NNN: An Attractive Alternative For Income Investors In Retail REITs

At current prices, some retail REITs stand out for their high dividend yields and reasonable multiples. The largest of them, Realty Income (O) has a market cap of over $50bn and a projected dividend yield of 5.13%. Essential Properties Realty Trust (EPRT) has a market cap of $5.5bn and an NTM dividend yield of 3.75%, balancing out its higher expected growth, as this is a newer REIT that focuses on lower credit tenants. Lastly, and what will be the main focus of this analysis, NNN REIT (NYSE:NNN), is a “middle ground” between the two, with a market cap of $8.6bn and an NTM dividend yield of 4.97%, but with a portfolio that is also quite consolidated.

In other words, NNN isn’t as big and consolidated as Realty Income, but it’s also not as new and aggressive as EPRT. As a result, NNN manages to surf both higher quality and more predictable tenants (with a lower cap rate) and tenants with lower credits and higher returns, offering a consolidated portfolio that is well diversified and manages to achieve a gradual and sustainable return over the long term.

For those investors looking to complement their portfolio with a retail REIT with a sustainable income, or looking for an alternative to diversify with Realty Income, NNN could be a good choice.

NNN’s Diversified Portfolio and Tenant Mix

Like its main triple net lease peers, NNN has a robust and diversified portfolio in terms of sectors. A large part of this portfolio is focused on experience, services or sub-segments that are more resilient to crises and less susceptible to technological disruption, such as automotive services, restaurants and convenience stores.

It is even more interesting to note the diversification among the toners, with only two of them representing more than 4% of the Rent base, 7-Eleven with 4.6% and Mister Car Wash with 4.1%. Despite the similarity of being the two main NNN tenants, they have latent differences. In addition to the sectoral difference, 7-Eleven has an A credit rating from S&P Global (SPGI), which classifies it as investment grade with a higher quality, and due to the lower risk, it also has a lower cap rate. Meanwhile, Mister Car Wash has a B- rating from S&P, already placing this tenant in a speculative category (just one level above the default risk category).

With these characteristics, NNN has maintained a historical occupancy rate of over 98.2% since 2004, while the Q2 rate was 99.3%. This occupancy rate is well above the REIT industry ex-hotels and health care, which in Q2 was 89.7%. As a result, there is less volatility in cash generation and the possibility of sustainable dividend distributions. This is another highlight for NNN, as there has been a consecutive increase in dividends over the last 35 years, leading to a total return of ~11% over the last 3 decades.

This is really an interesting attraction when we note that the distribution is quite sustainable, with the dividend per share never exceeding the FFO per share in the quarterly analysis over the last 10 years, evidencing conservatism and a healthy payout.

NNN Shows a Positive Outlook with Some Retail Risks

Going forward, NNN is expected to maintain this sustainable pace of shareholder value generation. Most of its investments are made through relationship-based acquisition, which guarantees a better cap rate and mitigates competition as it takes longer. In recent years, relationship-based investment volume has achieved a cap rate of 7.5% and a volume of $7.5bn, while through market/auction, the cap rate has been 7.3%.

This solid capital allocation translates into a sustainable increase in shareholder value generation. To reinforce this, in the quarter NNN acquired 16 properties (~$110 million) with an initial cash cap rate of 7.9% and a weighted average remaining lease term of 16 years, and sold 14 properties with a cap rate of 7.7%. 100% of these acquisitions were made through its free cash flow, also reinforcing its financial strength, despite its net debt/EBITDA of ~5.5x, a reasonable level.

As for the risks, since it is a well-established and diversified REIT, there is little risk overall. Most of them can also be attributed to the sector in general, such as rising interest rates, recession risks in the US and other macroeconomic risks. To mention some more specific risks, even though NNN is diversified, it has a greater exposure to the retail segment, so more drastic changes in this sector end up affecting it directly and could change the investment dynamics and possibly the risk of its tenants. For example, 16.7% of its portfolio is automotive services, so if consumer preferences change over time to some new trend that its tenants can’t keep up with, this could be detrimental to the portfolio.

The main risk is that of sector competition. Even though the long-term relationship and its relatively large size mitigate this risk, it is something that should be monitored on a quarterly basis. The current cap rate is good, and according to management, the expectation is that it will remain in the mid-to high 7s by the end of the year. The justification is a result of “one, kind of the third quarter transaction pricing for the most part is locked in. Two, the run-up in equity prices in the sector create marginally better cost of equity, and lastly, the market is starting to price in the short-term rate cuts.”

In other words, the current situation remains positive. Monitoring is necessary to ascertain the risk of competition, since it is possible that the market will eventually become more aggressive for this type of property, causing new investments to have a lower cap rate, so management will have to maintain an interesting allocation of capital to keep investments at an attractive level.

NNN’s Valuation is Reasonable, With a Steady Dividend Yield Around 5%

Compared to the other two REITs mentioned here (Realty Income and EPRT), NNN is trading at similar levels, so it can be considered attractive, although there isn’t a major highlight that classifies it as a huge bargain. NNN’s price-to-FFO is 12.79x, slightly higher than Realty Income at 12.3x and lower than EPRT which is trading at 14.65x due to more optimistic prospects for FFO growth. All these levels are interesting for income investors, as they are capable of sustaining a dividend yield above 4-5% on a sustainable basis. One of the highlights is that since 2018 the NNN mean is 15.85x, while the median is 14.94x, so in comparison with its own history the current stock price appears to be an opportunity.

NNN’s NTM Dividend yield stands at 4.97%, a very reasonable level and in line/slightly below its average over the last 5 years. The Free Cash Flow yield (in relation to EV) is 4.8%, above its peers due to its controlled indebtedness and robust free cash flow.

In my opinion, this ~5% dividend yield combined with sustainable growth of ~4% per year (a very plausible level) is enough to justify investing in the thesis. Using a Gordon Growth Model, considering next year’s $2.32 dividend per share, an annual dividend growth rate of 4% and a discount rate, we have a fair price for NNN stocks of $46.60, very similar to the current stock price. This shows that in a base/conservative scenario, at current prices the REIT should be able to continue remunerating its shareholders at an attractive level, and of course, with possible positive surprises, such as additional distributions or capturing higher than expected growth.

Final Thoughts

In view of the information above, NNN doesn’t lose much compared to its main peer Realty Income, offering a solid track record of sustainable growth and interesting prospects given its capital allocation with a cap rate above the mid-7s and diversified portfolio capable of exploring a range of sectors and tenants with different credit ratings.

With a very healthy dividend distribution, NNN appears to be a solid and reliable option for income investors, making it an attractive alternative for diversification in a REIT portfolio and working as an alternative (or in a complementary way) to other REITs such as Realty Income itself or other more aggressive ones such as EPRT.