NNN - Forget Bonds NNN's 6% Yield Is A Great Deal

2023-11-14 07:40:12 ET

Summary

• NNN REIT is a well-managed company and one of the best high-yield buys on the market.
• The company has consistent growth and a strong tenant portfolio, making it a stable investment option.
• Despite its recent stock price rally, NNN remains undervalued and offers great value for income-focused investors.

Introduction

I'm a very picky investor. I currently hold a dividend (growth) portfolio consisting of only 20 individual stocks (with a plan to expand this gradually to 25).

Given my age, I'm currently not fully focused on income. However, if I were, I would be a buyer of NNN REIT (NNN) , formerly known as National Retail Properties.

The company is a smaller peer of Realty Income (O) and one of the best-managed REITs on the market.

On September 11, I wrote an article titled 6% Yielding NNN Hasn't Been This Cheap Since The Great Financial Crisis . In that article, I highlighted some of the company's qualities, including its stellar dividend growth history and strong asset portfolio.

In this article, I'm going to elaborate on this, using the company's recently released earnings, new economic developments, and surprising strength in the nation's retail real estate sector.

Given NNN's valuation, I think it remains one of the best high-yield buys on the market.

Betting On Stability

This is not a fun market to be in.

With mortgage rates close to 8%, elevated and sticky inflation, and a Federal Reserve more eager to fight inflation than to protect financial stability, this market has become a minefield for investors.

Nonetheless, while my portfolio hasn't seen meaningful growth, I do enjoy the opportunity to buy great companies at great valuations.

After all, building wealth relies on finding good buys during times of distress.

• Excluding dividends, real estate stocks ( VNQ ) are trading 35% below their highs, making it the worst sell-off since the Great Financial Crisis and the worst sell-off outside of a recession.

NNN is down 35% as well.

Having said that, I only want quality REITs.

Not only does this protect us against further mayhem (we can buy stocks at great valuations but never rule out more weakness), but it also helps us accumulate wealth on a long-term basis.

After all, limited volatility is an important requirement of long-term wealth building.

NNN is such a company. Although it is highly correlated to long-term bonds (triple-net-lease companies are seen as bond proxies), the company has returned 86% over the past ten years despite its recent sell-off. It has beaten its VNQ peers and 20+ year bonds ( TLT ) by a solid margin.

On top of that, the yield argument is still in favor of NNN.

• NNN yields 5.8%.
• The U.S. 10-year yield is at 4.7%.
• The 30-year yield is 4.8%.

Looking at the history of the ratio between NNN and TLT (including dividends and interest), we see that NNN has consistently outperformed TLT. The ratio has even broken out recently, triggered by lower long-bond yields and strong NNN earnings.

While I'm obviously aware that buying REITs comes with higher risks than buying government bonds, we also should not forget that NNN is consistently growing its income and dividend. Bonds do not have that benefit.

NNN Is Where It's At

I like both Realty Income and NNN - a lot. However, what I like about NNN is its size. The $7 billion market cap makes it a giant. However, it doesn't have to engage in massive multi-billion deals to maintain growth.

It also has a fantastic tenant portfolio.

The company, which focuses on single-tenant net lease retail properties, has a history of 34 consecutive annual dividend increases, making it one of the few REIT dividend aristocrats.

On July 14, the company hiked its dividend by 2.7%. That's in line with the five-year dividend CAGR of 2.7%.

In other words, the yield is good, but dividend growth isn't very exciting.

However, it's consistent. And that's what buying high-quality income is all about.

It's also safe.

The AFFO (adjusted funds from operations) dividend payout ratio for the first nine months of 2023 was approximately 68%, resulting in $141 million of free cash flow after covering all expenses and dividends. The annualized free cash flow rate is $188 million.

Speaking of safety:

• The company has a BBB+ credit rating. That's one step below the A-range.
• Its debt has an average weighted effective interest rate of just 3.9%.
• Its debt has an average weighted maturity of 12.6 years. That's one of the best numbers I've seen in the REIT industry.
• Before 2026, less than 8% of its debt is due.
• It has an interest coverage ratio of 4.6x.

The company is also upbeat about its future, as core FFO guidance for 2023 was increased, with a new range of $3.19 to $3.23 per share.

AFFO guidance was also raised to $3.22 to $3.26 per share.

The updated guidance suggests 2% to 2.5% growth in core FFO for 2023, with potential higher growth if excluding deferred rent repayments.

Analysts expect the company's AFFO to grow by 1% this year, followed by a gradual rebound to 3% by 2025.

This is what I meant when I wrote that NNN has consistent growth. Bonds do not have that benefit.

Another reason why NNN is expected to escape retail woes is its portfolio.

Occupancy stood at 99.2% at the end of the third quarter, showing a 20 basis points decrease from the prior quarter and year-end 2022.

This 20 basis points decline is nothing to get worried about, as it is well within the longer-term range.

The company didn't even see a sub-96% occupancy rate during the Great Financial Crisis. It has consistently outperformed its peers when it mattered most.

NNN sold 13 properties during the third quarter, raising $49 million at a 6.0% cap rate and reinvesting at a 7.4% cap rate.

Year-to-date, 26 assets were sold, generating approximately 90 million in proceeds. The focus remains on re-leasing vacancies, but nonperforming assets are sold if there's no clear path to generating rental income.

In the first nine months, NNN invested approximately $550 million in 125 properties at a cash cap rate of 7.2%. Despite an overall market volume decrease, NNN maintained a thoughtful and disciplined underwriting approach.

NNN also completed a $500 million 10-year unsecured bond offering with a 5.6% coupon.

During its earnings call, the company highlighted the execution and timing of the deal, positioning the company well for continued strategy execution. NNN's long-standing discipline in capital deployment and opportunistic capital raising contributed to its strong position, which we already briefly discussed.

Based on that context, the company has strong tenants. Roughly 17% of its properties are leased by convenience stores, followed by automotive services, restaurants, entertainment, EV dealers, health and fitness, and others.

Its largest tenant is 7-Eleven, which accounts for 4.5% of annual base rent.

Only 2% of leases expire through 2024! The weighted average remaining lease term is 10.1 years.

Valuation

Despite rising 10% from its 52-week lows, NNN remains in deep value territory.

• The REIT is trading at a blended P/AFFO ratio of 11.8x.
• The long-term normalized AFFO multiple is 16.0x.
• Analysts expect the company to maintain positive growth in this environment.
• Hence, a return to its longer-term valuation could result in a 23% annualized return through 2025 (including its dividend).

With that in mind, a return to 16x AFFO won't happen in an elevated rates environment.

However, it does show that the longer-term risk/reward is good. After all, the best buying opportunities are when rates are high. The moment rates come down, we'll likely see a massive rotation back into REITs.

While that may take a while, I don't mind buying great companies and collecting dividends until capital gains start to improve.

We also get unexpected benefits from surprisingly strong retail real estate fundamentals. As reported by Scotsman Guide :

JLL described the shortage of space as "significant," considering that 145 million square feet of retail space has been demolished in the past five years and high building costs continues to hold back construction. Deliveries fell 30.4% quarter over quarter to stay near historic lows. Availability in the sector, per JLL, is nearly 200 basis points below its historic average of 6.8%, and is not expected to see meaningful improvement in the coming year given the slowdown in construction and a projected increase in teardowns of obsolete space.

Market rents are still on the upswing as a result, although rent growth is moderating from its high points logged last year. The strongest rent growth is still concentrated in the Sun Belt states, where space for midsized boxes and outparcels is hard to find.

NNN has close to 60% Sunbelt exposure!

Having said all of this, if I had an income-focused portfolio, I would be buying NNN at these levels. I have bought NNN for some family accounts and believe that it will continue to outperform its VNQ peers on a prolonged basis.

Takeaway

In a challenging market, NNN stands out as a beacon of stability.

With a solid tenant portfolio, consistent dividend increases, and a disciplined approach to capital deployment, NNN has weathered market turbulence while maintaining a 99.2% occupancy rate.

Its financial strength, highlighted by a BBB+ credit rating and impressive debt metrics, positions it well for continued success.

Despite its recent 10% rise from lows, NNN remains significantly undervalued, offering great value for income-focused investors.

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