The Federal Reserve's drastic interest rate increases during the past 15 months have upended valuations in the real estate investment trust (REIT) sector. REITs tend to be highly sensitive to interest rates, as they generally borrow a lot of money and rising rates increase the cost of debt. Meanwhile, rental increases tend to be a function of the supply-demand dynamics in the real estate niche where the REIT operates.
REITs must pay out almost all of their net income in dividends, and they tend to have above-market yields and often trade like bonds -- meaning their prices tend to fall when interest rates rise as they have recently. At the same time, there is mounting evidence of problems in the commercial real estate market, particularly office and retail. Agree Realty (ADC -0.48%) is a retail REIT with defensive characteristics, meaning it tends to hold up in economic downturns. Is it a buy?
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Agree Realty is a triple-net lease retail REIT
Agree Realty uses what are known as triple-net leases. Under these leases, the tenant is responsible for rent as well as the property's operating expenses such as maintenance, insurance, and taxes. These leases generally have long terms and are notoriously expensive to break. For triple-net leases to make sense for both parties, the tenant has to have a resilient business model and the financial strength to make it through a recession. A fashion retailer would be a bad candidate, but a grocery store would ideal: people always need to eat, but they don't necessarily need clothes in the latest styles.
As of the end of 2022, Agree's portfolio consisted of 1,839 properties with about 38.1 million square feet in gross leasable area. The average remaining lease term was just under nine years and the portfolio was almost fully leased. Just over two-thirds of base rent comes from tenants with investment-grade credit ratings. Agree Realty's biggest clients include WalMart (WMT -0.08%), Dollar General (DG -0.41%) and Tractor Supply (TSCO 3.26%). Agree Realty's biggest sector exposure is to home-improvement companies, grocery stores, tire-auto service establishments, convenience stores and dollar stores. These sectors are highly defensive, which is important should the U.S. economy head into a recession.
The commercial real estate sector is experiencing pain
With increasing stress in the commercial and retail real estate sectors, a big issue for many REITs is whether they will be able to refinance maturing debt. If a REIT finds itself unable to roll over existing debt, it may be forced to sell properties or even face bankruptcy if it doesn't have the cash to pay bondholders. Luckily for Agree Realty, it has very little debt maturing in 2023 and 2024. The vast majority of its debt matures in 2028 and after.
Agree Realty earned $3.83 in adjusted funds from operations (FFO) in 2022. This was an increase of 9.1% from 2021. REITs tend to use FFO in lieu of net income as reported under generally accepted accounting principles (GAAP). This is because real estate companies have a lot of depreciation and amortization charges that are deducted from revenue under GAAP, but don't represent actual cash expenses. FFO ignores these charges, giving a better indication of the company's actual cash flows.
Agree is not cheap, but it is a quality company
At current levels, Agree is trading at a multiple of about 17 times 2022 per-share FFO. This is on the high side for a REIT, but Agree has historically traded at a premium. For comparison, triple-net lease REIT Realty Income (O -0.17%) trades at just under 15 times 2022 per-share FFO. Agree's 4.5% dividend yield is also lower than Realty Income's 5.2% yield. That said, Agree Realty has a strong balance sheet and it's certainly a retail REIT worth considering for an income investor.
