Agree Realty: Too Bad The Market Knows About This Superb Net Lease REIT

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Investment Thesis

At the beginning of this year, I had no position in net lease REIT Agree Realty Corporation (ADC), and, honestly, I didn’t know very much about it. Now I consider it a core holding in my portfolio. I wish it was my largest holding. Instead, it is now my 9th largest holding.

In a low interest rate environment, net lease REITs are an excellent way to generate a growing income stream. The landlords’ cost of capital falls fairly quickly when interest rates drop, but it enjoys long, contractually fixed rental revenue streams. Plus, with tenants responsible for all building maintenance, insurance, and taxes, it’s an extremely efficient business model. ADC, for instance, enjoys an EBITDA margin of 92%.

Perhaps that is why the longest running net lease REITS (in terms of existence as publicly traded companies) have handily outperformed the stock market since the late 1990s:

Data by YCharts

ADC looks particularly well suited to continue growing rapidly and outperforming the market going forward, due to its high-quality portfolio of pandemic-resistant, recession-resistant, and e-commerce-resistant net lease properties. The only bad news is that the market seems to know about ADC’s amazing prospects, and it has priced in much of its future growth.

At $67 per share and a 3.57% dividend yield, I view ADC as a hold right now, but I offer my maximum Buy price below.

Agree Playing Offense While Peers Play Defense

I wrote an article about ADC back in March, near the height of panic and the trough of the stock market. Back then, the REIT traded at $52.71 per share. (Why, oh why, didn’t I buy more?)

ADC has been consistently growing its revenue by 25-30% YoY each quarter since around 2013. That makes the 28.1% YoY revenue growth reported in Q2 of this year only “average” for the company. (What an average!) Annual base rent rose at a stunning 29.3% compound annual growth rate from 2014 to 2019.

Data by YCharts

More impressive is the fact that Q2 AFFO per share of $0.76 not only beat the consensus estimate by 3 cents but also that it is slightly higher than Q2 2019’s $0.75 showing — which also beat the consensus estimate, by the way.

Even during a global pandemic that is particularly bad in the United States (where all of ADC’s properties are located), the company manages to grow its per share AFFO year-over-year.

Rent collection for ADC has been the strongest of the retail-focused net lease REITs, with 90% collected in Q2 along with 3% of rent under deferral agreements. As of July 20th, 94% of July rent had been received, again with 3% deferred. REITs that focus on industrial and office tenants have collected only slightly higher percentages (around 95%), so ADC’s collection statistics highlight the resiliency of its portfolio as well as the quality of its underwriting.

With such high rent collection, ADC can afford to put a lot of focus on acquisitions when most other net lease REITs (and net lease real estate owners in general) are focused on collecting rent and working out deferral agreements. The market has rewarded this strength and resiliency with a low cost of capital — i.e. very low dividend yield and falling interest rates on debt, courtesy of ADC’s shiny new investment grade credit rating (BBB from S&P to accompany its existing Baa2 rating from Moody’s).

Let’s compare the average cost of capital to the average acquisition cap rate in Q2 of 6.5%.

  • Cost of debt = 4.35% average interest rate on debt (which should fall as ADC has achieved multiple investment grade credit ratings).
  • Average cost of 2020 equity issuance = $63.22 per share (3.79% yield).

ADC has issued $825 million in low-cost equity so far this year (with $780 million of that before April 21st), compared to a little more than $500 million of acquisitions in the first half of the year.

Given the persistently high stock price (and relatively low yield), I would expect the company to continue funding acquisitions mostly through equity issuance, which means that the spread between cost of capital and asset yields is around 2.5 to 2.7 this year. That is phenomenal! It provides a significant advantage over ADC’s higher cost of capital peers. It also increases ADC’s equity percentage of total market capitalization — and by necessity lowers its debt-to-assets or loan-to-value ratio.

What’s more, ADC has plenty of dry powder to continue its acquisition spree. The company boasted $1 billion in liquidity as of the end of June, providing ample capacity for continued expansion. Management has raised investment spending guidance twice this year, from $600-700 million at the beginning of the year to $700-800 million at the end of Q1 to the current range of $900 million to $1.1 billion. For some context, ADC began 2020 with an enterprise value of about $4.1 billion, and as such the total value of the company is set to explode higher by around 24-25% this year.

It’s also interesting to note that $1 billion of acquisitions this year would amount to about 1/3rd of ADC’s total acquisition activity in the five years between 2015 and 2019.

I’m hoping that total investment spending guidance will be lifted again in the third quarter. As long as ADC’s cost of equity remains low enough and its acquisition pipeline deep enough, I see no reason why the company couldn’t reach around $1.35 billion total acquisitions (or 1/3rd of the company’s EV at the start of 2020) for the year. That would require about $425 million in acquisitions in each quarter in the back half of the year, compared to $276 million in Q2, so that goal may not be realistic. It would certainly strain the acquisitions team, who, after all, still have to perform due diligence for each addition to the portfolio.

But a guy can hope, can’t he? Management did make clear on the Q2 conference call that ADC currently enjoys “the largest pipeline that we’ve ever had” — and this huge pipeline is “top tier” in quality.

Baird analyst R.J. Milligan calls ADC’s “balance sheet firepower unmatched in net-lease.” Milligan forecasts AFFO growth of 7% this year and 11% for 2021.

And the company does not have to compromise on asset quality in order to utilize this balance sheet firepower. According to CEO Joey Agree (on the Q2 conference call), the “75 properties acquired during the second quarter were leased to 16 tenants operating in 11 distinct sectors, including best in class operators in the off-price, general merchandise, auto parts, tire and auto service, grocery dollar stores and convenience store sectors.” These newly acquired properties have an average of 10.9 years remaining on their lease terms, and 80% of them are investment-grade. In the first half of the year, 84% of acquired properties (by rent) were leased to investment grade tenants.

The total portfolio is now 936 properties that are 99.8% leased, have a weighted average remaining lease term of 9.7 years, and generate 61% of annualized rent from investment grade tenants. Only 7% of annual base rent expires in the next three and a half years (by the end of 2023).

Management asserts that they invest in the top 1% (or 99th percentile) of retail, which consists of 20-30 extremely strong, recession-resistant, e-commerce-resistant tenants. Walmart (WMT) is ADC’s largest tenant by revenue at 7.6%, up from 4.4% in Q2 2019.

Source: ADC Q2 Earnings Report

Many of these Walmart properties are ground leases. The company’s ground lease properties are a particularly attractive part of its portfolio. ADC owns 69 ground lease properties representing 8% of rent, with 10.4 average years of remaining lease terms and 89.3% of rent ultimately derived from investment grade tenants.

Here are ADC’s top ground lease tenants as of the end of Q1:

Source: ADC Q1 Presentation

The primary “problem tenants” for ADC in the 2nd quarter were its three Dave & Buster’s (PLAY) properties (i.e. “entertainment retail” below) and its movie theaters and fitness centers. These account for most of the $3.5 million of uncollected rent (5.6% of contractual rent) that was not deferred. Management considers these its “non-core” properties that it will likely try to dispose of in the coming quarters or years, but there simply are not buyers of these properties at remotely reasonable prices in today’s market.

Source: ADC Q2 Earnings Report

The company has been able to dispose of 14 properties this year at a weighted average cap rate of 7.2% for total proceeds of $44.1 million. Many of these have been franchised fast food restaurants that do not have corporate guarantees.

General and administrative costs (basically: the management fee) came to 8.2% of rental revenue in the first half of the year and 8.0% in the 2nd quarter, specifically. That should come down into the upper 7s when ~100% of rent is being collected again. That’s not quite as low as the much larger Realty Income’s (O) G&A of 4.4% of revenue, as I discussed in a recent article on REITs vs. Rentals, but as ADC continues to grow, its percentage should continue to fall.

Debt remains very low, with net debt to recurring EBITDA finishing the quarter at 3.5x. Total debt made up only 18.2% of EV at the end of the 2nd quarter. No debt comes due until 2023. Fixed charge coverage is also quite strong at 4.6x.

In the first half of the year, despite the pandemic, the dividend payout accounted for only 76% of AFFO. And even that number is slightly elevated due to Q2’s 79% payout ratio, which probably came in higher as a quirk of a large amount of equity issuance. Once all of the proceeds from equity issuance are invested into rent-paying assets, that payout ratio will come back down to 75% or under.

Share issuance also accounts for the massive disparity between total AFFO and per share AFFO. Total AFFO increased 33.6% YoY in the first half of the year, while AFFO per share increased only 7.6% YoY.

Buy Price & Conclusion

Back in that March piece on ADC, I recommended the stock at $50 per share, but I was also bullish on the stock in general. Assuming AFFO comes in at $3.22 per share in 2020, a price of $50 puts ADC at a price to AFFO of 15.5x. Today’s price of a little over $67 per share puts the company at an AFFO multiple of 20.9x. (Again, why didn’t I buy more?!)

Let’s assume AFFO growth hits 7% this year, 11% next year, and slows to 6% the following eight years. Let’s also assume the dividend grows at the exact same pace as AFFO. Buying in at today’s starting yield of 3.57% would render a yield-on-cost after ten years of 6.76%. Okay, not bad for a conservative dividend growth investment like ADC.

But I like to target at least a 7% 10-year YoC. What price would I need to buy in order to reach that projected YoC with the above assumptions? Answer: $64.85 per share, or a starting yield of 3.7%. That is my maximum Buy price for ADC, and I very much hope that I get another chance to add to my position.

It really is too bad that the market knows about this rapidly growing net lease gem of a REIT. It is well-managed, conservatively financed, and high-quality, with plenty of strong growth ahead. I suspect that opportunities to buy ADC will be few and far between in the coming months, but I will be watching it like a hawk.

Then again, there’s a “glass half full” way of looking at a rich stock valuation for ADC. With a high valuation and low dividend yield, it becomes feasible to avoid building up debt by instead issuing low-cost equity to fund growth. This allows ADC to retain a low debt load while continuing to focus on quality properties. In so doing, the company maintains its ability to raise debt levels in the future, if and when it makes sense to do so.

Agree Realty is quickly becoming the new gold standard among net lease REITs, and I’m glad I get to participate in its stunning growth.

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Disclosure: I am/we are long ADC, O. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.