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This article took a bit longer to prepare. I was trying to find an answer for precisely where I went wrong.

I did some extensive research on the net lease REITs while setting targets before. The thesis looked great. It was built on solid accounting. 

Despite the research, National Retail Properties (NNN) significantly outperformed my expectations. I initially brushed this off as the market overreacting to inflated figures. 

However, fresh research required me to update my price targets for the net lease REITs.

Upon digging in, I came to three conclusions:

1. National Retail Properties had a couple of really good years. Not as good as the market seems to think, but still really good.
2. I didn’t adjust for differences in relative performances that could be expected in the underlying real estate portfolio based on property type. Seems like a silly thing to miss, but the timing was brutal. This was right after Realty Income (O) made upgrading their portfolio look easy. In hindsight, what Realty Income did was the equivalent of hitting a full-court shot with half a second on the clock.
3. We reduced targets for W. P. Carey (WPC) based on management’s stupid plan (spin properties & cut the dividend). That was a good call. I went into full detail in WPC: Slam Dunk? Rejected. However, I was a bit too gentle. I didn’t adjust for some weakness in the real estate. This was a bit surprising because the listed property types should be outperforming. Industrial and warehouse space should be good! Their retail shouldn’t be falling so far behind peers.

The AFFO and Revenue Timeline
 

I wanted to go from start to finish, but there was a problem. That layout spreads things out across several years. So, I’m going to start with the spoiler:

• NNN’s 2020 results were missing revenue (and AFFO) they could have recognized.
• NNN’s 2021 and 2022 results would have bonus revenue (and AFFO) from their actions in 2020.
• NNN’s 2023 to 2025 results would see progressively smaller benefits.

That was roughly how things have been playing out. Yet something else was off.

NNN’s real underlying performance was better than I was giving them credit for. 

Not dramatically better, but still materially better. Well done to National Retail Properties.

They hammered that point home by raising guidance again in the Q2 2024 earnings release. AFFO per share guidance is only up 0.6%, but that’s still a solid boost for a Q2 earnings release.

The headwind still exists for future years, but the total headwind remaining is less than 1% of AFFO per share. That should occur across multiple years, so it is basically a non-issue today.

Now that you know what happened with the numbers, we can step into the analysis process.

When National Retail Properties Was Punished
 

In late 2020, I argued that National Retail Properties was unfairly punished because of conservative accounting. NNN was being very careful not to recognize revenue unless they were confident the tenant would fulfill the terms of the lease. They also modified several leases to give tenants a bit more time to catch up on rent. I argued during 2020 that NNN was being prudent in their relationships with tenants, though the careful revenue recognition would create issues down the road. NNN wasn’t giving up cash. They were giving time and being careful not to book revenues too early. It was good management, though some investors criticized management for being so prudent with their customers.

This was one call I got precisely right.

When Realty Income Revealed Their Plan
 

That thesis was playing out precisely as I expected in late 2021. Meanwhile, Realty Income (O) had a great deal. It looked okay at the time, but not great. 

In mid-to-late 2021, Realty Income swung two deals together. The combination here was the masterpiece. Neither deal alone would’ve been so great.

These are the two transactions:

1. Realty Income acquired VEREIT (VER).
2. Realty Income announced they would spin off their crappy (office, okay, crappy is a euphemism for office) properties.

If we exclude the office properties owned by Realty Income, their average portfolio quality was better than the stuff owned by VEREIT.

The deal was going to be accretive to AFFO, but that didn’t seem too impressive.

However, Realty Income lined this up perfectly.

The Realty Income Combination
 

Realty Income drilled the timing:

1. Inflation escalators were giving REITs moderately better revenue growth for 2022.
2. The acquisition of VEREIT was driving AFFO per share growth.

That combination meant Realty Income could announce strong AFFO per share growth (and easily cover the dividend) even though they were ejecting some office trash.

To be clear, office properties were not a large portion of Realty Income’s portfolio. It was only 3.0% before the merger with VEREIT. However, adjusting for leverage, spinning those properties off should’ve hit AFFO per share for more than 3%. That would’ve made growth look bad for a year. By doing these transactions together, Realty Income was able to provide a much more compelling story to investors.

In this case, I was right about the value of the transaction with VEREIT but didn’t realize how difficult it would be for any other REIT to achieve something similar.

When National Retail Properties Roared Back
 

National Retail Properties performed well over the last few years.

I attributed a bit too much of their recovery to the impact of the deferred revenue and AFFO. 

Consequently, I didn’t adjust them as early as I should have.

I expected the market to be disappointed about slower growth. The market often overreacts to some short-term headwind, so it seemed likely here.

After all, we saw the market overreacting in 2020. Yeah, there was this whole financial crisis thing with the pandemic. But NNN was overly punished.

It seemed reasonable that history would repeat itself, but it didn’t.

Conclusion
 

I did some good research on National Retail Properties. However, I was too quick to brush off their strong recent growth in AFFO per share. Because I was expecting a big benefit from recognizing revenue that was earned in prior years, I didn’t look as closely at the performance. Likewise, I was right to criticize WPC. However, I underestimated the difficulty they would face because we witnessed Realty Income handling a somewhat similar situation so much better.

All of the major net lease REITs are currently within our neutral range for valuation. Precise targets and expanded coverage are included in the Net Lease REIT Q2 2024 Sector Update.

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