Starbucks And McDonald’s Still Play The Rent: The Case For Net-Lease REITs

This article was coproduced with Leo Nelissen.

I’m a Starbucks (SBX) fan.

I can’t help it.

That coffee calls me, as do some of their breakfast treats.

Like their oatmeal?

Sign me up, please.

That kind of combination just hits the spot for me.

So if my loyal readers are wondering, no. I’m not the reason why Starbucks reported less-than-stellar quarterly results.

The company is still getting my money, same as always.

Yet it isn’t receiving the same die-hard loyalty it used to from other customers. That’s clear from the financial headlines, much less the facts they summarize.

Yahoo’s “Starbucks Stock Plunges 14% After Badly Missing Its Q2 Earnings Estimates,” for instance, reads:

“For its second-quarter earnings, the company missed expectations across the board, posting lower-than-expected revenue, earnings, and same-store sales growth, as customers pulled back on the frequency of their visits and the size of their orders.

“Its shares opened 14% lower on Wednesday (after reporting) results after market close on Tuesday…

“Revenue for the second quarter dropped 2% year over year to $8.6 billion. Adjusted earnings per share also came in lower, down 8% to $0.68.”

CEO Laxman Narasimhan described the current economic climate as “a highly challenged environment.” This, he added, was particularly true “around the pressures that consumers face, particularly with the occasional customer.”

That’s undeniable, but Starbucks’ investors expected it to be above such things. And when it proved otherwise, they punished it.

Intensely.

The stock ended 15.88% lower for the day.

The All-Powerful McDonald’s Failed Too

Then there’s McDonald’s (MCD).

It reported a Q1 increase in net income, at $1.93 billion compared to last year’s $1.80 billion. That makes for $2.66 per share versus $2.45 per share.

Moreover, net sales rose 5% to $6.17. And global same-store sales were up 1.9%.

Problem is, analysts expected that latter figure to jump 2.1%. Just like they thought U.S. same-store sales would rise 2.6% instead of the disclosed 2.5%. And adjusted earnings per share were $2.70, two cents short of projections.

Shareholders were not impressed.

Now, the markets have been harsh in general this quarter. But McDonald’s management had to acknowledge disappointment as well.

After the typical self-promotional details, CEO Chris Kempczinski said this on the subject:

“As I reflect on the first quarter of the year, it’s clear that broad-based consumer pressures persist around the world. Consumers continue to be even more discriminating with every dollar that they spend as they faced elevated prices in their day-to-day spending, which is putting pressure on the QSR industry. It is worth noting that, in Q1, industry traffic was flat to declining in the U.S., Australia, Canada, Germany, Japan, and the U.K. And across almost all major markets industry traffic is slowing.”

The company pointed to Middle East conflicts as part of the problem. But CFO Ian Borden also noted how:

“Clearly, everybody’s fighting for fewer consumers or consumers that are certainly visiting less frequently, and we’ve got to make sure that we’ve got that street-fighting mentality to win, (regardless) of the context around us.”

It more than enough to make an investor wonder what will happen as the rest of the year unfolds. While these global chains will almost undoubtedly survive, the next few quarters might not impress the way shareholders want them to.

Net-Lease REIT Landlords Could Be the Solution Shareholders Need

Again, nobody expects Starbucks or McDonald’s to fall apart because of these difficult economic conditions.

They’ll still keep attracting customers – even if it is fewer for now.

They’ll still keep making a profit – even if it is muted.

And they’ll still keep paying their dividends of $0.57 dividend (with a current 3.10% yield) and $1.67 (with a current 2.43% yield), respectively.

There’s no foreseeable qualifier on that last expectation, which makes them nice little incentives even if their stock prices drop or stagnate for a few quarters. After all, a loss isn’t a real loss until you sell your shares for less than you bought them.

And shares of quality companies with massive brand appeal have a tendency to rise over time.

Yet if you’re feeling fretful about such unnecessarily expensive fast-food and beverage companies right now… or if you’re just looking for quality companies to add to your portfolio…

I would suggest considering their landlords.

Net-lease real estate investment trusts (REITs) cater to exactly this kind of business: Corporations that so often prefer standalone properties they can manage on their own hours and their terms… while still not owning the land.

They pay less rent this way – especially since they pay all property-related expenses, from taxes to utilities to maintenance – an arrangement that works so well for them they’re willing to sign 15-year leases or longer.

That means when hard economic times come, they keep getting paid by these long-standing tenants. Moreover, they typically get paid with inflationary forces in mind – as in the contracted rent keeps going up over time.

Best yet, net-lease REITs pay faithful, growing dividends with yields that tend to be significantly greater than their tenants.

There’s a lot to like about this sector, and even more to appreciate about select stocks within it.

Realty Income (O) – The Triple-Net Lease King

When talking about triple-net leases, there’s no way around Realty Income, the biggest net lease REIT in the world.

Even better, it’s a company that has been a reliable source of steadily rising income for almost three decades.

The company, which currently yields 5.6%, has grown its dividend for 29 consecutive years with a 4.3% CAGR, which means dividends have been protected against average inflation rates as well.

Furthermore, this dividend has been protected by 5% average annual AFFO (adjusted funds from operations) growth since 1996, with stability during all major recessions and the 2020 pandemic.

In addition to allowing retirees to receive steady monthly dividends, it also has helped people to retire early, as the stock has compounded investor’s wealth by 13.9% since its IPO in 1994.

Moreover, it has done this with a 0.5 beta, indicating highly favorable volatility.

We don’t call Realty Income an ultimate SWAN (sleep well at night) for nothing.

While the company’s returns have come down in recent years, Realty Income makes the case for an 8%-10% annual operating return (excluding valuation changes) based on at least 4% annual AFFO growth and a dividend yield in the mid-single-digit range.

After all, if the P/AFFO multiple remains unchanged, 4-5% annual AFFO growth should indicate 4-5% annual capital gains. When adding its dividend, we get an annual total return (capital gains plus dividends) of roughly 9%.

Based on that context, the valuation is a huge benefit. Due to the general distrust in REITs in an environment of elevated interest rates and sticky inflation, Realty Income trades at a blended P/AFFO ratio of just 13.6x, almost four points below its longer-term normalized AFFO multiple of 17.5x.

Although it may require lower interest rates to unlock value, Realty Income is in a good spot to return north of 14% per year, including its juicy 5.6% dividend.

Speaking of elevated inflation, the company also brings a lot of stability to the table, including strong operations when it matters most.

For example, in the fourth quarter, the company saw a particularly active period with $2.7 billion in investments closed at a weighted average cash yield of 7.6%.

It’s also growing inorganically as it successfully completed the $9.3 billion merger with Spirit Realty Capital, which further bolsters its portfolio of top-tier tenants.

As we can see below, while neither McDonald’s nor Starbucks are among its largest 20 tenants, it caters to the nation’s biggest grocery and convenience stores, dollar stores, home improvement retailers, and drug stores.

It also has a balance sheet with an A- rating, which comes with more than $4 billion in liquidity and a weighted average term to maturity of 6.7%.

This portfolio puts the company in a great spot to exploit sale-leaseback operations, an area Realty Income is targeting due to companies’ need for attractive funding in the current environment.

Essentially, in a sale-leaseback deal, companies in need of capital sell their buildings to a company like Realty Income. This unlocks capital in return for regular rent payments.

According to Realty Income, S&P 500 companies alone own more than $1.6 trillion in real estate, which opens up a lot of opportunities in case companies want to sell real estate to free up cash for investments without having to engage in often expensive lending on the open market.

The second pick also comes with both growth and safety.

Agree Realty (ADC) – Where Safety Meets Growth

Agree Realty is smaller than Realty Income. Instead of a $48 billion market cap, it has a $6 billion market cap.

That said, a smaller size does not make this net-lease REIT less impressive.

To me, the most important thing that stands out is the company’s stellar portfolio, which attracts the best tenants in the net lease universe.

As we can see below, it has the best diversification among major net lease REITs as its largest three sectors account for just 27% of total annual rent.

Even better, the company’s portfolio has another benefit, as roughly 69% of rents come from investment-grade retailers.

In other words, not only are these tenants rated by major rating agencies, but they come with ratings better than BBB- (or equivalent), which ensures stability even during tough economic times.

Moreover, with a weighted average lease maturity of over eight years and minimal lease term maturities, Agree Realty’s portfolio adds even more stability to the table.

On top of that, the company’s balance sheet is characterized by total liquidity exceeding $920 million, substantial hedge capital, and no significant debt maturities until 2028.

Like most of its tenants, Agree Realty has an investment-grade credit rating and a strategy of opportunistic equity issuance to use both debt and equity to fund growth.

This continues to pay off, as the company expects roughly 4.2% per-share AFFO growth this year, which also supports its dividend.

It also pays a monthly dividend.

On April 9, the monthly dividend was hiked by 1.2% to $0.25 per share, translating to a yield of 5.1%. This dividend has a ten-year CAGR of 6%.

Valuation-wise, Agree Realty is trading at a blended P/AFFO ratio of 14.7x, below its longer-term normalized multiple of 15.4x.

This paves the road for >10% annual returns, as analysts expect 3%-4% annual per-share AFFO growth to continue using the FactSet data in the chart below.

While it will take lower rates to unlock a higher multiple, Agree Realty is well protected against current headwinds and pays investors north of 5% to wait for favorable tailwinds to return.

Essential Properties Realty Trust (EPRT) – Small and Ready To Win Big

With a sub-$5 billion market cap and a 2018 IPO, EPRT is one of the smallest and newest REITs on the market.

One major reason why investors pick this net lease giant is faster growth.

Using the data below, Essential Properties has shown a strong financial performance in the first quarter, with investments totaling $249 million and a solid AFFO per share growth of 5%.

When looking for new investments, EPRT focuses on essential assets, which explains its name as well.

This internally managed REIT focuses on single-tenant properties leased on a long-term basis to middle-market companies, with 10 to 250 locations and $20 million to $1 billion in annual revenue.

These companies primarily operate service-oriented or experience-based businesses across various industries such as automotive services, convenience stores, entertainment, and healthcare.

EPRT believes these businesses are essential to their tenants’ sales and profits and are less prone to e-commerce pressure.

As we can see below, this includes car washes, early childhood education, quick service, medical/dental facilities, auto service, casual dining, and many others.

When it comes to expanding its empire, the company watches for two principles.

• Firstly, it aims for a diversified portfolio where no more than 5% of annualized base rent comes from any single tenant or 1% from any single property.

Its largest tenant accounts for 3.8% of its annual rent. The top 10 account for roughly 18% of annual rents.

• Secondly, the company focuses on long-term net leases, with a weighted average remaining lease term of 14.0 years as of December 31, 2023.

As of 1Q24, the company had a 99.9% occupancy rate.

Moreover, like Realty Income (and Agree Realty, to some extent), EPRT is a big fan of sale-leasebacks, which is supported by a healthy balance sheet with a 3.6x leverage ratio and roughly $860 million in liquidity (all 2024 investment plans are funded, with no need for equity issuance).

In fact, 100% of its investments in 1Q24 were sale-leaseback transactions, and 87% of these were done with existing tenants.

The weighted average lease term of these deals was 17.2 years.

With regard to its dividend, the company pays a quarterly dividend. After hiking its dividend by 1.8% on Dec. 4, 2023, it currently pays $0.285 per share per quarter.

This translates to a 4.2% dividend yield, protected by a 66% AFFO payout ratio. The five-year dividend CAGR is 11.9%.

The AFFO payout ratio is based on favorable analyst estimates.

Using the FactSet numbers in the chart below, analysts expect 5% per-share AFFO growth this year, potentially followed by 7% and 6% growth in 2025 and 2026, respectively.

This bodes well for its valuation, as EPRT trades at a blended P/AFFO ratio of 16.0x, below its normalized 18.5x AFFO multiple. When adding expected per-share AFFO growth and its dividend, we get a theoretical annual return of 16%.

Again, to unlock this much value, we need interest rates to come down.

However, even if that takes a while, EPRT brings tremendous value to the table, which could result in above-average REIT returns on a prolonged basis.

As long as EPRT management is able to identify sale-leaseback opportunities in the middle market without adding too many risky tenants, I believe it has found the recipe for success.

In Closing

If you’re feeling disheartened by the recent struggles of fast-food giants like Starbucks and McDonald’s, there’s a silver lining worth considering: Net-lease real estate investment trusts (REITs).

These REITs, like Realty Income, Agree Realty, and Essential Properties Realty Trust, offer stability and growth potential in uncertain times.

Realty Income, known as the “Triple-Net Lease King,” boasts a fantastic track record of consistent dividend growth and solid returns. With a diverse portfolio and strong financials, it’s a dependable choice for investors seeking reliability.

Agree Realty stands out for its impressive tenant roster, with the majority being investment-grade retailers. Its prudent approach to growth and monthly dividends make it an attractive option for income-focused investors.

Essential Properties Realty Trust, while smaller, offers faster growth potential. Focused on essential assets and long-term leases, it prioritizes stability and expansion through sale-leaseback transactions.

In a volatile market, these net-lease REITs offer a beacon of stability and opportunity, making them worthy additions to any portfolio.

Note: Brad Thomas is a Wall Street writer, which means he’s not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.