NNN REIT Is Downplaying Emerging Tenant Troubles

seekingalpha11-06

NNN REIT reported stable Q3 earnings, but the stock fell over 10% due to tenant issues, which management downplayed on the earnings call.NNN is likely to lose more than 2% of ABR as two tenants move ...

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href=https://seekingalpha.com/article/4733554-nnn-reit-q3-earnings-downplaying-emerging-tenant-troubles-downgrade-hold><strong>seekingalpha</strong></a>\n\n\n</h4>\n\n</header>\n<article>\n<div>\n<p>NNN REIT reported stable Q3 earnings, but the stock fell over 10% due to tenant issues, which management downplayed on the earnings call.NNN is likely to lose more than 2% of ABR as two tenants move ...</p>\n\n<a href=\"https://seekingalpha.com/article/4733554-nnn-reit-q3-earnings-downplaying-emerging-tenant-troubles-downgrade-hold\">Source Link</a>\n\n</div>\n\n\n</article>\n</div>\n</body>\n</html>\n","isBrief":false,"type":0,"news_type":1,"symbol":"LU0048597586.USD","symbol_name":"富达亚洲焦点A","start_time":0,"source_url":"https://seekingalpha.com/article/4733554-nnn-reit-q3-earnings-downplaying-emerging-tenant-troubles-downgrade-hold","article_id":"2481955926","we_media_id":null,"thumbnails":["https://static.seekingalpha.com/cdn/s3/uploads/getty_images/170031554/image_170031554.jpg"],"rights":null,"url":"https://stock-news.laohu8.com/highlight/detail?id=2481955926","pubTimestamp":1730894400,"sourceInfo":{"source_id":"seekingalpha","name":"Seeking Alpha"},"weMediaInfo":null,"summary":"NNN REIT reported stable Q3 earnings, but the stock fell over 10% due to tenant issues, which management downplayed on the earnings call.NNN is likely to lose more than 2% of ABR as two tenants move 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Gannet77  Today, we return to the world of net lease REITs, the bread and butter of REITer’s Digest. In most of our articles, we allude to the strengths of net lease REITs. One of the main benefits is stability, both of year-to-year cash flow and also the growing market of net lease. Most REITs like Realty Income (O) and Agree Realty (ADC) rarely change and when they do, the transformations typically take years. From another perspective, net lease REITs are slow-moving ships. These REITs rarely miss earnings and when they do, it tends to be by small, predictable margins. There are rarely surprises in the world of net lease REITs. Rarely is the operative word in that sentence. In August, we covered NNN REIT (NYSE:NNN), the oldest publicly traded REIT focusing on net leased assets. The article is linked below and, as the title suggests, discussed NNN’s dividend. NNN REIT: Evaluating One Of The Safest Dividends In Net Lease In the article we unpacked a lot around NNN focusing on the company’s business model, balance sheet, and historical returns. We made the case that NNN was undervalued relative to peers based on their growth and payout ratio. We assigned a Buy rating as a solid pick in the net lease industry. If you are unfamiliar with NNN, the article is a must-read because we are going to dive straight into business today. What On Earth Just Happened? As we just said, net lease REITs are slow-moving ships. Stock prices tend to move consistently in one direction or another based on the short term operating performance of the REIT, generally expressed in per share metrics like adjusted funds from operations per share. These metrics are predictable, so surprises are infrequent. Data by YCharts On October 31st, NNN REIT reported earnings for Q3 which were broadly aligned with estimates. Top line earnings such as AFFO per share and the company’s dividend were aligned with expectations. AFFO per share grew by 2.4% as compared to the prior year and occupancy remained at 99.3% NNN’s other teams remained hard at work making over $100 million in acquisitions during the quarter at a going-in capitalization rate of 7.6%. Dispositions were healthy totaling $20 million. Management seemed even more enthusiastic about earnings with CEO Steve Horn commenting: NNN continues to perform consistently, with a 3.7 percent increase in FFO and Core FFO per share results in the third quarter 2024 compared to prior year results. With over $175 million of cash, $1.2 billion available on our revolving credit facility and no debt maturities until the fourth quarter of 2025, our balance sheet continues to allow NNN to capitalize on sufficiently accretive opportunities and remain well positioned to provide long-term shareholder value. Reading the earnings release means that NNN is still wonderful, unchanged, and operating beautifully. That is, until you notice that NNN’s stock fell more than 10% in the days following the earnings release. This type of decline is unusual for a net lease REIT, much less the oldest participant in the sector and one with a balance sheet rated investment grade. Before buying the dip on NNN, we need to understand where a shift like this comes from. So…what on earth just happened. NNN REIT Is Facing Mounting Tenant Issues The past several years have been difficult for the economy, despite the success of the stock market. The S&P500 and similar indices are a poor indicator of economic health and the health of most businesses in the United States. Rising costs, a tightening labor market, and increased borrowing costs have begun to stress companies and consumers alike. Facing headwinds together, many retailers have begun to struggle as their top and bottom lines face compounding challenges. These issues have unfortunately begun to materialize through issues like store closures, diminishing interest in new development opportunities, and declining rent coverage ratios. Unfortunately for NNN, it means more serious issues that are at play. Over the past few quarters, NNN has alluded to tenant issues that were brewing. Below is an excerpt from the Q2 earnings call that caught my attention for future update and calls to brokers/contacts around the country. The only other one I'd mention, again, not in our top 20, but we have two tenants that are in bankruptcy. One's called Badcock Furniture and within which we have -- it's 0.7% of our rent, 0.7%…The Badcock is early. They just recently filed and we do have that company, Badcock got bought by a company called Conn, which is a retailer that's been around for a long time. We own no Conn stores. But the Badcock became a part of Conn about a year ago, the company that sold Badcock to Conn remains a guarantor on our lead. During the prior quarter’s earnings call, NNN brought up issues with several tenants including a major furniture retailer called Badcock Furniture. While outside of the top ten, Badcock still accounted for 70 basis points of NNN’s annualized base rent. While not overly significant, issues of any size can be leading indicators of more problems to come. The most important piece here was that management emphasized how early this was in the process, indicating that this was more of a warning to assuage concerns. Times Change…Fast Things have evolved quite quickly for NNN, Badcock, and other tenants in NNN’s portfolio who were facing early-stage issues in the prior quarter. This quarter, NNN provided updates on Badcock which were not positive. Badcock was sold to Conn’s HomePlus furniture who recently filed for bankruptcy. Management’s update on the Q3 earnings call was much less positive.  As Steve mentioned, yes, a quick update on a couple of tenants that are having credit challenges, both of which we've talked about for a few quarters now. Badcock Furniture was previously owned by a company named FRG and Badcock was sold with the FRG guarantee in place to Conn's HomePlus who filed for bankruptcy in July. So we own 32 Badcock Furniture stores, representing 0.6% of our annual base rent, which translates to about $5.2 million in annual base rent. We are operating in an assumption that we'll get these properties back. But precisely when is unknown as it's still working its way through the bankruptcy process. We will pursue the FRG guarantee of these leases, but we do recognize FRG may have its own credit challenges.  NNN’s management team addressed the Badcock issues head-on stating that the company owns 32 locations accounting for 0.6% of annualized base rent. The company acknowledges that the tenant will likely reject the leases in bankruptcy court and the company will return the stores to NNN vacant. This next part is important… This implies that these locations were poorly performing or unprofitable for the operator. NNN notes that they intend to pursue a resolution for lost rent, but it could be unlikely to secure much of an outcome given the parent is facing similar issues around creditworthiness. Another One Bites The Dust Unfortunately for NNN, another major tenant is facing serious issues around financial viability. Frisch’s is a hamburger quick service restaurant, or QSR. NNN acknowledged that Frisch’s paid only half of rent owed during Q3. The likelihood of this rent being repaid or future rent being paid in full is low. According to NNN, the company owns 64 Frisch’s properties, accounting for 1.5% of annualized base rent. The second tenant of note is Frisch's, and Frisch's is a Midwest Big boy hamburger concept that has been around for several decades. They only paid us half rent owed in the third quarter; half the rent owed in the third quarter. So we own 64 Frisch's properties at quarter end, representing 1.5% of annual base rent, and that translates to $12.6 million. While I don't want to get too detailed in the plans here due to various claims we're pursuing to protect our interest in this regard, we did want to provide some information on these situations. The bankruptcy of Frisch’s is a more significant downside in terms of rental revenue. Representing 1.5% of annualized base rent, this tenant is far more material to the business than Badcock furniture. However, on a combined basis, this means that more than 2% of NNN’s annualized revenue has come under threat during the past three months alone. How Big Of An Issue Is This? Well…that certainly depends on who you ask. Management was optimistic on the call, essentially calling these sorts of bankruptcies “business as usual.” That is the job of a REIT’s management team, pursue upside, manage downside, and deliver returns to their shareholders. NNN has a great track record of doing so, powering through COVID, the financial crisis, and more.  Both of these tenants are on cash basis accounting, so we are only recording what we actually collect. Over the years, our guidance has generally assumed 100 basis points of rent loss in any given period but these 2 tenant issues could push us over that level, obviously, in the fourth quarter. We should get some incremental clarity on these 2 situations in the fourth quarter, which we think will allow us to better estimate the outcomes when we provide our 2025 guidance in February. These kinds of tenant credit events are historically a normal part of our business. The way we think about it as, as long as our rents are not too far from market rent, we don't lose too much sleep. If we get properties back, there may be some timing gap in the income production, whether we decide to sell, re-lease or redevelop the properties. But in the long run, which is our perspective, our experience suggests that any loss rent will likely be a manageable headwind.  That’s a great response from management! Sure, the tenant might leave, but we have the knowhow and capabilities to easily replace the rent and move on with the business. After all, they do build 100 basis points of credit loss into their guidance, how much of a difference would another 100 basis points make? The issue is that NNN’s response comes with a serious of assumptions that are not necessarily givens. For example, the company often points back to their underwriting competencies to invest in properties at favorable rental revenue which make replacing those revenues feasible in a downside. In the real estate world, we call this investing at market rent. If your tenant is paying the same rental rate as a replacement tenant, there is less downside to bankruptcy. In their own words, “reasonable rents win the race.” Long time followers of NNN know our position. Real estate leased at reasonable rents win the race in our opinion, and that -- which allows us to deal with whatever tenant credit problems might come our way. Despite these challenges, like I said, we were able to affirm the earnings guidance that we increased in the second quarter. So, no big issue here for NNN, right? The company assumes that when Badcock Furniture and Frisch’s vacate the properties, they can easily replace the lost rent with a new tenant. Not So Fast… The weight of this assumption cannot be overemphasized. It is basically the lynchpin of NNN’s business and operating model. As we noted in previous coverage, NNN derives little rent from highly rated tenants. Most tenants are either sponsored businesses who did a sale leaseback with NNN or market tenants who occupy big box stores. These deal profiles have different contexts and underlying strategies. I would assume that NNN acquired their Frisch’s locations via sale leaseback with the operator. It is also possible that they acquired the properties from another party who previously did a sale leaseback. The point being the leases likely originated via sale leaseback. The investor behind the company’s operations would have chosen to recapitalize the balance sheet, selling properties to generate proceeds which could be distributed as a dividend or reinvested into new locations around the country. NNN would have been the enthusiastic buyer in this transaction known as a sale leaseback. A sale leaseback is designed with different goals in mind for both parties. The seller of the real estate is seeking maximum proceeds to either extract capital from the business or fund a growth initiative. From their perspective, more is better. The REIT buying the properties is seeking a risk-adjusted return on their investment. A key piece of the risk puzzle for NNN is ensuring that they are not overpaying for these assets such that the basis is too high or in-place rent would be unrealistic to replace. Herein lies the tug of war, tenants want more money, and the REIT must negotiate down to protect their rent basis. But how are sale leaseback rents even set? For existing locations like Frisch’s burgers, rent at the time of sale leaseback would be set through a ratio called rent-to-sales, calculated as the name implied. Generally, the REIT and management will review a historical profit & loss statement, setting rent as a portion of top line sales. In my experience 7% was a rule of thumb for a rent-to-sales ratio. This means for a QSR doing $1 million per year in revenue, they can expect to pay $70,000 per year in rent. This is done to set rent as a sustainable portion of the company’s operations at the time of sale leaseback. This means that the in-place rent set during the sale leaseback is based on the revenue generated by a successful restaurant that NNN would have wanted to purchase. This means their market rent is set based on a first generation, successful burger operator. The bankruptcy of Frisch’s implies that these operations are no longer successful. A competitor is unlikely to step in and take over the existing operations without considerable investment from NNN or a material rent cut to make the risk worth their while. After all, if Frisch’s could not operate the location, why would a competitor try? This scenario implies that NNN is now negotiating with tenants based on an entirely different set of circumstances than during the SLB. What is significant is that their perception of “market rent” set during the original transaction has zero bearing on how they will negotiate with a replacement tenant. Think about it from a different context. How likely is NNN to be able to negotiate more rent from a speculative operator taking over a bankrupt burger chain location than from the operator of the existing restaurant when Frisch’s was doing well? From my perspective? Low. With 1.5% of annual rental revenue determined by the outcome of finding a replacement tenant, this could lead to material issues for NNN. What To Make Of It… Sale leaseback rents are typically high. In my experience, far higher than the REIT issuing capital would like them to be. In recent history, negotiating power has landed with the operators due to increasing competition for sale leaseback deals. The number of capital partners continues to increase and their appetite for yield is higher than classic investors like NNN. This makes me concerned that NNN is likely to only replace a portion of their rental revenue stemming from a tenant like Frisch’s. With these sale leaseback profile deals with specialized building formats, the REIT can typically expect to replace 40%-60% of existing rent with the second generation tenants. This would mean the elimination of 75bps from NNN’s top line revenue over the short term. Although this is relatively small, it is massive in the world of net lease. It could also portend more significant issues for net lease landlords in the coming future, especially those with SLB heavy business models, like Essential Properties Realty Trust (EPRT). As the sector becomes increasingly volatile, companies like NNN are coming under a microscope. Their strategies and bottom line results navigating these issues will determine their success in the eyes of the market.  NNN is currently falling behind and these merging tenant issues are problematic for the REIT. We rate NNN a Hold until more clarity emerges around the situation with these tenants.","kind":"highlight","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"analysis","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.3","shortVersion":"4.29.3","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2481955926"}