For those of you who aren’t familiar with the term - net leases are about as sweet a spot as a landlord can get.
The owner doesn’t have to worry about much of anything other than providing the building itself.
Realty Income remains my second-largest holding and I wanted to provide readers with three good reasons why I maintain healthy exposure in this all-purpose SWAN.
If I asked you what the largest real estate company in the world was, what would your answer be?
Quickly. And without consulting Google, Alexa, Siri, or any other such source of artificial intelligence.
Put on the spot like that, you might have come up with some pretty good answers, such as:
If you went with any of those possibilities, you’d definitely be on track. Two of them made Forbes’ Top 10 in its “World’s Largest Real Estate Companies 2018” list.
As of June 6, 2018, Brookfield was actually No. 1 on there, with sales of $47.59 billion, profit of $2.34 billion, assets of $195.94 billion, and market value of $38.91 billion.
Simon Property Group, another REIT, made No. 3. And Blackstone wasn’t included at all, probably because it’s a private equity firm, first and foremost.
Though, with $157 billion of real estate-related investor capital under management, I still say it’s a good guess.
Then again, according to National Real Estate Investor, the same could be said if you’d answered “McDonald's” (MCD) too.
A Massive Real Estate Empire
If that last line sounded like an out-of-the-blue subject switch, it really wasn’t. And I’m sure the information below can convince you as much.
It’s compelling data to take in, to say the least.
On Nov. 6, National Real Estate Investor released a very interesting review. “Under New Leadership,” the headline read, “Will McDonald’s Grill Up a New Real Estate Strategy?”
It went on to detail how:
Steve Easterbrook became president and CEO of McDonald’s Corp. in March 2015, just eight months before the fast-food chain rejected the idea of spinning off its vast real estate holdings into a REIT. But now that Easterbrook has been ousted as the head honcho of McDonald’s, will the country’s No. 1 fast-food chain, as measured by revenue, revisit the REIT route?
I won’t make you guess about that answer. Because the writer immediately provides an opinion for his own question.
Though I will mention, in case you didn’t know, that Easterbrook’s ousting wasn’t job performance related. He was seeing someone within the company – something McDonald’s apparently doesn’t tolerate.
Especially in the #MeToo era (even though the affair was entirely consensual, by all reports).
That aside, here's the article’s solid opinion on McDonald’s spinning off a real estate investment trust:
“Don’t count on it, experts say. It’s about as likely that McDonald’s would launch a REIT spinoff as it would be to spot the new president and CEO, Chris Kempczinski, chowing down on a Burger King or Wendy’s hamburger.”
Considering the figures McDonald’s is working with, I don’t see any reason to disagree. Besides, the IRS no longer allows C-Corps to spin real estate into a REIT, the ruling only works now for REIT-to-REIT spins.
They Work Hard for the Money
It’s not exactly common knowledge, but as the article points out, McDonald’s profits pertain to more than just food. For that matter, the company is very well aware of that fact, flat-out promoting it for maximum gain.
“Whenever the chain has weighed a REIT, it has nixed the concept, says Randy Blankstein, president of The Boulder Group, a Wilmette, (Illinois)-based real estate investment brokerage firm specializing in net lease properties, including McDonald’s restaurants. Why? Because McDonald’s views real estate “as a core business and profit center,” Blankstein says.
… Essentially, McDonald’s is a $34-billion real estate goliath – a goliath that the company hardly wants to monkey with.”
I don’t know if you’ve ever considered opening a fast-food restaurant. But you might want to think long and hard before inquiring about one with a signature yellow and red sign.
Apparently, McDonald’s is more than a little cutthroat about the money it makes from its franchisees. The Service Employees International Union, for one, has criticized it for charging double or even triple the 5.9% industry average.
Moreover, since it owns about 80% of its restaurant buildings, that makes for quite a pile of profits, much more so than what it makes from its food. That’s not surprising considering how McDonald’s only really provides the buildings (and equipment). The store “owner” is prone to paying taxes, insurance premiums, and maintenance expenses.
In other words, almost the full enchilada. Or Big Mac, as it were.
That at least makes McDonald’s a net lease REIT in its operations, even if it isn’t – and never will be – one in the legal sense of the word.
And that, in turn, makes it a shrewd business operator.
Filling Up With Net Lease REITs
For those of you who aren’t familiar with the term, net leases are about as sweet a spot as a landlord can get. The owner doesn’t have to worry about much of anything other than providing the building itself.
Typically, yes, this does mean they can’t charge as much (unless, apparently, if they’re McDonald’s). But it also means they don’t have to pay as many employees or deal with as many unexpected expenses.
They also don’t have to worry about as much turnover since “trashy” tenants aren’t the kinds that typically go for net-lease deals. The kind of customers they cater to are overall financially stable establishments that can more than cover their costs.
As such, I agree with our fast-food friend that they can be appetizing meals to feed our portfolios. Hence the reason why I’m evaluating a list of net-lease REITs today.
First off, let’s take a closer look at REIT valuations, compared with other REIT property sectors. Here’s a snapshot of all property sectors based upon our R.I.N.O. scores and P/FFO variance (current P/FFO vs. five-year average):
As you can see, the Net Lease REITs are now trading at a 20% premium to their five-year P/FFO average. The average P/FFO multiple in the Net Lease REIT sector is 17.5x. Now let’s take a closer look at the sector by examining all of the Net Lease REITs (including gaming) and their P/FFO multiple:
As you can see (above) Realty Income (O), Store Capital (STOR), W.P. Carey (WPC), National Retail Properties (NNN), and Agree Realty (ADC) score well in terms of our quality rating (R.I.N.O.) and they also are trading at premium valuation levels (19-24x P/FFO). Now let’s examine their dividend yields:
Again, it’s evident that the hunger for yield has found its way to the net lease sector, as illustrated by these modest yields for these premium net lease REITs (ranging from 3.1% to 4%).
What’s more interesting though is that these premium REITs are generating record low cost of capital, that in turn drives them to generate impressive acquisition growth. For example, in the latest quarter Agree bumped its full-year 2019 guidance to a range of $650 million to $700 million and National Retail Properties increased 2019 acquisition guidance to $650 million - $750 million and also established 2020 acquisition guidance of $550 million - $650 million.
Also, in Q3-19 Realty Income announced the acquisition of CIM Real Estate Finance Trust for $1.25 billion and the company expects 2019 acquisition guideline of $3.25 billion to $3.5 billion.
While there's no margin of safety for prospective investors to purchase shares in these premium-powered net lease REITs, the companies with the lowest cost of capital continue to thrive.
Fr example, Realty Income’s investment spreads relative to its weighted average cost of capital were healthy during Q1-19 averaging approximately 198 basis points, above historical average spreads. Keep in mind, having low cost of capital is the most important competitive advantage in the net lease industry.
Source: Realty Income Presentation
3 Reasons Why Realty Income Remains A Core Holding
Like most blue-chip REITs, shares in Realty Income have soared so far this year, returning 26.2%. As a result, we have gotten emails and messages from many subscribers asking whether to sell their shares.
For those lucky “O” investors who were smart enough to purchase the stock in February 2009 (at $17.53), shares have since returned a whopping 473%, that equates to around 17.7% annualized.
Yet, Realty Income remains my second-largest holding and I wanted to provide readers with three good reasons that I maintain healthy exposure in this all-purpose SWAN.
Investors should focus on the earnings yield spread to the 10-year yield, not the stock price. Based on consensus 2020 AFFO/sh ($3.53), O trades at an AFFO yield of 4.4%, and the 10-year yield currently is 1.8%. That 260-basis point spread is right in line with recent historical averages, suggesting investors are not paying up for quality, predictability and good risk-adjusted returns.
If you buy into the thesis that an earnings yield spread to the 10-year yield is an appropriate way to value a yield-oriented stock, then your fundamental thesis on the stock should coincide with your view on where long-term yields are going. One could easily make a compelling argument that there's more downside pressure and catalysts to long yields than upside ones.
The accommodative Fed, geopolitical pressures and uncertainties, slowing global growth, recession fears and the “age” of the current economic cycle, low yields abroad that actually make a 1.8% 10-year yield seem high, etc.
The fundamentals of the business itself have rarely been stronger. O’s balance sheet remains strong (one of less than 10 REITs with two “A” ratings), 2020 AFFO/sh growth rates (per consensus) are over 6%, and the 3.4% dividend yield remains well covered.
In September the company increased the dividend for the 103rd time in its history and the current annualized dividend represents an approximately 3% increase over the year ago period and equates to a payout ratio of 82.2% based on the midpoint of 2019 AFFO guidance.
Realty Income has increased its dividend every year since the company's listing in 1994, growing the dividend at a compound average annual rate of 4.5%.
Investors can continue to bank on high-single digit total returns with beta volatility that’s less than half the S&P 500. Historically this has been a winning formula over the intermediate and long term.
For now, I'm enjoying the fruits of labor, as shares have returned ~22% annually for me since my first investment (September 2014).
Who knows, at some point it's conceivable that Realty Income acquires a substantial portfolio from McDonald's. That would not surprise me in the least, recognizing that this favored blue chip is one of the few REITs capable of acquiring such a large sale/leaseback portfolio. At the end of Q3-19 Realty Income had nothing outstanding on its $3 billion line of credit and approximately $236 million of cash on hand.
Besides, who wouldn’t want to fill up on burgers and fries?
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, STOR, VER, WPC, VICI. 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.