2023-03-08 17:59:26 ET
Summary
- The retail sector bifurcation has accelerated as skyrocketing theft rates and stagnant retail spending cause store closures.
- Agree Realty's portfolio is less risky than retail properties but not recession-proof.
- Agree may not continue to increase its dividend due to falling coverage ratios and growing interest costs.
- The REIT's effort to pursue rapid acquisitions during a rising rate environment increases its exposure to a likely rise in capitalization rates.
- Overall, ADC appears significantly overvalued compared to its estimated net asset value and most REIT valuations.
The "big box" retail sector is transforming today after tremendous growth over recent decades. In general, the construction and development of large retail spaces have slowed, causing vacancy rates to decline for many retail properties. However, at the same time, lower-quality retail spaces in less desirable areas are seeing weakening interest. This shift manifests in growing cap-rate spreads across retail properties as a "flight to quality" grows amongst large retailers. As exemplified by the recent mass closure of all Portland, Oregon, Walmart stores ( WMT ) retail properties in lower-quality areas with increasing crime rates ( a major growing issue ) are potentially doomed, while retail properties that offer "experience-driven shopping" gain competitive advantages.
The "bifurcation" of retail properties has dramatically accelerated over the past three years . Lockdowns created immense strain for virtually all retailers, forcing lower performers to close and further ingraining online shopping habits. The subsequent increase in inflationary pressures, particularly in energy prices and wages, created further challenges as retail overhead costs grew disproportionately to sales. This trend has led to the downfall of large retailers like Bed Bath & Beyond ( BBBY ). More recently, skyrocketing retail theft rates have led to the closure of many stores in urban areas, even causing New York City to discourage face masks to deter theft (highlighting the depth of the issue). Further, growing pressures in household financial stability and declining real retail sales may exacerbate the theft issue and create new cyclical pressures for retailers.
These numerous trends will likely have far-reaching long-term consequences for retail REITs. One interesting example is Agree Realty Corporation ( ADC ), the largest retail-oriented REIT. Despite potential headwinds, the REIT is trading near its peak price and valuation at a dividend yield of 4.1% and "P/FFO" of 17.7X - around 35% above the REIT sector median . Many investors like the REIT due to its consistent dividend growth; however, that may end soon as its dividend coverage falters. While ADC has attractive qualities, growing headwinds in the retail sector and its seeming overvaluation could cause it to decline in value this year.
Is Agree Realty "Recession Resistant"
Agree Realty markets itself as a "Recession Resistant" REIT due to its focus on higher-quality properties with some "counter-cyclical" tenants, such as Dollar General ( DG ) and Dollar Tree ( DLTR ), and "non-cyclical" tenants like gas stations, auto parts stores, etc. Additionally, over two-thirds of its tenants are rated " investment grade, " and most are at low insolvency risk.
Of course, not all recessions are identical, and a significant slowdown today would likely look very different than historical precedents due to the immense growth of e-commerce since ~2008. Further, while some retailers may not suffer declining demand due to a recession, ongoing "supply side" inflationary pressures challenge most retailers through growing overhead costs and lower gross margins . Considering the company is buying and selling properties at capitalization rates of around 6.5% , the low-end retail spaces , its portfolio is undoubtedly less risky than retail at large. That said, in the event of prolonged economic strain, I believe the inherent cyclical and secular risks in retail will impact Agree's portfolio.
Despite many signs of retail spending headwinds and seller resistance to reducing cap rates, the company continues to invest aggressively in new acquisitions - potentially creating poor financial positioning in a weakening environment. Rising borrowing costs exacerbate this risk. Agree is deploying capital into properties at a record pace, using its credit revolver or other financing sources for money. This was a profitable strategy when base borrowing costs were near zero and capitalization rates on retail spaces were above 7%. Today, however, with the Fed's terminal rate expected to rise to (or above) 6% , it will be challenging and likely impossible for ADC to cash-flow positively on new investments without increasing rents. I believe it will be challenging for ADC to increase rental rates in the current economic environment. Thus, its ongoing investing binge may hamper its cash flow per share and expose the firm to a sharp rise in capitalization rates.
What is Agree Realty Worth?
Agree's dividend growth record is a significant eye-catcher for income investors, as it is uncommon for REITs to expand their dividends consistently. ADC's dividend per share has risen 132 consecutive times over the past decade at an annual pace of ~6% . However, its income per share has actually declined since 2016, causing its dividend coverage level to plummet. See below:
Given the REITs falling dividend coverage, it seems unlikely to maintain its long-term dividend growth. Indeed, given the ongoing rise in borrowing costs and its significant acquisition rate, its cash flows may eventually become constrained. Further, investor bias toward "dividend growth" stocks may be causing ADC to become relatively overvalued. ADC is currently trading at a "P/FFO" 34% above the REIT sector median and a 44% "P/E" premium. Although its debt level is lower than that of many REITs at ~30% of capital, it still trades at an "EV/EBITDA" of 22.1X, 30% above the sector median.
To value ADC more accurately, it is likely best to determine its estimated net asset value based on the capitalization rate of its properties. The REIT has generated a net operating income of $347M over the past year (or operating income plus depreciation). At a 6.5% estimated capitalization rate valuation (based on its stated purchase and disposition cap rates), I estimate its properties are likely worth around $5.35B today. The company also has around $911M in other assets today (cash, lease intangibles, etc.), bringing its estimated total market value to $6.26B. Subtracting $2.08B in total liabilities and $175M in preferred equity, the estimated value of ADC's common equity comes to about $4.01B. This is about 10% below its current book value and ~37% below its market capitalization.
This NAV estimate is likely below ADC's book value because the capitalization rates on retail properties today are slightly higher than it has been over recent years. However, the overall increase in capitalization rates has been meager compared to the meteoric rise in financing costs. Historically, capitalization rates are correlated to interest rates, particularly " real interest rates " after inflation (because rents are expected to rise with inflation). With the "real yield" on a ten-year Treasury around 1.6% today, borrowing costs after inflation are the highest in a decade, suggesting capitalization rates may rise considerably (potentially by ~2% as indicated by the rise in real yields).
The commercial property market lags the financial market a great deal, but falling commercial transaction volumes suggest capitalization rates will rise faster this year. If we estimate a 1% rise in ADC's property's capitalization rate (to 7.5%), its assets' estimated value declines to $4.63B. After accounting for other assets and liabilities (-$1.34B net), its estimated equity NAV drops to ~$3.29B. Using the same metrics, a 2% cap rate increase to 8.5% would bring its estimated equity NAV to $2.74B, less than half of ADC's current market capitalization.
The Bottom Line
The potential rise in capitalization rates is a systemic risk that impacts all REITs. Notably, the "highest quality" REITs generally carry greater exposure to capitalization rates because of the " convexity factor " from lower rates. Fundamentally, this is why "low-risk" Treasury bonds fell much more than "high-risk" junk bonds last year. So, while ADC's "safer" portfolio does reduce its recession exposure, it also increases its potential interest rate exposure. However, due to its lower leverage, ADC's overall exposure to rising capitalization rates is healthier than many of its peers.
Even using today's capitalization rates, ADC is considerably overvalued today. The REIT trades at an estimated 56% premium to its estimated net asset value. In other words, ADC would likely decline by ~36% to reach its estimated NAV of ~$4B. Of course, ADC has traded at a hefty premium to its equity for an extended period, and most REITs trade at NAV premiums today due to high investor demand. Due to the rising capitalization rate environment, I would not buy a REIT above its estimated NAV today.
While ADC may continue to trade at a 25-50% premium to its peers (based on various metrics) and estimated asset value, I am bearish on the stock. ADC has many attractive qualities, but I do not believe its portfolio is so strong that it should trade at such a significant premium. Further, the fact that the company is making considerable investments in a rising-rate environment suggests it may be more interested in growing its portfolio than benefiting equity owners. Additionally, the REIT will likely stop raising its dividend due to weakening coverage and stagnating EPS. Finally, increasing retail-centric risks, such as theft and supply-side inflation, could elevate risks, though ADC is less exposed to this factor than most retail properties.
For further details see:
Agree Realty Corporation: Valuation Premium Not Justified Due To Growing Retail Risks