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When the Federal Reserve began raising the federal funds rate in 2015, conventual wisdom was that real estate investment trusts, or REITs, would suffer.
The thought was rising interest rates would hit REITs in three different ways. First, REITs have to distribute at least 90% of their taxable income in the form of dividends. This doesn't leave much leftover to purchase new properties to grow the business. REITs often have to issue more shares, thus diluting funds from operations, or tap debt markets, and load up the balance sheet, in order to grow. Neither choice is very appealing.
Next, higher interest rates also lead to higher interest on debt, costing the REITs even more in interest expense. Again, this could impact their ability to continue paying and raising dividends.
The third way higher interest rates might hurt is that stocks, particularly high-yielding stocks like REITs, would have competition from bond yields. Many investors hold REITs for the dividend income they produce. Higher yields on bonds might result in some investors accepting a slightly smaller yield for more safety than equities can offer.
In 2019, however, the Federal Reserve cut rates three times. With the Fed likely maintaining rates where they are for the foreseeable future, REITs won't face much competition from bonds as income-seeking investors will likely take on more risk for a higher yield.
One REIT that I have watched for some time is National Retail Properties Inc (NYSE:NNN). The trust has returned nearly 40% since the Federal Reserve began raising interest rates in 2015 and gained more than 11% in 2019. Both results vastly underperformed the S&P 500, but the stock's dividend yield is significantly higher than that of the index. On the other hand, shares are richly valued against the historical average. National Retail has an impressive dividend track record, but is this enough to make up for the current valuation?
Recent earnings results and growth prospects
National Retail reported third-quarter earnings results on Oct. 31, 2019. The company's funds from operations totaled 70 cents per share. This topped estimates by 1 cent and represented a 4.5% improvement from the previous year. Revenue grew 8.6% to $169 million, which was about $2 million above estimates.
Portfolio occupancy of 99.1% tied a record for the third quarter. This was an improvement from 98.8% in the second quarter. National Retail also acquired 27 properties during the quarter, adding 533,000 square feet at an initial cash yield of 6.8%. The trust also sold 13 properties for a net gain of $2.1 million. National Retail issued more than 8 million shares during the quarter, raising $434 million in proceeds. The trust has acquired more than $510 million worth of properties in 2019.
The trust raised its guidance for core FFO to a range of $2.74 to $2.77 per share, up from a previous range of $2.71 to $2.76. The midpoint of this updated guidance would be a 2.2% improvement from last year's results. National Retail also issued initial guidance for FFO for 2020 of $2.83 to $2.87 per share. Consensus estimates had called for $2.87 of FFO. Shares dropped on the news, but achieving this guidance would be a 3.4% increase from the midpoint of guidance for 2019.
Long-term investors should be more concerned with the company's prospects for growth in the years ahead as opposed to just the current year. And National Retail appears to have a solid business model in place for the future.
National Retail focuses on single-tenant, net-leased retail properties. The trust has nearly 3,100 such properties leased to more than 400 tenants spread out over 48 U.S. states. It has a very diversified group of tenants.
Source: National Retail Third Quarter Earnings Presentation, slide 9.
National Retail's largest tenant category is convenience stores, but this group accounts for less than 18% of all properties leased. Only one other category (full service restaurants) accounts for more than 10% of total properties leased. The trust is also diversified geographically. The Southeast, Midwest and South regions each hold between 22% to 27% of total properties. This tenant category and geographic diversification helps balance risk for the trust.
National Retail focuses on single-tenant properties because these tenants would likely risk losing their customer base if they decided to move locations. National Retail is able to more easily pass along rate hikes without a significant risk of losing tenants because of this factor.
This strategy has proven effective over the years in terms of preserving the trust's tenant base.
Source: Investor Presentation, slide 15.
National Retail has averaged nearly a 98% occupancy rate over the last 15 years. Even during the depths of the Great Recession, one of the worst economic downturns since the Great Depression, the occupancy rate hit a "low" of 96.5% in 2009. This was still above the average for the entire REIT industry.
Despite economic conditions, the trust's properties stayed mostly occupied. Once growth returned to the economy, the occupancy rate generally went higher, outside of a slight dip in 2016 and 2018.
The occupancy rate for the most recent quarter tied a 15-year high for National Retail even though the REIT industry as a whole saw a decline.
One interesting fact derived from examining the chart above is that during the years with the lowest occupancy rates years (2008 and 2009), the difference between National Retail's occupancy rates and the REIT narrowed. Once economic expansion occurred, the trust saw a sizeable difference in occupancy rates compared to the industry average. I take this to mean that while National Retail did suffer along with its industry during the recession, the trust performed much better than average in terms of occupancy rates once the economy began expanding.
In addition to maintaining a very high occupancy rate through the different phases of the economic cycle, National Retail is in a very good position regarding upcoming lease renewals.
Just 6% of leases expire through 2021, with the bulk (60%) of leases expiring after 2028. The average number of years remaining on leases is more than 11 years.
With a low percentage of tenants up for lease renewals in the near term, National Retail can focus on those properties as well as acquire new ones to add to its pipeline of growth.
Recession performance, dividend history and valuation
As a retail REIT, National Retail is exposed to economic downturns. Businesses struggle when the economy falters as consumers tend to spend less. Almost all of the trust's tenants are at risk when this happens as they depend on consumer spending to stay open.
National Retail's occupancy rate has never fallen below 96% over the last 15 years. The trust, however, did suffer declines in funds from operations during the last recession.
2007 FFO: $1.87
2008 FFO: $1.99 (6% increase)
2009 FFO: $1.61 (19% decline)
2010 FFO: $1.31 (19% decline)
2011 FFO: $1.57 (20% increase)
2012 FFO: $1.74 (11% increase)
2013 FFO: $1.93 (10% increase)
No doubt about it, the Great Recession was difficult for National Retail as FFO declined 30% from 2007 to 2010. By 2013, however, the trust had established a new high for FFO.
Funds from operations has more than doubled since 2010. Making this even more impressive is that the share count has more than doubled as well. While the trust may have difficult in the next recession in terms of FFO, National Retail has proven very adept at growing its business during economic expansions.
The business may struggle during a recession, but National Retail's ability to increase its dividend has not.
Source: Investor Presentation, slide 20.
The trust has increased dividends for the past 30 years, qualifying it as a Dividend Champion. This period of time covers three recessions, showing that National Retail has proven its ability to continue paying dividends even in less than ideal economic conditions.
National Retail has increased its dividend by an average of:
4.5% per year over the past three years.
4.0% per year over the past five years.
2.8% per year over the past 10 years.
As you can see above, the trust's average increase has gone up over the periods of time. National Retail raised its dividend by 3% for the Aug. 15 distribution. Shares offer a yield of 3.7% today. This is slightly more than double the 1.8% average yield of the S&P 500, but well below the trust's five and 10-year average yields of 4.3% and 5.3%, respectively.
Using National Retail's annualized dividend of $2.06 and the midpoint for revised guidance of $2.74, the trust has a payout ratio of 75%. This is right about on the mark of National Retail's five-year average payout ratio of 74%, but well below the 10-year average payout ratio of 85%.
Seeing as how the trust has maintained its payout ratios in the mid-70% range for the past few years, it can reasonably be assumed that this will be the case in the future. Therefore, dividend growth will likely match FFO growth in the years to come.
Still, National Retail's payout ratio is quite low for a REIT and the trust has been able to raise its dividends through multiple recessions. Dividend growth may not match past results, but I consider the dividend to be extremely safe.
The one issue I have with National Retail is its current valuation. Using the current share price of $55.34 and the guidance for the midpoint for FFO of $2.76, shares have a price-to-FFO ratio of 20.1. This is much higher than the average multiple of 14.4 shares have had since 2009.
I am willing to give National Retail a target valuation that is slightly above its historical average due to business model and dividend history. Assigning a multiple of 15 or 16 times FFO gives a price target of $41 to $44. Shares of National Retail would therefore have to suffer a significant of at least 20% before I would consider buying the stock.
National Retail has had a solid quarter and current shareholders are likely happy with their total returns even as initial 2020 guidance was slightly below estimates. The trust has a solid yield and a long history of dividend growth, but the multiple is well above the historical average. If National Retail were more recession-proof, I would consider giving it a higher target valuation. Because it's not, I feel shares are overvalued today and will stay on the side lines for now.
Disclouser: I am not long National Retail.
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This article first appeared on GuruFocus.