National Retail Properties: Almost Perfect (NYSE:NNN)

My hope is to purchase inventory in Nationwide Retail Properties (NYSE:NNN) when market actions let me try this with out lack of present dividend revenue. They give attention to single-tenant, retail properties, with triple-net leases underneath which the tenants are answerable for all upkeep, insurance coverage, and taxes.

Nationwide Retail has been the subject of many favorable articles on SA, together with lately. Going again a number of years, there are not any bearish articles and just a few impartial ones. And certainly, my article at the moment shouldn’t be bearish.

These articles spotlight numerous constructive facets of Nationwide Retail. These are successfully portrayed of their investor presentation. Right here is simply a partial record of the issues to love:

• Funding-grade BBB+ credit standing
• Considerably no secured debt
• Negligible debt maturities earlier than 2024, a yr forward
• 13.7 yr weighted-average debt maturity
• 10.4 yr weighted-average lease time period
• Ample liquidity
• 33 years of elevated dividends
• Sustained very excessive occupancy (now 99.4%)
• Center-market focus (on corporations that can’t promote bonds)
• Dominantly (71% since 2006) relationship-based acquisitions
• Excellent diversification by geography and line of commerce

Word that the debt maturities exceed the lease phrases. Nationwide Retail could be the solely Web Lease REIT that has managed to borrow lengthy and lease quick. That is really stellar.

As well as, they saved a spot of two years to the closest debt maturity till final yr. My expectation as that they are going to restore that when possible.

On high of all that, Nationwide Retail has been so profitable with their choice of middle-market tenants that 18% of them have develop into investment-grade later.

There may be, clearly, quite a bit to love right here. That mentioned, I got down to study and mannequin Nationwide Retail intimately, as I’ve finished this yr with Simon Property Group (SPG), AvalonBay Communities (AVB), and EPR Properties (EPR).

As is commonly true of REIT shares about which I write, I see NNN as extra compelling for some traders than for others. NNN is a part of the Purchase Maintain and Go Fishing Portfolio I revealed a pair months in the past, aimed toward retirees who need an revenue REIT portfolio that wants little monitoring.

After my analysis, mentioned under, my view is that there are some enhancements that Nationwide Retail ought to implement. To save lots of unnecessary suspense these are the enhancements:

• Cease issuing inventory till if and when it turns into considerably accretive to shareholders. It’s not now.
• Enhance their charge of inclinations as wanted to maintain their acquisitions.
• Promote their Funding-Grade properties.

Now let’s dig into what makes Nationwide Retail tick.

Some Historical past from Money Flows

I like to take a look at historical past to see how a REIT has dealt with previous challenges and alternatives. This speaks to their versatility, can present enduring tendencies, and may check my modeling of their progress.

Here’s a 20-year historical past of Money from Operations, or CfO, proven as inexperienced bars, and dividends paid (on each frequent and most popular inventory), proven as yellow bars. You possibly can see that the dividends have been nicely coated by CfO for the past16 years.

You may as well see that the retained money earnings (the distinction) have grown. These earnings will be paired with leverage-neutral new debt and used to accumulate new properties with out issuing any inventory.

Nationwide Retail has been bragging for a while that they’ve been pushing their dividend up and their payout ratio down. This allows a bigger quantity of internally funded acquisitions. For a 40% Debt Ratio (ratio of debt to whole belongings), right here is the quantity of acquisitions that these retained earnings supported.

This quantity has grown to about 40% of their whole acquisitions over the previous two years. We are going to see under that that is very important.

We will take the cash-flow story a bit additional by trying on the whole inner sources of capital, from retained earnings, leverage-neutral debt on these, and inclinations. (There will be further debt leveraging positive aspects on inclinations, however that is small and in addition unclear from the Statements of Money Flows, so we go away it out.) We examine these inner sources of capital to acquisitions right here:

Right here the web retained earnings mentioned above are proven by the inexperienced bars. You possibly can see them rising bigger with time.

The inclinations are proven by blue bars, the required debt by grey bars, and the acquisitions by yellow bars. We will see {that a} decade in the past, the inner sources of capital have been a couple of quarter of the acquisitions. However by 2018 and since, the inner sources have been half or extra of the acquisitions.

Paying for the rest of the acquisitions was completed by issuing inventory and extra debt, nonetheless leverage-neutral general (and over time). We add these within the subsequent graphic with the brand new inventory proven by pink bars. We pass over small stuff, particularly the web of different financing and different investing money circulation.

The inexperienced bars now present the entire inner capital from the earlier plot, together with the related, leverage-neutral debt. The yellow bars are once more the acquisitions. These have been paid for primarily by issuing inventory (pink bars) in most years from 2011 by means of 2019. New debt (grey bars), and the inner capital additionally contributed.

The primary decade on this century was a turbulent time. I selected to not unpack that however included that interval on among the plots right here as a reminder that what works in a single decade might not work within the subsequent.

A lot of the previous decade has been an excellent time for Nationwide Retail so as to add per share worth by issuing inventory to boost capital. It appears within the graphic above that numerous shares have been issued. However on a proportion foundation it was not a lot, as you’ll be able to see right here:

After the turmoil surrounding the Nice Recession, the fraction of shares issued every year has not exceeded 10%. And since 2016, it has not exceeded 5%. (The plot exhibits diluted common shares, which lag the instantaneous share issuance.)

As well as, you’ll be able to see that the rise in FFO/sh, or Funds From Operations per share, has almost all the time been above 5% per yr, besides throughout recessions. This enhance will probably be fairly small in 2023, as they roll off of post-pandemic tailwinds, however the common of 2022 and 2023 will stay above the typical from the teenagers.

You may as well see within the cash-flow graphic above that the acquisitions didn’t change quite a bit over the previous decade (save for 2020). They ran close to $700M per yr on common. However the shares issued dropped because the retained earnings elevated, even earlier than the pandemic.

The above is the place the money got here from and went to. What we care about as potential shareholders is charges of progress per share. Let’s have a look at that.

Progress of Money Earnings

We search to know how a lot Nationwide Retail can develop earnings going ahead and what decisions they might have. We are going to mannequin the yr 2014 and the current. The yr 2014 was in the course of these years when the money flows proven above say that they have been doing numerous exterior progress, issuing shares to fund growth.

The primary distinction between 2014 and 2023 is the distinction in retained earnings. As retained earnings go up, the dividend yield above which issuing shares is not accretive will increase, as I explored on this article.

Here’s what occurred over the last decade from 2012 by means of 2022:

Money from Operations grew extra slowly than Gross Property. I imagine this displays primarily the gradual decline in cap charges.

The shares excellent grew amply, though some Web Lease REITs issued much more shares. That is one other solution to see that this was a interval of exterior progress.

The general progress of CfO/share was 4.6%. In a long-term context, that may be a excellent end result for a REIT, although not spectacular. It might have been, although, with out the pandemic.

The year-to-year outcomes do range, after all.

Return on New Fairness

We will perceive the expansion seen above as follows. The underlying elementary parameter is the return on new fairness (or Funding Yield), by which I imply the money earnings produced when new capital is invested whereas sustaining the goal Debt Ratio.

This return and all the expansion charges proven under have a decent mathematical relation to a couple key parameters. I mentioned these relationships right here. See that article for explanations; the Appendix under comprises the formulae.

This desk exhibits the items and matches them collectively for the Funding Yield in our two years of curiosity:

The Debt Ratio, Curiosity Charge, and Cap Charge, proven in rows shaded orange, mix to supply the curiosity bills as a fraction of NOI. (The 2023 Cap Charge is that disclosed for This fall 2022.) The primary row shaded blue exhibits that amount, whereas the second exhibits the Money prices as a fraction of NOI.

These mix to provide Chris Volk’s V-factor, the ratio of money earnings to NOI. This, with Cap Charge and Debt Ratio, offers the Funding Yield.

We see that the bigger cap charge in 2014 greater than compensated for the bigger rate of interest, in order that the Funding Yield was 8.3% then vs 7.9% now.

Inner Progress: Hire Bumps, Capital Recycling, and Retained Earnings

To my thoughts, it is smart to explain progress funded by retained earnings, capital recycling, and reflecting lease will increase as inner progress. For Nationwide Retail, their 1.8% lease escalators work by means of to a 1.6% progress of CfO, for causes described on this article.

Turning to capital recycling, Nationwide Retail brags about two facets. First, they handle to purchase at low price, giving the tenant low lease. Second, they’ve a really efficient disposition course of.

Disposing property signifies that you lose the NOI it produces. The concept is to get bigger NOI when the proceeds are reinvested. However we care about CfO.

What we have to know is the unfold within the CfO per unit property worth between the brand new acquisitions and the inclinations. Within the This fall 2022 earnings name, we study that the cap charge for inclinations has run about 50 foundation factors smaller than that for acquisitions. We are going to assume that within the following for each years of curiosity.

That fifty bps offers us the unfold in NOI however we have to know the unfold in CfO. The fact is that the (unsecured) debt and the G&A prices related to the inclinations won’t drop after which reappear when the proceeds are used for acquisitions. However treating them that approach avoids substantial problems within the calculation.

So what we are able to do is to judge a ratio of misplaced CfO to misplaced NOI by assuming that G&A and Debt are lowered in proportion to the misplaced NOI, after which discover a Disposition Yield based mostly on the disposition cap charge. Then we assign the Funding Yield mentioned above to the next acquisitions, successfully assuming that the G&A and Debt come again.

That approach, the unfold from Funding Yield to Disposition Yield determines the achieve in CfO produced by the recycling course of. Listed here are how issues add up for inner progress, for the years of curiosity:

The rows shaded blue consider the rise in CfO produced by the lease bumps. These in orange consider the rise in CfO from capital recycling, utilizing the calculation described above. The inclinations have been about 20% of CfO in each years.

The next row, shaded gold, exhibits crucial distinction between the 2 years. The retained earnings have been 19% in 2014 however elevated to 34% in 2022 and will probably be comparably excessive in 2023. This proves to be a giant distinction, considerably right here and extra for exterior progress, mentioned under.

That fraction of retained earnings generates the retained money, proven within the first row in inexperienced. Multiplying that by the Funding Yield will get you the brand new CfO from reinvestment, proven on the third row in inexperienced.

Combining all sources of inner progress one finds that the speed of enhance in CfO (and in CfO/sh if there isn’t a share issuance) grew from 3.3% to 4.4% from 2014 to 2023. The influence of an elevated fraction of retained earnings was stronger than the influence of a smaller Funding Yield.

It’s value emphasizing what Nationwide Retail can do now. They will make investments their almost $200M of retained money earnings at that 7.9% yield to generate an extra $16M of CfO, a rise of two.7%.

(Nationwide Retail comes up with $188M of retained earnings, not the $197M that’s straight from the Statements of Money Flows. The origin of the distinction shouldn’t be clear to me, but in addition sufficiently small to not matter.)

That enhance requires solely proportional debt. Extra importantly, it requires no issuance of inventory. All the standard discussions of spreads and of WACC have zero software right here (together with the one on p. 33 of their Institutional Investor Presentation).

Simply make your cash, reinvest it, and compound from there.

Together, lease progress, capital recycling, and reinvested earnings can now develop CfO at a charge above 4%.

Right here is the way it appears to me: Nationwide Retail can develop money earnings per share at the moment, with out issuing any inventory, at almost the speed they managed in the course of the previous decade.

Let’s have a look at the influence of issuing inventory.

Exterior Progress: Not So Sizzling Any Extra

Rising by issuing shares (diluting current shareholders), elevating leverage-neutral debt, and shopping for extra properties is extra complicated. The market controls the value you may get on your shares; you don’t.

As you promote shares, there may be an earnings yield discovered by dividing your money earnings by the value. This has two elements, a dividend yield and a yield on the retained earnings.

You management the fraction of earnings which are retained. You additionally management how a lot inventory to situation. That inventory offers capital but in addition dilutes all earnings. The query turns into how a lot whole progress you generate as you situation extra inventory, relying on the dividend yield and on the retained earnings.

First we are going to have a look at the yr 2014, from the interval when share issuance (plus leverage) was offering about 3/4 of the funds for acquisitions. Importantly, the retained earnings have been 19% and inclinations have been 20% of CfO. We will show how this labored out, based mostly on the maths within the appendix, in a contour plot:

This exhibits by contours and colour the entire progress charge of money earnings per share. The contours are labeled by the expansion charge. The heavy, dashed contour exhibits the contour for the inner progress charge of three.3% they might get in 2014 with out issuing new shares.

In 2014, Nationwide raised $360M at a 5% dividend yield. On the time the Market Cap was about $4400M, in order that they diluted the shareholders by about 8.1%. The yellow dot exhibits that location on the contour plot.

The calculation says that money earnings per share ought to have elevated about 6%. When these present up is delayed, as most acquisitions happen late within the yr. CfO/sh progress in 2015 was 6.6%. Throughout that interval, the share issuance roughly doubled the earnings progress charge.

From this it seems that now we have an affordable mannequin of how Nationwide Retail grows earnings. Now let’s look at present period when the retained earnings have moved to 34%, inclinations are nonetheless 20%, and the cap charge has dropped to six.6%.

Right here the heavy, dashed contour corresponds to the expansion charge for which share issuance produces no enhance in money earnings per share, just under 4.4%. The mixture of decrease cap charge and better retained earnings has pushed down the edge dividend yield above which share issuance shouldn’t be accretive to per share earnings.

Additionally, the yellow dot exhibits what they did in 2022. They diluted shareholders by 3.1% at a dividend yield of 4.9%.

From the perspective of accelerating per share earnings, this dilution was pointless. The earnings progress produced by the 2022 acquisitions (most displaying up in 2023) would have been the identical if that they had issued no fairness.

Within the earnings name, Nationwide Retail emphasised that they obtained a possibility within the brokered market to buy a portfolio of drug shops for what they thought of a compelling value. But when they simply function these drug shops, they are going to have finished nothing important for shareholders.

Alternatively, if the plan is to promote that portfolio as soon as the property market rebounds, that might be useful. But when that’s the plan then up to now, now we have seen no trace of it of their disclosures.

One can see within the plot that issuing shares when the dividend yield is above about 5% is dilutive to per share money earnings underneath current circumstances. That’s for the indicated cap charge and rate of interest. Modest adjustments within the rate of interest transfer the contours round in intuitive methods, however don’t create large adjustments.

Will increase in cap charge do have a constructive impact. They’re more likely to include will increase in rates of interest, too. Suppose cap charges go to 7.5% and rates of interest enhance to 4.5%. On this case the inner progress charge would enhance to 4.8%. Here’s what one would then have for exterior progress:

Now the heavy, dashed curve corresponds to the expansion charge of 4.8% for no fairness issuance. The yellow dot nonetheless exhibits the 2022 share issuance.

Now there can be a profit from issuing shares. However it’s fairly small, being close to a one p.c enhance in earnings progress charge for cheap share portions. It appears to me Nationwide Retail would nonetheless be on the level of diminishing returns for share issuance even with elevated cap charges.

Placing this collectively generates this image. Nationwide Retail took benefit of the low earnings yields of the previous decade to develop earnings per share and to push up their retained earnings whereas additionally rising their dividend. This has pushed them into a brand new regime vis a vis issuing shares.

At at the moment’s dividend yield of 4.9%, they can not enhance CfO/sh by issuing inventory. However even when the yield comes again down close to 4%, the returns for doing so are restricted and will characterize diminishing returns.

The historic dividend yield on NNN offers some perspective in enthusiastic about possible future circumstances.

The historic yield spent the teenagers above 4% on common, however largely under 5%. Sooner than that dividend yields have been larger, as have been cap charges. For instance, cap charges have been above 8% in 2011 and 2012 when dividend yields have been close to 6%.

Now yields may plummet under 4% quickly, restoring the facility of fairness from share issuance to considerably enhance earnings progress. However yields additionally may proceed a bumpy climb upward because the financial system general proceeds into its subsequent section.

It appears to me removed from sure and even unlikely that issuing shares will probably be an efficient approach so as to add shareholder worth anytime quickly.

Volumes

A considerable a part of exercise for such a REIT entails creating a pipeline of future acquisitions after which closing offers that add to the property portfolio. Of their current institutional investor presentation, Nationwide Retail reported possession of three,411 properties.

We noticed above that acquisitions have run close to $700M per yr over the previous decade. The reported acquisition price averages a bit under $3M per property, so to maintain that tempo they should shut over 200 offers per yr. That’s a mean of some per week.

Nationwide Retail has ongoing relationships with administration of about 25 rising retail ideas. Their “relationship based mostly acquisitions” over the previous 5 years have averaged $460M per yr. To maintain the flexibility to develop from these sources, they should proceed to assist the wants of these firms.

There could also be some stress between the necessity to do that and the necessity to deploy capital solely in methods which are accretive to shareholders. As we noticed above, this stress is a brand new factor arising from excessive retained earnings and low inventory costs.

On this context, I hope Nationwide Retail pays consideration to balancing the long-term wants of the enterprise with shareholder worth. Assuring ever-higher volumes and going after “good offers” shouldn’t be essentially the perfect course. And as mentioned above, it’s removed from clear that their current buy of drug shops was the perfect course.

Nationwide Retail has guided for decrease acquisitions throughout 2023, as have many different REITs. From their This fall 2022 earnings name:

Now we have the choice protecting leverage impartial to make use of an affordable quantity of availability of the credit score facility to roughly $180 million of free money circulation plus $110 million of inclinations to execute our 2023 technique. Utilizing these three sources, as I discussed, leaves NNN with a manageable fairness requirement for the yr.”

That is barely disturbing, as follows. Why situation any fairness in any respect when it isn’t accretive? Simply so you’ll be able to comply with some plan? There are different methods to try this.

Wanting past the present disruptions, suppose you need $700M of acquisitions going ahead, on common. The 40% debt will probably be about $300M, so that you want $400M of recent capital.

The retained earnings will probably be about $200M of that. So they are going to want one other $200M.

Historic inclinations have run about $100M and inventory issuance over the prior 3 years has averaged $130M. My desire is that they not return to issuing inventory when it produces little or no profit to shareholders. It might make extra sense to situation no inventory and to up the inclinations to close $200M.

The present $100M of inclinations is only one% of Gross Property. A better charge would allow enchancment of the portfolio. It additionally would offer extra safety associated to debt, which matures at a charge considerably above $350M per yr.

Past that, it’s arduous to see the worth of holding onto their properties which have moved to funding grade after buy. These are actually extra priceless as a result of the markets overvalue their obvious safety.

However they will’t produce any further revenue. So promote them except there are compelling causes not to take action.

With the disruption of the capital markets this yr, some Web Lease REITs are discovering compelling alternatives. The purpose value making is that for the circumstances of Nationwide Retail particularly it takes a very large enhance of cap charge to generate important shareholder accretion.

Offers that might require doubling the acquisition quantity and solely enhance shareholder returns from 4% to five% aren’t clearly value doing. Including quantity comes with prices and dangers, too. Past that, the longer it takes for Nationwide Retail to develop to the purpose that shareholder returns are more durable to return by, as Realty Revenue (O) already has, the higher for shareholders.

Valuation

It’s wise to take a look at P/FFO for NNN, since FFO, AFFO, and CfO don’t differ a lot. CfO averages about 10% greater than FFO, so maybe costs needs to be 10% larger than one may suppose. However that’s within the noise.

Right here is the historical past of P/FFO, from TIKR:

On the one hand, NNN was priced at a P/FFO averaging 17x by means of the teenagers. Alternatively, ahead progress could also be a bit slower and low cost charges could also be a bit larger. That mentioned, they will develop for a really, very very long time on their enterprise mannequin.

If we use a ten% low cost charge and 4% progress charge, indefinitely, then we get a ratio of about 17x. If we enhance the low cost charge to 12%, this drops to 13x, a bit under at the moment’s pricing.

So NNN is actually undervalued in comparison with current historical past. And there’s a good probability the inventory value will enhance going ahead. However a return to 17x, not to mention 20x, is much from assured.

Takeaways

My take is that it makes numerous sense to purchase NNN inventory for modestly rising, very secure dividends. They’ll develop earnings and dividends at about 4% per yr. With their dividend yield close to 5%, the entire returns will probably be within the excessive single digits.

However substantial upside is extra of a crapshoot on the place the broad markets go. So whether or not or not NNN is for you is dependent upon who you might be as an investor.

That mentioned, let me repeat the actions it is smart to me for Nationwide Retail to take.

• Cease issuing inventory till if and when it turns into considerably accretive to shareholders. It’s not now.
• Enhance their charge of inclinations as wanted to maintain their acquisitions.
• Promote their Funding-Grade Properties

We are going to see in a couple of yr what Nationwide Retail has finished in 2023 and plans for 2024.

Appendix: Simply the Math

One can reproduce all of the theoretical outcomes on this article utilizing the next bits of math. The central concepts that the maths implements are these of Chris Volk.