Interview With Agree Realty Corporation (Buy Rating Reaffirmed)
Last week, I was in Ann Arbor to teach a class on REIT investing at the University of Michigan:
I was fortunate to get this opportunity thanks to Joey Agree, the CEO of Agree Realty Corporation (ADC), who connected me with the University after reading my new book on REIT investing.
By the way, if you have not received your copy of the book yet, you can get it for free by clicking here.
On this same trip, I got to visit their headquarters, where Joey Agree gave me a tour of their offices and spent an hour discussing net lease REITs with me.
This was probably the single most valuable learning experience on net lease investing I have ever had, and this is coming from someone who started his career working for a small private equity firm that specialized in net lease properties.
Here are the main takeaways:
Takeaway #1: Tenant Credit Quality Can Change Over Time, But So Does Tenant Profitability
A lot of net lease REITs like Essential Properties Realty Trust (EPRT) argue that the credit quality of tenants is irrelevant because what ultimately matters is the profitability of the real estate.
If a tenant is profitable at a specific location, it is unlikely to want to vacate, and the lease should survive even in bankruptcy.
Moreover, studies show that the credit quality of tenants is likely to change drastically over the lease term, so paying a premium for better credit is likely not worth it.
Therefore, REITs like EPRT will typically focus on properties occupied by smaller non-rated tenants. This allows them to get a much higher cap rate at the time of acquisition, which translates into larger spreads and faster growth, and they will then mitigate risks by making sure that the property is profitable and will structure a strong lease that results in consistent rental income.
At first glance, this seems to make sense.
But there is a significant catch to this approach, and it is that the property’s profitability is also likely to change over time, based on the quality of the real estate.
The largest and best-rated retailers, like Walmart and McDonald’s, will commonly get the best locations in growing markets with barriers-to-entry to protect themselves from future potential competitors.
However, the net lease properties that are occupied by smaller non-rated companies will commonly be in worse locations, often in secondary or even tertiary markets, with ample land available for future development and few barriers to entry, exposing them to significant risk as future competitors enter their markets.
The tenant may have a 3x rent coverage ratio when the lease is initially signed, but there is often little to stop a competitor from building a similar property across the street, potentially cutting the property’s profitability in half overnight.
Worse yet, if your tenant is a smaller, non-rated, private equity-backed company with poor access to capital, they are then much more likely to default on your lease, leaving you with a vacant property that will be very hard to release unless you cut the rent very drastically to make up for its now lower profitability.
Adding to the risk, many of these properties targeted by REITs like EPRT are not fungible. They are things like car washes, which would be impossible to release to any other type of business, further reducing your recovery potential.
That is why the quality of the real estate and tenant matter much more than what a lot of net lease investors seem to understand. The lease can protect you over the short-to-mid term and give you a false sense of safety, especially if the current rent coverage is high.
But over the long run, the quality of the real estate first, and its tenant second, will determine whether the property remains profitable, which will ultimately also determine whether you will be able to sustainably grow the rent.
So yes, the tenant credit quality is not everything, but the fact is that the best net lease properties in the strongest locations are typically occupied by national investment-grade rated tenants, and this is logical when you think of it.
If you are a property developer and you have a great location and high-quality property, you will always favor a high-quality tenant if you can, given that this will result in a lower cap rate and higher property value.
As a result, these large investment-grade rated tenants will commonly end up with the best real estate, especially since they have the best resources to identify those superior sites.
The point here is that higher tenant credit quality typically equals higher real estate quality, and this is ultimately the most important thing, as this superior quality will lead to greater profitability over the long run.
Takeaway #2: No Net Lease REIT Comes Close to Agree Realty in Terms of Real Estate Quality
Today, there is really only one net lease REIT left that’s laser-focused on real estate quality, and it is Agree Realty.
Nearly all of its tenants are some of the most successful national retailers, like Costco and Walmart. These retailers are so successful in a big part because they are very picky about the locations of their properties, focusing on growing markets with barriers-to-entry to protect their businesses:
Agree Realty also clearly focuses on more defensive net lease categories that typically have fungible rectangular property types that would be easier to release if needed, and are also recession-resistant:
Finally, about 2/3 of its tenants have an investment-grade rating, and the remaining 1/3 are typically highly successful retailers like Aldi and Publix, but they are not rated because they are private.
Here is how it compares to close peers:
Other net lease REITs will often cut corners in order to secure higher cap rates and maximize immediate accretion, which then results in faster short-term FFO per share, at the likely cost of slower long-term FFO per share growth as they eventually hit some setbacks.
Netstreit (NTST) has tried to inflate its investment-grade tenant exposure by heavily investing in dollar stores, which are typically located in secondary and tertiary markets, resulting in poor real estate quality, and in pharmacies, which are today oversupplied and facing poor long-term prospects. Agree Realty has almost entirely sold its pharmacies for this reason.
Realty Income (O) has completely lost its focus on investment-grade rated retailers and is now investing all over the place to make up for its massive size, including vertical farming, industrial properties, casinos, data centers, Europe, etc. Its exposure to investment-grade tenants is now more than 2x lower than that of Agree Realty.
NNN REIT (NNN) made the mistake of stretching its balance sheet for short-term wins, and it is now stuck with quite a bit of exposure to non-fungible assets like car washes and Camping World properties. Reducing this exposure by investing in other categories is now harder due to its higher leverage.
Essential Properties Realty Trust (EPRT) is almost entirely focused on weaker secondary markets with worse barriers-to-entry and lots of non-fungible properties leased to private equity-backed non-rated tenants. In other words, this is some of the worst possible real estate in the net lease category, which will almost inevitably eventually lead to some major setbacks. Car washes, as an example, make up about 15% of its rental income today.
EPR Properties (EPR) may first seem like the worst of the bunch, being almost entirely invested in non-fungible assets with shaky tenants, but the one thing protecting it is that its locations are actually quite decent and enjoy better barriers-to-entry, limiting the risk of future competitors impacting its properties’ profitability. Still, this remains a higher-risk strategy.
Getty Realty (GTY) is also heavily invested in non-fungible properties, such as car washes and gas stations in secondary markets that would be harder to redevelop if and when this property sector becomes oversupplied as a result of electric vehicles gaining market share.
The point here is that no other net lease REIT is even close to Agree Realty in terms of their real estate quality. They will often focus on riskier categories, own less fungible properties in weaker locations, and have much lower exposure to large national investment-grade tenants.
This works fine as long as you have years left on your leases, and the economy is doing fine. But poor real estate quality can only be masked by a lease for so long. Eventually, issues will arise as new competitors enter your market and steal market share, and your tenant defaults and/or your lease expires.
It is also worth remembering that we have not had a proper recession in a long time, and we are long overdue for one to happen. When the tide goes out, you discover who has been swimming naked, and there are lots of net lease tenants that are highly leveraged private equity-backed companies operating in discretionary retail categories like car washes that would likely default on their leases.
