BNL - 6.5% Yield And Up To 30% Undervalued - A Closer Look At Broadstone Net Lease

2023-12-15 17:35:35 ET

Summary

• Broadstone Net Lease's (BNL) stock price is benefiting from expectations of a return to low rates and low inflation in the real estate sector.
• BNL has a well-diversified portfolio with a focus on industrial properties and a strong tenant base.
• Despite challenges with specific tenants and macroeconomic headwinds, BNL maintains a healthy balance sheet and offers an attractive dividend yield.

Introduction

Markets are celebrating. The CNN Business Fear & Greed Index is getting close to "extreme greed" again after markets started to price in a much more dovish Fed in 2024.

Both the Fed and the European Central Bank are expected to cut rates by 150 basis points next year, giving investors hope that we're finally on the path to a "normal" economic environment of subdued rates and low inflation.

One of the biggest winners of this trend is the real estate sector, which relies on low rates and low inflation.

Low rates make it easier to fund M&A and property acquisitions while maintaining healthy balance sheets. Inflation is key, as it is a major driver of operating expenses and rent growth. A lot of REITs have capped rent escalators close to 2-3%, meaning elevated inflation not only pressures balance sheets but also operating results.

One of the biggest winners of the past four weeks is Broadstone Net Lease ( BNL ) , a net lease giant with a $3.4 billion market cap. It has returned more than 14% since mid-November.

On August 30, I initiated coverage of BNL in an article titled 7% Yield And Undervalued - What To Make Of Broadstone Net Lease?

In this article, I'll update my call and explain why BNL continues to offer value despite certain disadvantages that could pressure the company (and its peers) if inflation continues to remain sticky.

So, let's get to it!

Diversified Net-Lease Exposure

BNL is a well-diversified REIT with 800 properties in 44 states and four Canadian provinces.

51% of its annual rent is generated from industrial buildings, followed by 18% healthcare, 14% restaurants, 11% retail, and 6% office.

Looking at its industrial exposure (below), we see that the company has put an emphasis on this segment, as its exposure has increased by 20 points since the end of 2018.

Like most of its assets, this segment also has a weighted average rent escalation of 2.0%, which protects BNL against inflation below or at the Federal Reserve's target range.

On a side note, a major risk here is prolonged elevated inflation, which would expose BNL to risks like elevated expenses.

The weighted average lease term is 11.5 years.

Also, it has a well-diversified tenant base, with its top ten tenants generating less than 18% of its annual base rent.

In this segment, close to 60% of rent is generated in manufacturing and distribution/warehouses.

Its other assets are also well-diversified, with annual rent escalators close to 2%.

Its biggest operating state is the Lone Star State, Texas, which is home to 72 of its properties and accounts for roughly 10% of annual base rent.

During its 3Q23 earnings call, the company noted that its portfolio continues to perform well. The focus on tenant and industry diversification, combined with top-tier annual rent escalations, mitigates downside risks.

As a result, the real estate portfolio achieved 99.9% rent collections and 99.4% occupancy as of September 30, 2023.

However, despite a resilient portfolio, BNL faced challenges with the Green Valley medical center tenant, who failed to meet milestones.

Rent collections have been impacted, causing the company to explore alternatives and potentially end the distraction caused by this single asset.

Furthermore, the company noted macroeconomic challenges.

The transaction market is experiencing ongoing price discovery, influenced by the upward trajectory of treasury yields.

This has led to a widening of bid-ask spreads and a decline in transaction volume in the broader market.

Despite this, the company remains focused on sourcing the right investments and is selective in pursuing opportunities amid the evolving market conditions.

During the quarter, a limited number of investments met BNL's criteria, primarily driven by development funding and revenue-generating CapEx.

The company's success in selling select assets with credit or residual risk helps mitigate risks within the portfolio while building dry powder for future accretive recycling.

For example, the company successfully disposed of select assets with credit or residual risk, selling two properties for gross proceeds of $62.3 million at a weighted average cash cap rate of 6.2%.

Year-to-date, 11 properties were sold for $189.1 million at a weighted average cash cap rate of 6%.

The company plans to continue executing asset sales opportunistically in the fourth quarter and into 2024.

Furthermore, the company's pipeline of potential investment opportunities is expanding, evaluating over $10 billion in acquisitions during the third quarter.

Despite the active sourcing and underwriting, the increase in interest rates impacted the number of opportunities meeting BNL's criteria.

For example, the company walked away from a significant late-stage investment due to pricing disagreements amid rapid rate increases.

In light of economic risks, thanks to prudent investments and careful decision-making, the company maintains a very healthy balance sheet.

As of the third quarter, the company has a net leverage ratio of 4.9x. This number has been lowered from 5.2x in the prior year quarter.

It also has close to $1 billion in liquidity, almost exclusively from available revolver capacity.

The company also has no major debt maturities until 2026.

As a result, it enjoys an investment grade BBB credit rating with a stable outlook.

Furthermore, the company maintained its 2023 per-share guidance with an AFFO (adjusted funds from operations) range of $1.40 to $1.42 per share.

• Investment volume was revised down.
• Total disposition volume is expected to be $200 million.

With regard to the dividend, the Board of Directors approved a $0.285 dividend per common share, representing a 1.8% increase from the last quarter.

This aligns with the targeted AFFO payout ratio in the mid-to high-70% range.

Currently, BNL yields 6.6%, which is 50% more than the 4.4% yield of the Vanguard Real Estate ETF ( VNQ ).

Going forward, we can assume that dividend growth will remain in the low-single-digit range based on expected AFFO growth rates, which brings me to the next part of this article.

Valuation

This year, BNL is expected to avoid contraction, with 1% AFFO growth in 2023. Next year, AFFO is expected to grow by 3%, followed by 4% growth in 2025.

Currently, BNL trades at a blended P/AFFO multiple of 12.3x.

The normalized valuation is 14.8x AFFO. Although it will likely need a sustainable decline in interest rates before investors award a higher multiple on a consistent basis, the stock could return close to 20% per year through 2025 by incorporating its juicy dividend and expected AFFO growth rates.

Needless to say, the stock is unlikely to return 20% per year on a long-term basis. One reason why this number is so high is because of the short time span of this calculation.

Nonetheless, I believe that the stock is roughly 30% undervalued, with a fair price target of $22 to $24.

Takeaway

Broadstone Net Lease stands out as a resilient real estate investment. The company's strategic focus on diversified net-lease exposure, particularly in industrial properties, has shielded it from potential downside.

Despite challenges with specific tenants and macroeconomic headwinds, BNL's portfolio maintains a remarkable 99.9% rent collection and 99.4% occupancy.

Furthermore, BNL's proactive approach to asset management, including strategic disposals and a robust liquidity position, contributes to a healthy balance sheet with a BBB credit rating.

The recent dividend increase and a 6.6% yield make BNL an attractive proposition for income-focused investors, especially compared to the Vanguard Real Estate ETF.

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