Up until recently, 2023 was a pretty terrible year for real estate investment trusts, or REITs. The Vanguard Real Estate Index Fund ETF Shares (VNQ) was up by about 7% on the year. But, it's worth noting that this index is up by 22% since the end of October, meaning that all of the year's gains came during the last 2 months. What's more, despite this recent rally, the real estate sector underperformed the broader market for the year (the S&P 500, which is nearing all-time highs, was up by about 25% during 2023).
But, looking at fundamental data, it's clear that this price weakness was the product of poor sentiment as opposed to bad operational results. In other words, the market was letting sentiment drive its decision making instead of the actual numbers. Fear like this creates opportunities, and that's exactly what happened earlier in the year. That was especially the case for triple net lease REITs, which have historically been a defensive area of the sector because of their top-tier profit margins. In recent months, patience and discipline had paid off, with many of our favorite NNN REITs up double digits.
Looking out into 2024, I expect to see REITs continue to play catch up as the market realizes that their poor 2023 performance was irrational. And that thought begs the question: what are the best bargains now that sentiment has shifted, and buyers are active again? With that question in mind, we wanted to take a look at the triple let lease industry to see which of these popular stocks are situated to do well as we forge ahead into 2024.
Why Are NNN REITs So Popular?
When it comes to profit margins, it's hard to find a company that can outdo the top-tier NNN REITs. Why is that? Simply put, this business model allows landlords to pass along the vast majority of the costs associated with property ownership. Triple net lease REITs own the properties in their portfolios, but their lease agreements make tenants responsible for taxes, insurance, and property maintenance expenses. That's on top of rent and utilities. Think about that. How great would it be if someone else paid not only your mortgage payment, but homeowners' insurance, property taxes, that broken furnace, a new roof, and your monthly utilities?
Well, that's the situation that triple net lease companies find themselves in, making them some of the most efficient companies on Earth. REITs, in general, tend to produce very high margins; however, as you can see, blue chip NNN REITs like Realty Income Corporation (NYSE:O) have the ability to generate EBITDA margins north of 95%.
Such high margins tend to result in reliable profits. And since REITs have to pay out 90% of their taxable income to shareholders in the form of an annual dividend, those profits equate to cold, hard cash for shareholders. Some of the most reliable dividends in all of REITdom lie within the triple net lease industry, making this a great place to find SWAN (Sleep Well At Night) stocks.
Identifying The Highest Quality NNN REITs
The SWAN moniker revolves around much more than just dividends. Passive income is great, but a dividend is only as good as its safety metrics. It doesn't matter how high a yield is if it's not sustainable. I want to own stocks that pay predictable dividends that reliably grow over time. This means that I can count on my passive income to pay my bills…and keep up with inflation over the long term. Dividend growth ensures that the purchasing power of my passive income stream is not eroded away over time by inflation. That's especially important for someone in retirement who relies on their passive income to cover their expenses and maintain their quality of life.
So, with this in mind, let's take a look at the dividend-related metrics from the top-rated triple net lease stocks…
| Company | Ticker | iREIT IQ Quality Rating | Dividend Yield | Annual Increase Streak | 5-year dividend growth rate | Forward AFFO Payout Ratio | S&P Credit Rating |
|---|---|---|---|---|---|---|---|
| Agree Realty | (ADC) | 96/100 | 4.67% | 11 years | 6.25% | 72.00% | BBB |
| Essential Properties Realty Trust | (EPRT) | 80/100 | 4.38% | 6 years | 20.88% | 65.50% | BBB- |
| Four Corners Property Trust | (FCPT) | 77/100 | 5.41% | 9 years | 4.18% | 80.70% | n/a |
| National Retail Properties | (NNN) | 90/100 | 5.21% | 34 years | 2.72% | 68.10% | BBB+ |
| Realty Income | O | 97/100 | 5.25% | 30 years | 3.66% | 73.60% | A- |
| NETSTREIT | (NTST) | 77/100 | 4.55% | 3 years | n/a | 66.10% | n/a |
| Spirit Realty | (SRC) | 75/100 | 6.03% | 3 years | -2.05% | 73.00% | BBB |
| W. P. Carey | (WPC) | 90/100 | 5.24% | 0 years | -0.02% | 72.70% | BBB+ |
To compile this list, I looked at each of the stocks within iREIT®'s NNN coverage spectrum with an iREIT® IQ (our quality rating score) of at least 75/100. As you can see, there were 8 stocks that met this threshold. Of those 8 stocks, 7 had forward-looking adjusted funds from operations, or AFFO, payout ratios below 80%. 6 of them have an investment grade credit rating from S&P Global. These are both great places to look when seeking dividend safety.
Simply put, it's difficult (if not impossible) to pay a safe and reliably growing dividend if you have a poor balance sheet, a high cost of capital, and a narrow cushion between cash flows and the dividend burden. Furthermore, looking at this list, we have 5 stocks that have a 5-year dividend growth rate that exceeds the Fed's 2% target inflation rate. CPI levels haven't fallen that low yet, but disinflation has been a constant theme throughout recent quarters and macro data points towards more of that to come in 2024. I wouldn't be surprised to see us get back to "normal" - from an inflation standpoint - soon, and, therefore, I think that the 2% threshold is still the primary hurdle that high yielding stocks need to clear in terms of acceptable dividend growth.
Combining Quality With Value
After removing the 3 companies who failed to meet the target minimum dividend growth threshold, now it's time to take a look at valuation. The very best long-term stock picks combine both quality and value. Buying high quality companies with low valuations attached lets investors benefit from the best of both worlds when it comes to future fundamental growth and the prospect of multiple expansion via mean reversion. So, let's take a look at the margin of safeties that these top-tier NNN REITs currently trade with.
| Company | Ticker | YTD Gain/Loss % | Consensus 2023 AFFO Growth Est. | Consensus 2024 AFFO Growth Est. | Forward P/AFFO Ratio | 5-year average P/AFFO Ratio | Current Price | Fair Value Estimate | Margin of Safety |
|---|---|---|---|---|---|---|---|---|---|
| Agree Realty | ADC | -10.82% | 3.66% | 3.53% | 15.4x | 20.3x | $62.95 | $74.00 | 15% |
| Essential Properties Realty Trust | EPRT | 11.90% | 7.84% | 5.45% | 15.0x | 19.5x | $25.56 | $27.55 | 7% |
| Four Corners Property Trust | FCPT | -3.24% | 1.83% | 2.40% | 14.9x | 19.6x | $25.30 | $24.70 | -2% |
| NNN REIT | NNN | -6.37% | 1.25% | 2.15% | 13.1x | 16.8x | $43.10 | $48.00 | 10% |
| Realty Income | O | -10.00% | 2.04% | 4.25% | 14.1x | 19.2x | $57.42 | $70.30 | 18% |
As you can see, all but one of these companies (Essential Properties Realty Trust) posted negative returns on the year. Those negative returns, combined with positive AFFO growth, have resulted in attractive P/AFFO multiples. It's probably not a coincidence that EPRT also posted the strongest AFFO growth. Typically speaking, investors are willing to pay a premium for best-in-class growth and despite weakness by its peers, it's clear that demand for EPRT shares was strong during 2023.
However, looking ahead to 2024 AFFO growth estimates, the gap is closing a bit. EPRT still has the best estimated growth rate at 5.45%, but Realty Income's 4.25% growth expectation isn't far behind. What's more, you'll notice that Realty Income's forward-looking P/AFFO multiple is much lower than EPRT's (14.1x versus 15.0x). Realty Income's forward multiple isn't the lowest on this list. NNN REIT (formerly, National Retail Properties) holds that title with their 13.1x valuation. However, NNN also has the lowest 2024 consensus growth expectations. NNN shares are definitely cheap (as you can see above, I believe they're 10% undervalued); however, I think the market is correct in applying a relatively lower multiple to those shares compared to its peers and when looking for the best pick of the litter here, I'm looking for a combination of growth and value.
That leads us back to the EPRT/O comparison. Looking at these two REITs, we see that during the last 5 years both of these companies have traded at fairly similar average multiples (19.5x versus 19.2x). And with that in mind, O's relatively lower forward P/AFFO represents a more attractive historical discount. Overall, O's margin of safety is the most attractive of the group (relative to iREIT® fair value estimates) at 18%. Our fair value estimates factor in both quality and fundamental growth metrics. We believe that O deserves a high multiple because of its A- rated balance sheet (compared to EPRT's BBB- rating) and superior international portfolio (which provides management with unique opportunities that span a wide variety of geographic footprints, industries, and debt markets).
Mean reversion back to the 17x area, combined with O's fundamental growth prospects and expected dividend payments over the next 12 months, would result in annualized total returns north of 33%. Those are speculative technology-type of returns coming from a mature REIT with a 5%+ dividend yield. It doesn't get any better than that from a risk/reward standpoint. This is why "The Monthly Dividend Company" continues to be one of my favorite stock picks heading into 2024.
Conclusion
With the exception of Four Corners, each of these final 5 triple net lease REITs is a good buy right now. Each of the final 5 posted positive AFFO growth in 2023, and that trend is expected to continue into 2024 as well. That growth is likely to support ongoing dividend growth, and as an income-oriented investor, that makes me happy. However, when looking at quality and value, my favorite company of the bunch reigns supreme. It's rare that the highest quality company from an industry also has one of the largest discounts to fair value.
There's often an inverse relationship between quality and value, but right now, the sentiment surrounding Realty Income is poor and that provides the opportunity to buy shares at a nearly 20% discount with a 5.25% yield attached. So, when naming a top dog in the triple net REIT space, the answer is clear… Realty Income maintains its crown and I have big expectations for the stock as we head into the new year. Personally, I have over 10% of my portfolio invested in Realty Income, and while that's double my limit (my rules are to own no more than 5% max in one position), I'm extremely comfortable (with the exposure) given my cost basis in the shares. In addition, I have high confidence in the management team who has continued to deliver on its promise for over three decades (as a public company).