National Retail Properties (NYSE:NNN) is one of the largest net-lease real estate investment trusts (REITs) in the United States, competing with peers like Realty Income (NYSE:O) and W.P. Carey (NYSE:WPC). It has an incredible history of annual dividend increases, with over 30 years of increases under its belt. And yet the coronavirus pandemic has exposed a material weakness in its business model.
Here's what investors need to be thinking about today.
A heavy hit
National Retail Properties owns roughly 3,100 single-tenant retail properties that it rents to companies on a net-lease basis. That means that its tenants are responsible for most of the operating costs of the properties they occupy. National Retail revenue essentially comes from the difference between its financing costs to buy properties and the rents it collects. It's a fairly low-risk approach in the real estate investment trust space used by a large number of peers.
One of the big differentiating points for National Retail is that it focuses exclusively on the U.S. retail sector. To be fair, the REIT spreads its bets around. For example, its portfolio spans across more than 30 different business types, and no single region of the country accounts for more than about a quarter of its portfolio. However, at the end of the day, it still only owns retail properties.
When COVID-19 began to spread across the country, the government effectively asked people to stay home and forced non-essential businesses to close. The retail sector was hit particularly hard. National Retail's occupancy levels are great, in the high-90% area, but it was only able to collect around 50% of the rent it was due in April. That's terrible -- having paying tenants is the real goal. This wasn't an issue before COVID-19, but the illness has exposed a major weakness in National Retail's investment approach.
Comparisons are important here. Fellow bellwether Realty Income was able to collect around 87% of its rents in April, and W.P. Carey's collection rate was 97%. Additionally, Realty Income and Carey have both provided updates to their rent collection numbers while National Retail has not, so there's no way to tell if the trend is improving (which is highly likely) or not. Realty Income's collection rate averaged roughly 85.5% in the first quarter. W.P. Carey basically collected all of the rent it was due.
Time to reconsider the approach
The big difference here is National Retail's exclusive focus on retail assets. Realty Income is heavily weighted toward retail, with around 85% of its rent roll coming from the sector. However, it also has exposure to industrial (just shy of 11% of rents) and office (3.5%) assets, as well as a small and opportunistic investment in vineyards. It's likely that Realty Income's collection rate from its retail lessees was better than National Retail Properties' rate, but the property-type diversification was also a notable help.
That brings up W.P. Carey's portfolio, in which retail only makes up about 17% of the rent roll. The rest comes from industrial (24% of rent), office (23%), warehouse (22%), self-storage (5%), and a sizable "other" component. The "other" grouping is pretty broad, and includes things like theaters, gyms, restaurants, and hotels (together about 4% of rents) that National Retail and Realty Income would call retail. But the real takeaway is that retail is just one piece of a much broader portfolio at W.P. Carey. And it's worth noting that W.P. Carey also generates around a third of its rents from Europe. National Retail is focused domestically, and Realty Income is only just venturing beyond U.S. shores, with a small (about 2% of rents) of retail investment in Europe.
The story here is pretty clear: Just like diversification is good for your investment portfolio, it's also good for businesses to spread their bets around.
What to do?
National Retail Properties is not a bad REIT. In fact, it just announced a modest dividend increase, which suggests that its portfolio is starting to recover (a better picture will emerge when it reports second-quarter earnings). That said, the impact of COVID-19 on the REIT's business is worth some deep consideration by long-term investors, and especially those with a more conservative bent.
At the end of the day, the company's domestically focused and retail-centric portfolio may not be as good a fit for your portfolio as you once thought. If you own National Retail Properties you might want to think about other options, or even taking a portion of the money you have in the stock and buying a similar but more diversified peer like W.P. Carey.