Real estate investment trusts (REIT) make investing in institutional-level real estate much easier for small investors. One of the key benefits is scale, which is hard to achieve in the property market without material amounts of money. In some ways, bigger is better for REITs, but Agree Realty (ADC 1.63%) believes its relatively modest size is a big benefit right now. Here's why.
Up, up, and away
The past year or so has been marked by a very big trend. Interest rates are increasing swiftly, thanks to a concerted push by the Federal Reserve to combat fast-rising inflation. This creates some problems for REITs as the property markets adjust to new dynamics. Generally speaking, lower rates allow property to be acquired at higher prices because lending costs are more reasonable. Higher rates make it more difficult to justify investment decisions, and property prices largely have to adjust lower before deals will get done.
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That's not rocket science; it's really just basic finance. When rates are low, being an industry giant is a pretty good thing. For example, Realty Income (O 1.91%), the largest publicly traded net lease REIT, owns more than 11,700 properties and has a huge $45 billion market cap. When money was easy to get, it was out there buying whole companies and single billion dollar properties. This isn't at all shocking; it is basically what management said it was looking to do. Low interest rates helped support the effort.
With rates notably higher, it isn't as easy to find well-priced deals. Particularly at the scale Realty Income needs to move the needle on the top and bottom lines. Size is more of a headwind today than it has been many years.
A sharpshooter
That sets the stage for Agree Realty's current focus. Basically, the net lease market -- net lease tenants are responsible for most property level operating expenses -- is in something of a transition period. Higher interest rates, as noted, mean that property prices should adjust lower. But human beings aren't always rational, so property sellers are, in many cases, clinging to the pricing levels that existed when rates were historically low. It takes time for everyone to get on the same page and, perhaps, a little financial distress.
That distress often shows up first within certain areas of the property market. It is quickly present among highly leveraged landlords who have to sell assets to raise cash to cover rising interest costs, and also at developers who use the proceeds from completed projects to fund the next one they have on the drawing board. It's simple: When you have bills coming due, you've got to find money somewhere. These situations, however, are one-offs, not large-scale opportunities.
In other words, Realty Income probably isn't even looking at them. But Agree Realty, with a market cap of around $6.5 billion and a portfolio containing around 1,800 properties, can benefit from one-off deals. And that's exactly where management is putting the most effort today, allowing it to continue to expand its portfolio even as it waits for prices to more broadly adjust. During the third-quarter 2022 earnings conference call, management noted specifically that "if we're unable to invest capital accretively, we're going to maintain our discipline."
That's an important statement, and one to which investors should hold management. But this stance is supported by the ability to be an industry sharpshooter. Small deals, not big ones, appear to be the name of the game right now. Yes, being big is a good thing in the property sector, but Agree is showing today that being small isn't all that bad, either.
Know what you own
This isn't meant to be a knock on Realty Income, which is still a solid option for long-term dividend investors with a conservative bent. However, the benefits of scale that Realty Income enjoys come with drawbacks, too. In the current market, being more modestly sized positions Agree Realty to continue investing in growth even as the net lease market slowly adjusts to the reality of higher interest rates.
