A REIT for the NNNew Year

It's always nice when you can tell what a company does just by its ticker. National Retail Properties' (NYSE: NNN  ) symbol lets you know right off the bat that they're a real estate investment trust (REIT) that makes triple net leases (the lessee pays rent and expenses such as taxes, insurance, and maintenance) primarily to convenience stores and restaurants. (Some of my other favorite symbols are Natus Medical (BABY), Papa John's (PZZA), and Sotheby's (BID).)

But I digress. National Retail Properties recently reported pretty good fourth-quarter results, so let's take a look.

The company's funds from operations (FFO) -- a measure of a REIT's cash flow, similar to EBITDA -- showed healthy 11% growth to $1.67 for the year. The company also ended the year with 98.2% occupancy -- hard to do much better than that. For the quarter, sales increased 27% to $41.5 million, and FFO increased 38% to $27 million year over year. National Retail management expressed confidence, slightly raising the top end of its FFO guidance to $1.83 per share for 2007, versus $1.80 previously.

Get real estate
In the earnings call, management noted that they acquired 213 properties for $372 million at a 8.6% cap rate. A cap rate is what management thinks the investment will yield -- the higher, the better. In today's market, with one-year LIBOR (the rate at which banks lend to each other on an unsecured basis) at 5.44%, an 8.6% cap rate is pretty good, especially considering that REITs basically arbitrage the difference between their borrowing rates (plus real estate appreciation) and their cap rates.

However, higher yields usually entail higher risk. National Retail's management believes it has an edge by buying in bulk. In the conference call, management noted that comparable net leased properties sold, as single properties were going for cap rates at 100 basis points lower. In other words, if you buy something at an 8.6% cap rate and can immediately flip it at a 7.6% cap rate, you immediately reap a 13% gain -- and more if you employ leverage, as all REITs do.

About 16% of National Properties' leases are to convenience stores, 12% are to full-service restaurants, and 8% are to drugstores. It's generally able to earn a higher yield by leasing to tenants at the middle to lower end of the credit spectrum, such as Arby's, Susser (Nasdaq: SUSS  ) , Blockbuster, Rite Aid, and United Rentals. As of the latest quarter, its top five lessors were Susser (which operates Circle K), CVS (NYSE: CVS  ) , Best Buy (NYSE: BBY  ) , Uni-Mart, and Barnes & Noble (NYSE: BKS  ) .

With any REIT, the biggest concern is credit quality -- if a tenant defaults, the lessor is left holding the bag if it can't replace the lessee. However, National Retail believes it engages in the necessary due diligence to mitigate this risk. Its underwriting team makes sure that the metrics -- like rent per square foot and comparable market rates -- are adequate, and it generally requires that the tenant's unit economics make sense. In most cases, they require the unit to earn twice its rent.

So far, things have worked out. National Retail mentioned that its tenant credit quality has improved (Susser recently went public), which increases the value of the lease and allows National Retail to sell the property at a higher value and recycle the capital into a higher yielding property. For the year, National Retail earned $80 million in cash gains on the sale of retail estate. Of particular note was the sale of its 25% equity interest in its headquarter building. Its investment of $750,000 in 1999 ultimately yielded $13 million, roughly a 50% annualized return on an un-levered basis. (Note to self, buy real estate during next stock bubble!)

Although REITs have been hot (making me less interested in them), National Retail Properties seems to be doing a great job of creating shareholder value. And although the company is able to invest at a pretty decent cap rate of 8.6% -- and obviously not compromising credit quality for this yield -- it seems that it's still able to arbitrage the cap rates it's investing at (partly thanks to buying in bulk) versus the cap rates it's selling at.

So unless the market starts getting more competitive and National Retail finds itself unable to purchase at a suitable cap rate, this REIT should continue to harvest realized gains.

To read up more on REITs:

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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates comments, concerns, and complaints. The Motley Fool has a disclosure policy.


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