National Retail Properties (NNN): A Conservative REIT with 26 Straight Years of Dividend Growth

Fewer than 100 of the more than 10,000 publicly-traded companies have increased annual dividends for at least 26 consecutive years. National Retail Properties (NNN) is one of them.

 

Perhaps more impressively, National Retail’s average annual total return for the past 25 years has been 14.8%, significantly outpacing the market to provide meaningful value for shareholders.

 

The company is conservatively managed and generates a stream of highly predictable operating income, making it an appropriate income investment for our Conservative Retirees dividend portfolio.

 

Business Overview

National Retail was formed in 1984 and is a real estate investment trust (REIT) with more than 2,200 properties over 47 states. The company’s retail properties are leased to more than 400 tenants across 38 industry classifications such as convenience stores and restaurants, providing nice diversification.

 

Furthermore, National Retail only originates single-tenant triple-net leases, which shift property operating expenses such as maintenance, taxes, and utilities to the tenant. In other words, the rental revenue received by National Retail has substantially fewer expenses and more stable net cash flow than other REITs with a smaller mix of triple-net leases.

 

Business Analysis

We believe National Retail has a strong moat and plenty of opportunities for long-term profitable growth. The company’s strengths really begin with management’s focus on generating consistent annual funds from operations (FFO) per share growth, increasing the dividend annually, and assuming below average balance sheet and portfolio risk.

 

These objectives have resulted in a conservatively managed, well-diversified business that is not susceptible to any single industry, customer, or geography, which results in very reliable cash flows.

 

Convenience stores are the company’s largest exposure at about 17% of annual rent, followed by full-service restaurants (11%), limited service restaurants (7.2%), auto service (7%), family entertainment centers (5.6%), and theaters (5.2%).

 

National Retail’s largest tenant is Sunoco, which generated 5.9% of NNN’s total rent last fiscal year. The company’s top 25 tenants account for 60% of rent, which is a healthy level of diversification. Many of them are in very stable lines of business, too. This prevents National Retail from being overly exposed to the fate of any one customer, reducing its risk profile.

 

Its top tenants are also in good financial shape with a weighted average rent coverage ratio of 3.6x. By spreading its properties across nearly 40 different industries and hundreds of tenants, National Retail diversifies away a significant amount of fundamental risk.

 

Furthermore, National Retail owns well-placed retail locations. The company finished 2015 with an occupancy rate of 99.1%, and its occupancy rate has never dipped below 96.4% over the last 13 years. As seen below, National Retail enjoys significantly higher occupancy rates than the broader REIT industry, which results in lower earnings volatility.

 

Source: National Retail Properties Investor Presentation

 

Importantly, National Retail has not had to discount its leases or make substantial improvements to its properties to get tenants to stay. The chart below shows the company’s lease renewals by year.  From 2007-2015, National Retail renewed 86% of its leases, and 58% of renewals were at rates about the prior rent (14% were at the prior rent, and 28% were below the prior rent).

 

Importantly, National Retail only invested $338k in capital expenditures on these properties while renewing nearly $40 million in rent over this time period, highlighting the benefits of its triple-net leases (the company doesn’t have to “buy” higher rent with capital investments because tenants are on the hook for maintenance).

 

Source: National Retail Properties Investor Presentation

 

We believe National Retail has achieved these strong results for several reasons. First, the company intentionally owns properties with no anchor or co-tenancy issues. By owning single-tenant properties, tenants are unable to pool their bargaining power together to try and reduce their rent. National Retail’s main street locations also provide a strong market for replacement tenants and rent growth over time.

 

Finally, consumer-focused retailers also face more switching costs than an office or industrial customer because they are more location-driven; they don’t want to risk disrupting their established customer base to save a bit on rent, resulting in stronger renewal rates.

 

The company has also done a great job managing its lease renewal schedule. As seen below, over 60% of leases are not up for renewal before 2025, and fewer than 10% of leases are due for renewal any single year until then. This protects National Retail from being forced to renew a substantial portion of its leases during a down market. The company’s average remaining lease term is also 11.4 years, providing good cash flow visibility.

 

Source: National Retail Properties Investor Presentation

 

By now, it might not come as a surprise to learn that the company generates a strong capitalization rate on its properties. As seen below, National Retail has enjoyed an average cap rate of 8.1% since 2010. While the cost of debt for all REITs is currently cheap, National Retail appears to be very well positioned to continue earning a positive spread on its acquisitions if interest rates begin to rise thanks to its healthy cap rate.

 

Source: National Retail Properties Investor Presentation

 

One of the reasons why National Retail earns a strong cap rate is the nature of its market. According to National Retail’s 2014 annual report, the total size of the single tenant retail property market is estimated to be in the $1 trillion range, but the company generated just $483 million in revenue last year, providing plenty of room for future growth via acquisitions.

 

The market is extremely fragmented. Most of the company’s properties are $2-4 million in size, resulting in less buyer competition because it’s harder to scale in this market. The company also seemingly maintains strong relationships with its tenants, which positions it well for acquisitions and sale-leaseback transactions. All of these factors combine to help National Retail enjoy higher initial cap rates and built in rent growth.

 

Finally, it’s worth highlighting management’s financial conservatism with the company’s balance sheet. Since REITs are required to pay out at least 90% of their taxable income as a dividend, they are left with little capital to grow their business. As a result, they usually depend more heavily on capital markets for raising debt and issuing equity to keep operations growing.

 

As seen below, National Retail’s diluted shares outstanding have more than doubled from 55 million in 2005 to 134 million last year in order to fund acquisitions and grow FFO.

 

 

Despite the dilution, National Retail has still managed to consistently grow its FFO per share, highlighting management’s ability to make accretive acquisitions. Importantly, National Retail maintains one of the lowest leverage ratios relative to other REITs. As seen below, the company’s long-term debt to capital ratio stood at 37% at the end of 2015. Most REITs in our coverage have a ratio greater than 50%. While credit markets are loose and cheap today, highly levered REITs are more likely to cut their dividends if conditions unexpectedly tighten. We like National Retail’s relatively healthier balance sheet.

 

 

Despite maintaining just $14 million in cash on hand compared to about $2 billion of debt, National Retail maintains investment grade credit ratings from the major agencies and has a $650 million unsecured bank credit line it can tap. Importantly, less than $275 million of the company’s debt matures through 2020 (see below), and National Retail has no floating rate debt, helping shield it from rising interest rates and refinancing risk. We think management has done a nice job reducing the company’s credit risk through at least the next five years.

 

Source: National Retail Properties Investor Presentation

 

National Retail’s Key Risks

In our opinion, management’s conservatism reduces most of the diversifiable risk the company faces. It seems unlikely to us that any one industry, customer, or geography could permanently impair the company’s long-term earnings potential.

 

However, it’s worth noting that most of National Retail’s tenants are mostly non-investment grade businesses, which are ostensibly riskier that investment grade tenants in the event of a recession.

 

Management targets this group because it allows for better pricing and rent growth. The company also believes that tenant credit ratings can be a fleeting factor, and there is always room for tenant credit improvement.

 

We aren’t overly concerned about this risk factor based on National Retail’s results during the last recession (87% of prior leases were renewed in 2009), consistently high occupancy rates, and overall mix of tenants – roughly 66% of National Retail’s rent is from public companies of those with rated debt.

 

While most retail tenants will be impacted by an economic downturn, National Retail’s industry diversification provides some protection. For example, convenience stores are its largest industry exposure at 17% of rent and would likely perform relatively well during a recession. NNN’s stock also outperformed the S&P 500 by 16% in 2008, perhaps providing some support to this theory. Regardless, economic weakness would not impair the company’s long-term earnings power.

 

Finally, when analyzing REITs, we always feel obligated to mention that they generally face higher capital market risk than other types of business models. REITs have less capital at their disposal to grow their businesses because they are required to pay out almost all of their earnings in the form of dividends.

 

As a result, they depend on issuing shares and raising debt for growth. Should capital markets tighten up and business fundamentals deteriorate, dividend cuts can become a real risk depending on the REIT. We view National Retail as conservatively financed compared to most REITs given its leverage ratios and debt maturity schedule, but this is an important risk to remain aware of for all of your REIT holdings.

 

Dividend Analysis: National Retail Properties

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. National Retail’s long-term dividend and fundamental data charts can all be seen by clicking here.

 

Dividend Safety Score

Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

National Retail’s Dividend Safety Score of 59 suggests that its current dividend payment has above-average safety. The company’s adjusted funds from operations (AFFO) payout ratio was 75% in 2015. While we generally prefer a lower payout ratio for most types of businesses, National Retail’s long-term leases, high occupancy rates, and quality real estate locations alleviate some of our grievances. As seen below, the company has generated remarkably stable operating margins, resulting in a relatively stable earnings profile.

 

 

Dividend safety is also boosted by the company’s strong occupancy rates, which even held up during the last recession. At the end of 2009, National Retail’s occupancy rate was 96.4%. The company was also less diversified than it is today with tenants in 13 different industries compared to 38 in 2015. National Retail generated $1.70 AFFO per share in 2009, which solidly covered its $1.50 per share dividend. It’s also worth mentioning that the company has successfully made acquisitions most years to continue growing the business in many environments (sales increased throughout the recession thanks to acquisitions).

 

 

National Retail has managed to significantly grow its business without sacrificing its profitability. As seen below, the company has maintained a reasonable return on equity in the mid- to high-single digits over the last decade. REITs are capital intensive, but National Retail has been generating a fair return on its investments for shareholders.

 

 

Overall, we think National Retail’s dividend looks pretty safe. We like the company’s diversification across the retail sector and believe management will continue to conservatively manage the business to keep it protected during times of unexpected duress.

 

Dividend Growth Score

Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

National Retail’s Dividend Growth Score of 21 suggests the company’s dividend growth potential is rather weak. Despite the company’s solid track record of raising its dividend for 26 consecutive years, we can see below that dividend growth has only averaged about 3% for most the past decade. However, the company would still be a member of the dividend aristocrats list if it was big enough to be in the S&P 500.

 

 

Since REITs pay out most of their income as a dividend and are generally mature, capital-intensive businesses, dividend growth is often relatively low but reliable. We expect National Retail’s dividend growth to continue at a 2-4% annual pace.

 

Valuation

NNN’s stock trades at 19.4 times estimated 2016 FFO per share and has a dividend yield of 3.8%, which is significantly lower than its five-year average dividend yield of 4.9%.

 

National Retail’s strategy has generated on average annual 9% recurring FFO per share growth since 2012, but growth largely depends on acquisitions. If we assume that FFO per share grows at a mid-single digit pace going forward, the stock appears to offer total return potential of 8-11% per year.

 

However, it’s hard to ignore the run that NNN has had. The stock has surged nearly 30% over the last six months and trades at a premium multiple and dividend yield relative to its history. We believe this was fueled at least in part by investors’ looking even harder for income after the Fed moderated its projected number of interest rate increases this year.

 

Simply put, it’s hard to make a strong valuation case today despite NNN’s strong business fundamentals. REITs can be one of the best stock sectors for dividend income, but that doesn’t always mean they are attractively priced or worth the capital market risk.

 

Conclusion

National Retail is just one of four publicly traded REITs to increase its dividend for at least 26 consecutive years and shares many qualities with our favorite blue-chip dividend stocks.

 

Management has clearly managed the company conservatively over the years, and National Retail’s diversification by customer, industry, and geography provides further confidence in the dividend growth story continuing.

 

We think National Retail has solid long-term prospects, but the stock’s valuation admittedly looks a bit rich at the moment.