The markets are celebrating. CNN’s Business Fear and Greed Index is again approaching “extreme greed” as markets begin to price in a much weaker Fed in 2024.
Both the Fed and the European Central The bank is expected to cut rates by 150 basis points next year, giving investors hope that we are finally on the way to a “normal” economic environment with low rates and low inflation.
One of the biggest winners of this trend is the real estate sector, which relies on low rates and low inflation.
Low rates make it easier to finance M&A and property acquisitions while maintaining a healthy balance sheet. Inflation is key, as it is a major driver of operating expenses and rent growth. Many REITs have capped rental escalators near 2-3%, meaning elevated inflation not only puts pressure on balance sheets but also operational results.
One of the biggest winners of the last four weeks is Broadstone Net Lease (NYSE:BNL), a net rental giant with a market cap of $3.4 billion. It has returned more than 14% since mid-November.
On August 30, I initiated COVERAGE of BNL in an article titled 7% yield and undervalued – What to make of Broadstone’s net rent?
In this article, I’ll update my call and explain why BNL continues to offer value despite certain downsides that could pressure the company (and its peers) if inflation continues to hold.
So let’s get to it!
Diversified net-rent exposure
BNL is a well-diversified REIT with 800 properties in 44 states and four Canadian provinces.
51% of annual rent is generated by industrial buildings, followed by 18% healthcare, 14% restaurants, 11% retail and 6% offices.
Looking at its industrial exposure (below), we see that the company has put emphasis on this segment, as its exposure has increased by 20 points since the end of 2018.
Like most of its assets, this segment also has a weighted average rent escalation of 2.0%, which protects BNL from inflation below or at the Federal Reserve’s target range.
On a side note, a key risk here is prolonged elevated inflation, which would expose BNL to risks such as high spending.
The weighted average lease term is 11.5 years.
It also has a well-diversified tenant base, with its top ten tenants generating less than 18% of annual base rent.
In this segment, close to 60% of rent is generated in manufacturing and distribution/warehouses.
Its other assets are also well diversified, with annual rental rates close to 2%.
Its largest operating state is the Lone Star State, Texas, which is home to 72 of its properties and accounts for approximately 10% of annual base rent.
During its 3Q23 earnings call, the company noted that its portfolio continues to perform well. A focus on tenant and industry diversification, combined with top-tier annual rent escalation, mitigates downside risks.
As a result, the real estate portfolio achieved 99.9% rental collections and 99.4% occupancy at September 30, 2023.
However, despite a resilient portfolio, BNL faced challenges with tenant Green Valley Medical Center failing to meet key milestones.
Rent collection has been impacted, prompting the company to explore alternatives and potentially end the distraction caused by this single asset.
Additionally, the company noted macroeconomic challenges.
The transaction market is experiencing continued price discovery, driven by the upward trajectory of Treasury yields.
This has led to a widening of bid-ask spreads and a decline in transaction volume in the broader market.
Despite this, the company remains focused on securing the right investments and is selective in pursuing opportunities in emerging market conditions.
During the quarter, a limited number of investments met BNL’s criteria, driven primarily by development financing and revenue-generating CapEx.
The company’s success in selling selected credit risk or residual assets helps mitigate risks within the portfolio while building dry powder for future creative recycling.
For example, the company successfully disposed of selected credit risk or residual assets, selling two properties for gross proceeds of $62.3 million at a weighted average cash-on-equity rate of 6.2%.
Year to date, 11 properties sold for $189.1 million with a weighted average cash yield of 6%.
The company plans to continue to execute asset sales opportunistically in the fourth quarter and into 2024.
Additionally, the company’s pipeline of potential investment opportunities is expanding, estimating over $10 billion in acquisitions during the third quarter.
Regardless of active resources and underwriting, rising interest rates impacted the number of opportunities that meet BNL’s criteria.
For example, the company walked away from a significant late-stage investment due to pricing disputes amid rapid rate hikes.
In light of economic risks, thanks to prudent investments and careful decision-making, the company maintains a very healthy balance sheet.
As of the third quarter, the company has a net leverage ratio of 4.9x. This number has decreased from 5.2 times in the last year’s quarter.
It also has close to $1 billion in liquidity, almost exclusively from available revolver capacity.
The company also has no major debt maturities until 2026.
As a result, it enjoys a BBB investment grade credit rating with a stable outlook.
Additionally, the company maintained its 2023 guidance per share with an AFFO (adjusted funds from operations) range of $1.40 to $1.42 per share.
- The volume of investments was revised downwards.
- The total volume of the disposal is expected to be 200 million dollars.
Regarding the dividend, the Board of Directors approved a dividend of $0.285 per common share, representing an increase of 1.8% from the last quarter.
This is in line with the target AFFO payout ratio in the medium to high range of 70%.
BNL currently yields 6.6%, which is 50% more than the 4.4% yield of the Vanguard Real Estate ETF (VNQ).
Going forward, we can assume that dividend growth will remain in the low single-digit range based on expected AFFO growth rates, which brings me to the rest of this article.
This year, BNL is expected to avoid contraction, with 1% AFFO growth in 2023. Next year, AFFO is expected to grow by 3%, followed by 4% growth in 2025.
Currently, BNL trades at a blended P/AFFO multiple of 12.3x.
The normalized valuation is 14.8x AFFO. Although it will likely need a sustained decline in interest rates before investors will yield a higher multiple on a sustained basis, the stock could return close to 20% annually through 2025 including the dividend its liquid and expected AFFO growth rates.
Needless to say, the stock is unlikely to return 20% per year on a long-term basis. One reason why this number is so high is because of the short time span of this calculation.
However, I believe the stock is roughly 30% undervalued, with a fair price target of $22 to $24.
Broadstone Net Lease stands out as a resilient real estate investment. The company’s strategic focus on diversified net lease exposure, particularly in industrial properties, has shielded it from potential downside.
Despite challenges with specific tenants and macroeconomic headwinds, BNL’s portfolio maintains an outstanding 99.9% rent collection and 99.4% occupancy.
Additionally, BNL’s proactive approach to asset management, including strategic disposals and a strong liquidity position, contributes to a healthy balance sheet with a BBB credit rating.
The recent dividend increase and a yield of 6.6% make BNL an attractive proposition for income-focused investors, especially compared to the Vanguard Real Estate ETF.