Shares

Necessity Retail REIT Preferred Shares Offer A Safe Yield

High Yield, Low Risk Road Sign

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Thesis: High Yield, Some Upside, Low Risk

The Necessity Retail REIT (RTL) is a net lease real estate investment trust (“REIT”) that I have written about in the past. In this article from March 2022, for instance, I argued that long-term buy-and-hold investors like myself should steer clear of the stock.

Despite the company name change from “American Finance Trust” to “The Necessity Retail REIT” along with a full-scale portfolio transformation, the company’s historical problems of overindebtedness, excessive and inopportune equity issuance, and misaligned interests between external management (AR Global) and shareholders all remain.

Case in point: In Q1 2022, while cash NOI rose 16.6% year-over-year and adjusted funds from operations (“AFFO”) rose 24.7% YoY, AFFO per share remained flat at $0.24. Why? Because weighted average shares outstanding increased ~20% YoY.

On the other hand, RTL’s Preferred Series A (NASDAQ:RTLPP) shares look quite attractive in comparison to the common. At a price of just over $24, RTLPP has about 4% upside to redemption value of $25, and safely covered preferred dividend yields 7.8%.

Unlike common shareholders, preferred equity holders benefit from common stock issuance vis-a-vis debt issuance because preferred equity is ranked higher in the capital stack than common shares but lower than debt. Lenders have the highest claim on cash flows, then preferred equity shareholders, then common shareholders.

In what follows, we’ll provide an update on RTL, and then we will talk about the relative safety of RTLPP’s 7.8% yield.

Update On The Necessity Retail REIT

RTL owns a portfolio of over 1,020 multi-tenant and single-tenant retail properties across the United States.

Necessity Retail REIT properties

RTL February 2022 Presentation

Recently, RTL announced the $1.3 billion acquisition of a necessity-based, open-air shopping center portfolio from CIM Real Estate Finance Trust. These are power and neighborhood centers, some of which are anchored by a major grocery store. The portfolio as a whole was acquired at a fairly high cap rate of ~7.2%, likely due to its relatively low occupancy in the mid-80% territory as well as the need for RTL to assume some mortgage debt.

This CIM portfolio acquisition was an integral piece in RTL’s total portfolio transformation from the more highly diversified “American Finance Trust” to the more retail-focused “Necessity Retail REIT.”

RTL transformation

RTL May 2022 Presentation

Once this transaction fully closes, RTL will boast a $5.2 billion real estate portfolio made up of a little over half shopping centers and a little under half single-tenant retail (as well as some industrial) properties.

RTL tenant industries

RTL May 2022 Presentation

A little over one-fifth of the multi-tenant portfolio is in grocery-anchored centers. Meanwhile, on the single-tenant side, after the disposition of Sanofi-occupied office properties, office makes up only 2% of the single-tenant segment and 1% of the total portfolio.

The portfolio will also be largely focused on the Sunbelt region of the United States at 57% of straight-line rent.

RTL portfolio snapshot

RTL May 2022 Presentation

Post-transaction, 49.1% of the portfolio is leased to investment grade tenants.

By tenant industry, the portfolio is now highly diversified even while being much more focused on retail.

RTL tenant industries

RTL May 2022 Presentation

One of the primary reasons I avoid RTL is because it is externally managed by AR Global, which has had a poor record of financial management. One of the worst offenses AR Global has committed in the past has been issuing excessive amounts of common equity at inopportune prices. This has been the main reason why, up until 2021, AFFO per share was in a multi-year declining trend.

Additionally, AR Global loaded AFIN (and now RTL) up to the hilt in debt.

RTL had about $2.3 billion in net debt at the end of March 2022, up from $1.7 billion in net debt at the end of 2021, with most of the increase related to the CIM transaction completed. That marked a debt to gross asset value of about 46% and a net debt to EBITDA of 9.4x. Meanwhile, interest coverage of 2.9x is a touch lower than the 3.0x number from Q1 2021.

RTL debt profile

RTL May 2022 Presentation

Now, it should be noted that after the final closing of properties in the CIM portfolio, RTL plans to deleverage in part by selling $250 million of already identified assets. Furthermore, lease-up of its multi-tenant portfolio, which stands at only 89% leased as of Q1, should further lower leverage metrics.

Notice also that in the first quarter, RTL’s common stock payout ratio sat at 84%. This is based on a quarterly dividend of $0.21, which is around 22% lower than RTL’s pre-COVID quarterly dividend of $0.27.

Declining or flat-ish AFFO per share growth, in addition to the dividend cut at the beginning of the COVID outbreak, goes a long way in explaining why the stock price has been rangebound, at best, or falling, at worst, for years:

Chart
Data by YCharts

Investors lured in by RTL’s (or, previously, AFIN’s) ultra-high dividend yield of 8-10%+ have not only seen their principal eroded over the years but have also suffered the aforementioned dividend cut.

The Case For RTLPP

At this point, I will switch gears and explain why my pessimism about the common shares does not translate over to the preferred stock. In fact, since the beginning of 2021, RTLPP’s dividend coverage has only expanded.

While the common dividend must be covered by AFFO, the preferred dividends are paid out of operating cash flow or “cash from operations.” As such, the preferred dividends are covered far more comfortably than the common dividend:

Chart
Data by YCharts

In Q1 2022, preferred dividend coverage reached 772%, or operating cash flow 7.72x higher than the preferred stock dividend payout. That is up slightly from Q4 2021’s 770% preferred dividend coverage.

So, the preferred dividend coverage is increasing, but RTLPP’s share price has only slid in recent weeks, falling as low as ~$23.60 on April 14th. It appears that RTLPP has sold off indiscriminately along with the broader market over inflation and rising interest rate concerns, even though the safety of the dividend has only improved.

As I write this, RTLPP trades at a price of $24.06 and a yield of ~7.8%. That high yield is backed by strong, retail real estate, even if the common equity is impaired by a misaligned external manager that has repeatedly proven too trigger happy with share issuance.

Moreover, RTLPP’s call date is not until March 26th, 2024, which gives investors nearly two more years of high-yielding income before management can redeem shares. However, unless significant deleveraging progress is made between now and then, it is unlikely that RTLPP will be called/redeemed as soon as the call date is reached.

For income investors looking to lock in a high yield, there are few options better, in my opinion, than RTLPP.

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