2023-09-21 10:14:02 ET
Summary
- BNL has a positive spread of 26 basis points, indicating their ability to create value in the current interest rate environment.
- The total return that BNL's stock offers to equity investors potentially exceeds the opportunity cost by 245 basis points.
- Even accounting for the elevated risk posed by three tenants on BNL's watch list, the stock has appeal.
Introduction
Broadstone Net Lease ( BNL ) is an internally managed REIT that owns single-tenant properties net leased to a diversified group of tenants. As of June 30 th 2023, the company owned 801 properties, 794 of which are located across 44 U.S. states and the remaining seven in Canada. 51.6% of their annual base rent ((ABR)) comes from industrial properties with meaningful concentrations in manufacturing, distribution and warehousing. The next largest segment is healthcare related properties with 17.5% of ABR. 13.5% of ABR come from quick service restaurants and casual dining establishments. 11.6% from retail with the remaining 5.8% coming from office properties. In terms of tenant diversity, BNL has 221 distinct tenants that operate 209 brands across 54 different industries. No single tenant accounts for more than 4.0% of ABR.
Source: Broadstone Net Lease 10-Q for Q2 2023
In this article, we evaluate the current investment spread for BNL to assess their capacity to add value given the elevated interest rate environment. We compare their cost of capital with their capitalization rate for the second quarter of 2023. In estimating the cost of capital, we will form a view on the cost of equity and compare the total return available to equity investors at the current price with the cost of equity estimated. We also offer commentary on the relevance of the investment spread as an aid to investment decision making for REITs in general. We opine on how contractual rent escalations may affect our thesis and evaluate specific risks to BNL. Towards the end of the article, a conclusion is presented and an investment recommendation offered.
Spread Investor
Like other REITs, BNL is a spread investor. They generate rental income and derive profit from the difference between the rental income earned and the cost incurred to acquire the assets for which they derive the rental income. This spread can be calculated as the difference between the capitalization rate and the cost of capital. The capitalization rate, or cap rate, is typically the net operating income divided by the value of the assets and the cost of capital is the cost associated with debt and equity capital in proportion to how much of each is used in the business.
Please take a look at Table 1 for the total cash capitalization rate for BNL for Q2 2023. For BNL to create economic profit, the cost to finance the acquisition of properties must be less than this rate.
Table 1: Capitalization Rate | |
Q2 2023 Initial Cash Cap Rate | 7.30% |
Source: Q2 2023 Earnings Supplement for Broadstone Net Lease
Cost of Capital
In order to calculate the cost of capital, we have to calculate the cost of debt, the cost of equity and weigh each in proportion to how much is used in the business. Let us review the capital structure of BNL to see how much debt versus equity is being employed in the business. Please take a look at Table 2.
Table 2: Capital Structure ($ in thousands) | ||
Form of Capital | Value | % |
Debt | $ 1,953,176 | 39.2% |
Equity | $ 3,034,828 | 60.8% |
Total | $ 4,988,004 |
Now that we have the relative weights, let us look at each source of capital and estimate the cost. Please take a look at Table 3 for the cost of equity.
Table 3: Cost of Equity | |
? | 0.78 |
Risk free rate | 4.40% |
Equity risk premium | 4.40% |
Cost of equity | 7.83% |
Source: The beta statistic and the 10-year Treasury is from Seeking Alpha on September 20, 2023.
There are different methods and philosophies around calculating the cost of equity. We use the Capital Asset Pricing Model (CAPM) in which we essentially add a spread to the risk-free rate and scale the spread by the volatility of a particular stock.
The beta statistic measures the volatility with respect to the market. The beta is 0.78 implies that BNL’s stock is less sensitive than the market. Conceptually, this is justified since BNL’s revenue stream is secured by counterparties some of whom are investment grade tenants. It is for this reason that net lease REITs are sometimes considered bond-like investments and are frequently classified as a defensive holding.
It is important to note that the beta statistic only measures systematic risks or risks to the market as a whole. There are specific risks to BNL that is not included in the beta statistic that we will touch on later. Briefly, this has to with leases associated with Red Lobster, Carvana and Green Valley Medical Center.
Moving on to the next statistic, the risk-free rate. I use the 10-year Treasury which is a frequently used proxy for the risk-free rate. Finally, the last input is the equity risk of 4.40 % reflecting the most recent monthly data coming from Aswath Damodaran at NYU . This is well within the historic range. The cost of equity arrived at using this approach is 7.83 %.
Now that we have a cost of equity, let us now estimate the cost of debt. Please take look at Table 4 in which we provide the issuer rating for BNL and the median yield for similarly situated fixed-income investments.
Table 4: Issuer Rating and Cost of Debt | ||
Description | Rating/Yield | Outlook/Time Horizon |
Standard & Poor's Rating Services | BBB | Stable |
Moody's Investor Service | Baa2 | Stable |
Corporate (Baa/BBB) Median Yield | 5.81% | 10-year |
Source: Q2 2023 Investor Presentation , Fidelity.com on September 20, 2023
The implication of the cost of debt is that should BNL wish to secure or refinance debt at about the 10-year tenor, it would be facing a cost of debt of 5.81%. This does not mean that their interest expense is going to be exactly 5.81% of their long-term debt because fixed-rate debt could have originated at a different time when interest rates were lower. In general, businesses will be slow to refinance debt in an inflationary environment to take advantage of previous interest rate regimes and will be quick to refinance debt in a declining interest rate environment to take advantage of lower available interest rates. Because of this, the actual cost of debt will be less. Nevertheless, we are using the latest data for the cap rate and will similarly use the latest cost of debt estimate to reflect the current market conditions.
Now that we have a cost of debt, the cost of equity and the weights of each in the capital structure, we can calculate the weighted average cost of capital. Please take a look at Table 5.
Table 5: Weighted Average Cost of Capital ((WACC)) | |
Weight of Equity | 60.8% |
Weight of Debt | 39.2% |
Cost of Equity | 7.83% |
Cost of Debt | 5.81% |
WACC | 7.04% |
The tax shield normally included in the calculation of the weighted cost of capital is ignored because REITs generally do not pay taxes at the corporate level. Additionally, BNL does not have any preferred shares outstanding.
In Table 6 we quantify the amount of the value that is created by BNL by subtracting the cost of capital from the cap rate.
Table 6: Cap Rate Minus WACC | |
Cap Rate | 7.30% |
WACC | 7.04% |
Difference | 0.26% |
In the current elevated interest rate environment, BNL is able to create 26 basis points of value.
In general, the spread is usually but not always positive. If the spread is negative that implies that there is an imbalance in the marketplace. In the current REIT investing climate, there has been a steady march upward in interest rates which increases the cost of debt and a lag between when interest rates settle at a higher level and when cap rates correspondingly settle at an even higher level to maintain a positive spread. Investing while this lag is still working its way through increases the riskiness of an investment. If the cap rate is less than the cost of capital then the cap rate will have to increase sooner or later for profitability to be restored. For cap rate to improve there has to be an increase in the net operating income or a decrease in asset values. It is the risk of a decrease in asset value that is of potential concern to investors and is the rationale behind why it is risky to invest in a business in which the spread is negative.
The 26-basis point positive spread between the cap rate and cost of capital is a necessary but not a sufficient condition for an investment in BNL’s stock. It is equally important to consider to whom does the 26 basis points of value accrue to? Fixed income holders? Management? Holders of OP units?
To estimate how much value is created on behalf on equity investors, we will revisit the cost of equity calculated previously.
We estimated the cost of equity using the CAPM which is a statistical way of ascertaining the cost of equity. There are other methods to estimate the cost of equity. Also, cost of equity is the terminology used from the company’s perspective. It is the cost for them to obtain equity capital. From the investor’s point of view, the cost of equity is the required rate of return for an investment. And for many investors, particularly REIT investors, the required rate of return has two components: the current dividend yield and the growth rate of the dividends.
Currently, BNL has a 7.04% dividend yield. Please take a look at Table 7 for their dividend per share payment history which we will use to estimate their dividend growth.
Table 7: BNL Dividend per Share History | ||
Year | Amount | Quarter |
2023 | ||
$ 0.280 | Q3 | |
$ 0.280 | Q2 | |
$ 0.275 | Q1 | |
2022 | - | |
$ 0.275 | Q4 | |
$ 0.270 | Q3 | |
$ 0.270 | Q2 | |
$ 0.265 | Q1 | |
2021 | - | |
$ 0.265 | Q4 | |
$ 0.255 | Q3 | |
$ 0.255 | Q2 | |
$ 0.250 | Q1 | |
2020 | - | |
$ 0.250 | Q4 | |
$ 0.135 | Q3 |
Source: Seeking Alpha
If we compare the total dividend per share for 2022 versus 2021, we come to a 5.37% growth rate. If we were to assume that Q4 2023 dividends are going to be the same as the Q3 dividends per share and calculate a hypothetical total for 2023 versus the total for 2022, the growth rate we would get is 3.24%. Given their limited track record as a public company, we shall use the more conservative estimate of 3.24% in our analysis.
Please take a look at Table 8 for the total return for BNL as measured by the dividend yield plus the dividend growth rate.
Table 8: Total Return | |
Dividend Yield | 7.04% |
Dividend Growth Rate | 3.24% |
Total Return | 10.28% |
Source: Seeking Alpha on September 20, 2023
In Table 9, we compare the total return just presented to the cost of equity presented in an earlier table. The cost of equity in this case can be thought of as the opportunity cost for investing in the stock akin to a “hurdle rate”.
Table 9: Total Return Minus Cost of Equity | |
Total Return | 10.28% |
Cost of Equity | 7.83% |
Difference | 2.45% |
There is a 245-basis point margin of safety associated with investing in BNL’s stock at today’s price.
Risks
There are a few tenants that are on BNL’s watch list that they have been monitoring for several quarters. This has to do with an elevated risk profile associated with the tenant. For Red Lobster, BNL’s management is optimistic given the performance they see at the property level performance but it will probably be a few quarters more before an “all clear” message is communicated to investors. Red Lobster represents about 1.6% of ABR as of Q2. BNL is also modestly confident with their Carvana lease given the mission critical nature of the real estate involved. Carvana represents 1.2% of ABR as of Q2. The last tenant on the watch list is Green Valley Medical Center. Green Valley has failed to meet milestones as agreed with BNL’s management and there is less clarity as to the path forward with this particular tenant.
From their recent 10-Q, rent collection and occupancy was better than 99%. There was $236,000 of uncollected rent from an overall contractual rent amount billed of $96,456,000.
Another potential area that risk averse investors may be concerned with is that BNL has a relatively limited track record as a public company. BNL was formed in 2007 and elected to be taxed as a REIT in 2008. They first offered their shares to the public in September 2020. Their limited track record is somewhat mitigated by their business model. They are essentially rent collectors and it is the caliber and diversity of their tenant base that is probably more relevant. 15.3% of their tenants are investment grade rated and the diversity of the tenant base was recounted at the top of the article.
Rent Escalation
I have published a few articles using a similar framework to the one used in this article. One of the questions I have been asked by readers to comment on is how this framework, or model if you will, accounts for contractual rent escalation? In the case of BNL for example, 97.3% of the leases have contractual rent escalations with an ABR weighted minimum increase of 2.0%.
One way to consider the issue within the framework is first take a step back and recognize that contractual rent increases is a form of internal growth for a REIT. In 2022, BNL collected $1.99 per share in contractual rent for operating leases and paid $1.08 in dividends per share. That means that about 54.3% of rent collected is delivered to investors in the form of dividends. If there is a 2.0% increase in rent, then presumably, 54.3% of that 2.0% increase will go to investors. So, for every 2.0% growth in rent, investors should get about 1.08% growth in dividends. We know that from Table 8 that dividend growth is about 3.24% and since 1.08% is coming from contractual rent increase, that implies that 2.16% of the dividend growth is coming from somewhere else. Where is that somewhere else?
We have said that contractual rent increases are a form of an internal growth for a REIT. REITs can also employ an external growth strategy through acquisitions. External growth is likely to be more significant for REITs given their limited ability to retain earnings. It is difficult to quantify precisely how much of the external growth contributes to dividend growth. What is not difficult is to infer is that for external growth to make a meaningful contribution to dividend growth, the external growth has to be accretive. And for external growth to be accretive, the cap rate of the property considered by management to acquire must be more than the cost of the capital used to acquire the property. Which brings us to how we started this inquiry.
Source: Broadstone Net Lease 10-K 2022
Conclusion
There are idiosyncratic risks involved in a potential investment in BNL’s stock. BNL has a short track record as a public company and their dividend payment history is limited. Additionally, BNL has at least three tenants that are in various states of risk in terms of rent collectability. These risks are mitigated by the diversity of their tenant profile and their business model. They also have a strong recent record of rent collection and occupancy.
Finance is based on a balance of risk and reward. Given the measured risk and the 245-basis points excess of total return over the cost of equity, a prudent allocation in the stock is a worthwhile consideration.
For further details see:
Broadstone Net Lease: A Spread Worth Considering