Agree Realty Stock: Perfect Macro Setup For This High-Quality Retail REIT (NYSE:ADC)
In a January 20th article, I argued that “Disinflation and Falling Interest Rates Should Drive Strong Performance” of net lease REITs in 2023.
Net leases typically feature long terms of 10-20 years, and rent is contractually fixed either at a flat rate or a low average annual rate of 1-2%. That makes each individual net lease akin to a corporate bond proxy (although net lease REITs themselves do not really behave like bond proxies).
Thus, during periods of disinflation and falling interest rates, net lease REITs benefit in at least three ways:
- The real (inflation-adjusted) value of their rental revenue streams rises.
- Their cost of debt falls.
- Cap rates stabilize or decline, lifting property values and thus the REITs’ net asset values.
“But wait,” you might object. “What about the reason for falling interest rates? Won’t a recession hurt commercial real estate?”
It’s true, recessions do cause some damage to commercial real estate – but not all CRE sectors or property types equally. Some types of CRE are quite economically sensitive, while others are quite resilient in the face of recessions.
That’s where Agree Realty Corporation (NYSE:ADC) comes in.
It is a retail-focused single-tenant net lease REIT that concentrates its portfolio in the 20-30 largest and strongest retailers in the nation, with a little over 2/3rds of its tenant base investment grade-rated. These are some of the fastest-growing and most well-financed companies in the US, making them not only highly likely to keep paying rent through a recession but also able to keep investing in their own competitive advantages in the age of e-commerce and omnichannel.
Disinflation + falling interest rates + recession = the perfect macro setup for ADC to outperform.
Now, if the stock market endures a broad-based selloff sometime this year, ADC’s stock price will likely feel some pain along with it. But ADC is likely to fare far better in terms of both stock price and underlying fundamentals. On top of that, ADC’s peer-leading cost of capital will allow it to raise attractively priced capital in order to take advantage of any disruption in the markets, exactly as it did at the beginning of the COVID-19 pandemic.
Let’s first dive in to the portfolio and balance sheet of this high-quality, monthly-dividend-paying mid-cap REIT, and then we’ll look at past performance to look for hints about future performance.
Recession-Resilient Portfolio & Balance Sheet
If a picture is worth 1,000 words, how about a baker’s dozen pictures? This is a snapshot of the kind of properties that populate ADC’s portfolio:
ADC likes boxes. Sometimes they are big boxes occupied by the likes of Walmart (WMT), Target (TGT), or Costco (COST), and sometimes they are small boxes occupied by names like Wawa, Trader Joe’s, McDonald’s (MCD), or AutoZone (AZO).
In any case, ADC targets highly fungible boxes that can be swapped out fairly easily with other tenants, in the rare case of a vacancy.
But vacancies truly are rare for ADC, because the REIT also targets properties with low rents per square foot relative to their tenant industry and property type. (A Chick-fil-A is going to have higher rent per square foot than a Walmart, because its tenant sales PSF is likewise higher.) Below-market rents per square foot are a strong encouragement for tenants not to leave that location.
ADC’s 1,839-property portfolio is absolutely stacked with these high-quality tenants in highly fungible buildings.
To be fair, there is some measure of real estate risk in some of these tenants/properties. For example, Tractor Supply (TSCO) and Dollar General (DG) stores may be quite fungible buildings, capable of supporting other tenants, but they are also typically located in rural or small town areas. If the tenant ever left that building and handed the keys back to ADC, finding a new tenant to replace them would be extremely difficult – probably even at very low rent rates.
Luckily, I believe the risk of ADC losing tenants at these locations is very low. After all, TSCO and DG are both opening new stores and rarely ever permanently shutter their locations. Moreover, with low rents per square foot, the idea of TSCO or DG just building new stores (at today’s construction costs!) a mile down the road is not very enticing.
In addition to ~68% of tenants being investment grade-rated, another 16% are not rated, but most of those tenants (like Hobby Lobby, Ulta Beauty, Publix, and Gerber Collision) have investment grade profiles.
But it would be shortsighted to focus on investment grade credit ratings alone. After all, a company can always be downgraded.
I do not believe ADC blindly chases investment grade tenants simply to boast about their high portfolio IG percentage. Rather, I think a high IG percentage is simply a by-product of ADC’s focus on the largest and strongest retailers in the nation. These businesses are the best prepared to thrive in an age of ever-increasing online competition.
ADC has put a lot of thought into not just what retail is or was in the past, but also what retail is becoming over time. We live in an increasingly omnichannel world in which customers expect to have multiple ways to buy and receive goods. Customer convenience is paramount to maintain a competitive edge.
So, ADC has a thoughtfully curated and high-quality portfolio. But even very strong assets can be ruined by a weak balance sheet.
Fortunately, ADC matches its high-quality portfolio with a high-quality balance sheet.
The REIT’s net debt to EBITDA of 4.0x is (I believe) the lowest of all net lease REITs, and its ~8-year average debt maturity locks in its low interest rates for a long time. Only $109 million (5.2%) of its $2.1 billion in debt matures anytime in the next five years.
Where will interest rates be in five years? Who knows. But it is a comfort to know that ADC has very little refinancing to do between now and then.
This strong balance sheet goes a long way in awarding ADC with a low overall cost of capital, both on the debt and equity side. That low cost of capital is a huge benefit to a net lease REIT, because the primary channel of growth for its business model is acquisitions.
ADC has been taking advantage of its low cost of capital to ramp up investment/acquisition volume:
Moreover, ADC was able to significantly increase its number of development and partner capital solutions (“PCS”) projects last year. These are a nice way to bump up acquisition yields, as ADC takes very little risk on the construction side but eventually earns a higher stabilized cap rate because of the additional time involved in developing new properties.
This formula of strong portfolio + strong balance sheet + strong cost of capital has resulted in high single-digit average annual growth in AFFO per share as well as a 6% CAGR in the dividend over the last decade. And ADC isn’t slowing down. From 2021 to 2022, the dividend increased 8.1%.
The Story of ADC In 4 Charts
As discussed above, ADC’s Achilles Heel is a macro environment characterized by rising inflation and interest rates. Why? Because:
- Inflation is reducing the real (inflation-adjusted) value of its contractually fixed revenue streams.
- Higher interest rates will eventually cause interest expenses to rise.
- Cap rates are slow to respond to higher interest rates, causing the spread between cost of capital and acquisition yields to shrink.
ADC thrives most during periods of relatively low inflation and interest rates. That is exactly what we saw during the decade from 2011 to early 2020, a period of generally low rates and inflation:
Then, starting around the late summer of 2021, inflation began to spike, causing long-term interest rates to follow it higher, and ADC began severely underperforming the broader real estate index (VNQ) and the S&P 500 (SPY):
But sometime in the second quarter of 2022, signs began to appear that inflation was peaking. For example, the housing market peaked in May 2022. At that point, even as interest rates surged higher, ADC began to outperform the VNQ and SPY.
And now, one month into 2023, investors seem to be celebrating the Fed’s eventual pause and reversal of rate hikes. Meanwhile, ADC (a very low beta stock) has trailed VNQ and SPY so far this year.
But I think the market is being shortsighted, presuming a “soft landing” even amid numerous signs of an oncoming recession.
If a recession does occur this year, as I suspect it will, then ADC will actually perform much better than the broader real estate index or stock market on a fundamental basis.
As such, ADC’s underperformance so far this year should eventually turn into outperformance.
Perhaps I am wrong and the US economy will narrowly avoid a recession this year with a soft landing. But I view that scenario as unlikely. I think we will get a recession that will drag down inflation and interest rates.
ADC’s recession-resilient portfolio, fortress balance sheet, and peer-leading cost of capital make it ideally suited for this macro setup. That persuades me that there is more upside to come for ADC this year.