is likely likely to see slower growth over time as it continues expanding its property portfolio. That’s because the very disciplined approach to acquisitions that has made NNN such a high-quality blue chip also limit its set of future growth opportunities that can earn a reasonable return.
For example, record low interest rates and cheap money from the world’s central banks have resulted in large-scale U.S. asset inflation, including commercial real estate. That means that there is a limit to how many new deals NNN can make without sacrificing its high quality and profitability standards.
Then there’s the fact that National Retail Properties, as a triple net lease REIT, has higher-than-average interest rate sensitivity, more so than even the average REIT.
This is because the very long-term nature of its rental leases, which helps to ensure highly consistent cash flow and makes triple net lease REITs some of the market’s least volatile stocks, also makes the stock more interest rate sensitive.
Think of it like this. Over the past eight years record low interest rates have caused many yield starved income investors to turn to REITs as a high-quality bond alternative. However, like bonds, in which longer durations result in higher rate sensitivity (due to higher inflation risk), triple net lease REITs can’t renegotiate rental agreements very often.
Thus, in a rising rate environment, which generally coincides with higher inflation, a triple net leases annual rental escalators (usually 1% to 1.5% right now) can fall below the inflation rate and result in a negative real growth rate in its cash flow. This is why the triple net lease sector has traded so closely with 10-year Treasury yields in the past few years.
But how exactly do higher interest rates hurt National Retail? The answer goes beyond just a potential decline in share price.
Remember that by law, REITs must payout 90% of taxable income as dividends, meaning that they can retain only a small fraction of their AFFO to fund growth internally. Thus they are constantly raising debt and equity capital (i.e. selling new shares) to fund the growth of their property portfolios.
This means that REITs such as NNN are somewhat at the mercy of investor sentiment, which can quickly raise their cost of capital or even restrict their access to capital if Wall Street turns overly bearish on its share price.
In addition, even longer-term investors need to keep in mind that rising rates can make it harder for all REITs to grow. For example, here is how National Properties’ cost of capital would change if interest rates rise by 2%.
As you can see, not only would this affect NNN’s borrowing costs, but the higher dividend yield (necessary to compete with higher yielding risk-free income alternatives such as Treasury bonds) would greatly increase the REIT’s cost of equity.
Taken together, National Retail Properties’ cost of capital, assuming the same capital weightings as today, would rise above its current ROIC and close to the cap rate of its most recently acquired properties.
Does that mean that NNN can’t grow if rates rise by just 2%? No, remember that National Retail has a long track record of successfully growing in all manner of interest rate environments, including in the 1990s when interest rates got as high as 6%.
However, it might mean that the REIT’s dividend growth might have to slow because it finds fewer profitable investment opportunities and would need to use more of its internally-generated cash flow as growth capital.
National Retail Properties’ Dividend Safety
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.
National Retail Property has a Dividend Safety Score of 79, suggesting that the company’s dividend is one of the safest and most dependable payouts in all of real estate.
That’s not surprising given that National Retail’s history of raising payouts each year is better than 99% of publicly traded companies.
This impressive 27-year history of uninterrupted annual dividend growth is courtesy of two main factors.
First, management has been highly disciplined to grow the payout slowly, in line with the growth of AFFO per share.
Specifically, NNN generally likes to keep its AFFO payout ratio at 80% or less, creating a safety buffer in case of economic shocks, which can result in a temporary decrease in cash flow and restricted access to capital.
This relatively low AFFO payout ratio, when combined with the company’s long-term, contracted rents from strong financial counterparties, is why National Retail Properties has been able to raise its dividend so consistently, in all manner of economic and interest rate environments.
The second important factor to consider is the strength of the REIT’s balance sheet.
At first glance NNN’s high leverage ratio and negative cash flow might make you think the REIT has dangerous levels of debt. However, because the REIT industry is so capital intensive and high debt levels are baked into the business model, it’s important to keep these metrics in perspective.
For example, when we compare National Retail’s relative debt levels to its industry peers, we see that its leverage ratio (Debt/EBITDA) and debt to capital ratio are actually lower than average, which explains its strong investment-grade credit rating.
The same is true when we compare the leverage ratio against the entire REIT industry, which often features much higher (and less safe) leverage ratios.
Further proof of NNN’s conservative balance sheet can be found by looking at its overall capital structure, which shows only a moderate use of long-term, unsecured debt relative to shareholder equity.
Note also NNN’s high interest coverage ratio (most REIT’s have ratios of 3-4) and fixed-charge coverage ratio (Adjusted EBITDA/interest costs and preferred dividends). This indicates that the REIT’s cash flows easily cover its liabilities while leaving plenty of AFFO to pay the dividend.
More importantly, National Retail’s leverage ratios and fixed-charge coverage has been not just stable over time, but actually improving.
This is because management has wisely decided to use strong investor demand for its shares to grow through greater equity issuances, thus deleveraging the balance sheet ahead of rising interest rates that could result in share price weakness.
In other words, NNN has taken advantage of its high share price to grow is assets and cash flow so that in the future, when its share price could be weak (and cost of equity higher), it can still tap relatively cheap debt markets for access to low cost capital to keep growing.
Finally, a look at National Retail Properties covenant ratios, which are imposed by its creditors and if violated can result in an immediate calling in of its loans (and a dividend cut), shows that the REIT is nowhere near breaching any of these agreements, further enhancing the safety of its payout.
National Retail Properties’ Dividend Growth
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
NNN’s dividend Growth Score of 15, indicating below average dividend growth prospects. That’s not too surprising given that, despite NNN’s enviable track record of consistent payout growth, management has historically preferred to take a slow and steady approach to raising its dividend.
That being said National Retail’s payout growth has accelerated in recent years, largely a result of management having finished bringing the company’s AFFO payout ratio down to its preferred level of around 75%.
Going forward, income investors can likely expect dividend growth to closely track AFFO per share growth of around 3% to 5%. While that may not be as high as some faster-growing REITs, it should still outpace inflation and is respectable given the quality of this company.
That makes NNN is a prime candidate for a conservative retiree portfolio.
In the past year National Retail Properties has vastly underperformed the S&P 500 (by about 40%) thanks to concerns over rising interest rates and various retailers suffering from consumer spending habits (the “Amazonification”).
However, that could create a potentially good buying opportunity to consider for long-term investors. That’s because NNN’s forward price/AFFO (the REIT equivalent of a forward PE ratio) is 16, slightly above the industry average of 15 but below its historical norm of 17. It’s also less than the S&P 500’s forward P/E ratio of 17.8.
And when we compare National Retail’s P/AFFO to the entire REIT industry it is arguably offering an attractive valuation, especially when we take into account its industry-leading dividend security and sturdy fundamentals.
And while it’s true that the current 4.6% yield is significantly below NNN’s 13-year median dividend yield of 5.6%, when we compare NNN’s yield to that of other REITs we see that it looks pretty good, again given the blue chip nature of this company.
While NNN may not necessarily be trading at a bargain price right now, its potential long-term annual total return of 7.6% to 9.6% (4.6% yield + 3% to 5% annual earnings growth) suggests it could still be a reasonable fit for low risk, high-yield dividend growth portfolio.
National Retail’s industry-leading management quality, dividend safety, and impressive track record of rewarding shareholders with rising payouts make it a solid core holding for investors living on dividends in retirement with low-risk, diversified income portfolios.
Management has clearly managed the company conservatively over the years, and National Retail’s consistently high occupancy rate and diversification by customer, industry, and geography provide further confidence in the dividend growth story continuing.
With the stock trading at a seemingly reasonable price after its slump over the past year, National Retail Properties could be worth a closer look for high income portfolios today.