New Kid On The Triple-Net Block: NetSTREIT Stands Out Among Peers (NYSE:NTST)


I have typically kept REITs at arms length, both in regards to inclusion in my personal portfolio and as a sector to write about very often as a Seeking Alpha contributor. My reasons for this are many. Most importantly, businesses like REITs that need constant access to capital markets in order to grow make me very nervous. Since they can’t retain their earnings, REITs must routinely take on debt and/or issue equity in order to fund acquisitions. This opens them up to risk and variability (shareholder dilution, interest rate risk, principal payments, re-financing, etc.) that non-REIT entities don’t necessarily have to expose themselves to. The extra level of analysis therefore involved with REITs has made me rather shy about making them a big part of my portfolio or research.

Nonetheless, I have been drawn to real-estate lately. Land is a unique asset class, one that deserves a heavier weighting in my portfolio.

As I started screening for opportunities among REITs, I finally landed on a company that seems unique among peers, NetSTREIT (NTST). My intent with this article is to go into great detail about them, and why I think that they have the potential to outperform the market in the next 5-10 years. My reasons for thinking this, to be discussed further along with others, are:

NetSTREIT upper management have worked for some of the most respected and successful REITs in the world, to include Spirit Realty (SRC), Realty Income (O), and Federal Realty Trust (FRT). They are experienced, competent, prudent, and shareholder friendly.

– Focus on e-commerce resistant, defensive sector, investment grade tenants.

– Own mostly triple-net properties.

– Trade at a reasonable valuation.

It is on this basis that I have initiated a meaningful position in NTST, with the intent to pull down my cost basis if shares dip in the future. A dip is a real possibility, as the shares are trading at what many might consider a premium to peers, perhaps making them vulnerable to aggressive selling with any bad news. Nonetheless, that premium is warranted in my opinion. Read on to find out why.

Company Overview

NetSTREIT very recently went public, selling 12.5 million shares for $18.00 each in August of this year (2020). The company joins the ranks of several other REITs who focus on acquiring properties under triple-net leases. Those peers include Realty Income (O), National Retail Properties (NNN), Store Capital (STOR), and Agree Realty (ADC), among others.

They target single tenant retail properties in the $1-$10 million price range, but also make room for larger dollar transactions for the likes of Home Depot (HD) or Walmart (WMT). Their average price tag per location is $3.2 million, and the average annual base rent (NYSE:ABR) per property is $211,397. Typically lease terms are for at least 10 years, and their current weighted average lease term extends out 11.1 years. They have no leases expiring until April of 2022, and only 1.4% of leased ABR will turn over through year 2024. Occupancy is currently at 100%, with 189 properties across 37 states. Those properties are leased to 53 tenants across 24 industries.

So What Sets Them Apart?

68% of NetSTREITs portfolio consists of companies with investment grade credit ratings. That heavy of a weighting towards quality is matched only by Agree Realty, whose proportion of investment grade companies is at 66.1%. Another 6.4% are of NetSTREITs portfolio is of tenants with investment grade profiles but don’t have an official investment grade rating, which NTST further defines as:

…. tenants with more than $1.0 billion in annual sales and a debt to adjusted EBITDA ratio of less than 2.0x.

One example of such a tenant is Ollie’s Bargain Outlet (OLLI), who makes up 5.3% of NTST ABR and is their 6th largest tenant. I want to dig a bit into Ollie’s just to make it clear what NetSTREIT means when they talk about high-quality unrated tenants, and to show how sound of a tenant this is to have among their top ten. Check out this table, showing current critical metrics for Ollie’s:

Annual Rev. Annualized Rev. Growth ROIC Debt/EBITDA Current Ratio
$1,628 million 17% 14 .01 2.72

*Data compiled by author

Same-store sales at Ollie’s grew by an average of 2.4% annually from the 2015-2019 period. When NTST says high quality unrated, they mean it.

They have strict underwriting and are extremely selective, with 90% of their portfolio being in defensive industries, which they define as:

… necessity, discount and/or service-oriented industries. Necessity-based industries are those that are considered essential by consumers and include sectors such as drug stores, grocers and home improvement. Discount retailers offer a low price point and consist of off-price and dollar stores. Service-oriented industries consist of retailers that provide services rather than goods, including, for example, tire and auto services and quick service restaurants. These tenants operate in industries where their physical location is critical to the generation of sales and profits, with a focus on necessity goods and essential services….

*Image from Prospectus

They also boast zero exposure to experiential real estate like movie theatres or gyms, sectors that have been absolutely pummeled in the midst of the pandemic. Lest you think that such a strategy was born of COVID-19, know that they have been defensively minded before the world was ravaged:

*Image from investor presentation

They went into some detail about this in their conference call:

…. we designed our portfolio on balance sheet strategy for long-term stability and strength before the pandemic was even contemplated.

We have long believed that retail will continue to evolve, both in ways that we can predict and in ways that we cannot. With that backdrop, we have been and continue to be focused on retailers in industries that are well protected from threats that we can anticipate such as e-commerce pressures, but also have balance sheet strength and access to capital to be able to reinvest in their businesses and adapt with the changing retail landscape.

We’re also focused on acquiring real estate that is fungible and attractive to other retail uses, and at a basis that we can continue to replicate cash flows in a downside scenario.

While at first glance it may seem like undertaking an initial public offering in the midst of a pandemic would be a huge challenge for a retail REIT, it may end up being a huge benefit. While many other similar REITs are having to deal will legacy real estate that is quickly going out of style as consumer preferences evolve, changes that were well underway before but then accelerated by the pandemic, NetSTREIT does not have to worry at all about unloading or repurposing things like movie theatres that may not have a long life span looking forward. According to management:

…. given our portfolio was recently constructed, NetSTREIT has not had to work through legacy tenants and the worst struggling categories that may have felt an outsized impact from the pandemic. Proof of this is in our cash rent collections, which have been strong and consistent with 100% cash rent collections in both September and October.

A look at their top ten tenants makes it clear what their criteria are:

*Image from investor presentation

Check out how each of these companies have been doing the current recession, as gauged by change in revenue:

ChartData by YCharts

Of their top ten tenants, only two have been under considerable pressure, Kohl’s (KSS) and 7-Eleven (OTCPK:SVNDY). Four tenants have actually benefitted from the COVID-19 related shutdowns. There is only one tenant whose long-term prospects I would worry about, and that is Kohl’s. But they are #10 on the list.

This paints the picture of what they say no less than 17 times in their prospectus: they target businesses that are “e-commerce resistant and resilient through all economic cycles”. Unsurprisingly, their rent collections have held up better than many other triple-net REITs:

Rent Collection 2020 (%) May June July Aug Sep Oct
NTST 86.1 86.5 94.3 99 99.5 100
O 83.5 85.7 92.3 93.6 93.8 92.9
NNN** 69 69 90 90 90 94
ADC 87 88 95 96 99 99
STOR 68 78 87 87 88 90

*Data compiled by author

** Represent the average for the quarter

Impressive. The downside to having these safer tenants is that cap rates are lower and rent escalations are harder to secure. More established, investment grade companies have more negotiating power when it comes to lease terms due to their status and perceived durability. What NetSTREIT gets in security they give up in returns, a risk/return trade-off always in play when it comes to investing. It is for this reason that the annual rent escalations built into their leases across the entire portfolio averages only 0.8%. This is in stark contrast to a 1.9% average at STOR for example, who does not focus on investment grade tenants

A couple examples to highlight this risk/return interplay:

In July of this year NetSTREIT acquired a Walmart store, certainly one of the most secure retailers in the world. The cap rate was only 6.6%, with no annual rent escalations through the 12 year lease term. Over time that property will become less profitable as inflation eats away at the purchasing power of the fixed rent to be received. On the other hand, they acquired a Floor & Decor (FND) store in June that came at a 8.5% cap rate with a 2% annual rent escalation built in over the ten year term.

With 68% of their portfolio consisting of the retail properties like the Walmart, their annual rent increases aren’t great. Revenue growth will therefore almost exclusively come from acquisitions unless they start to weight their portfolio more towards “weaker” tenants over whom they have greater negotiating power, and can build in rent escalations on top of better initial cap rates. Indeed, from the conference call:

As we expand our portfolio, we will seek to include rent escalation provisions as part of our leases with unrated and sub-investment grade tenants.

This slide from their investor presentation explains these dynamics further. Pay particular attention to the fourth row:

*Image from investor presentation

There is opportunity for them to take on more of the Floor & Decor type tenants, as their minimum for investment grade exposure is at least 60%. They are currently at 68%. So they can stay above their baseline while taking on a bit more risk that will juice both the cap rates and annual rent increases. During the most recently reported quarter, 100% of their acquisition activity was for investment grade tenants. According to the conference call, looking forward they don’t expect to duplicate that, giving more room for:

…. high quality underrated tenants and selectively targeted sub-investment grade tenants where we have a high level of confidence in the tenant industry, the retailers management team, the trajectory of that retailers business as well as the quality of the real estate we are acquiring.

Lest investors get nervous about them taking on more “risk” with tenants like Floor & Decor, know that risk is relative. The metrics for FND are healthy:

Annual Rev. Annualized Rev. Growth ROIC Current Ratio
$2,229 million 28.45% 9.4% 1.56

*Data compiled by author

As of year end 2019, comparable store sales at Floor & Decor had averaged an explosive 12.5% annual growth over the prior five years. They also have more cash on the balance sheet than debt. Conventional wisdom might say the Floor & Décor is riskier, but NTST management does a lot of due diligence at both the corporate and property level that mitigates a lot of risk. This process is outlined in the investor presentation:

Triple-net REIT

They did a great job of putting these pictures into a narrative during the conference call upon being asked by an analyst about their priorities:

(Analyst) Ki Bin Kim

Could you discuss your investment philosophy? I’m sure there’s a host of variables that you consider when you’re buying assets. What’s your pecking order and if you just provide some details on that?

NetSTREIT CEO Mark Manheimer

Our primary focus is going to be on the corporate credit and making sure that we’re going to get rent during the lease term. We think in a world where retail continues to evolve, it’s extraordinarily important to have a strong management team that has access to capital and access to cash that will allow them to continue to reinvest in their business and allow them to adapt to the change that will continue to come. That’s the one thing that we’re sure of is that there will be change. I’m prepared for that, and not having tenants that are continually taking cash out of the business, but rather reinvesting in the business, we think is very important. Which happened to be a lot of investment grade credits and tenants that we focus on that have strong access to capital with lower leverage.

The next piece that is very important to us is making sure that we’re buying the real estate right. There will be disruption. We hope to get everything right, but it’s foolish to think we’ll get everything right. Our backstop is effectively what are we actually buying. What can we do with that real estate? How attractive is that going to be to other uses? Looking at the demographics and traffic counts and ingress/egress signage, and what the other traffic drivers are in the area. And we think is very important and really trying to analyze what happens if we do get it back. What can we do with it? How much money are we going to have to put into building if any, and what type of rent should we be able to get replacing the rent that we’re getting at the time that we initially do an acquisition?

And so we also think it’s important to focus on locations that generate positive cash flow for their tenants. Certainly, we’ve seen that be important as it relates to renewals. But that’s probably third in the pecking order behind corporate credit and real estate.

The Opportunity

NTST envisions many years of robust growth due to the segment of the market they are focusing on. While many much larger peers are looking to acquire much larger properties in order to move the needle, as it were, NTST is comfortable occupying the $1-$10 million, single tenant space. They think the opportunity is considerable:

The current market for retail net leased properties is fragmented and decentralized. Between 2017 and 2019, private, non-institutional buyers accounted for 58.6% of this market by volume and, in 2019, 53.8% of retail net lease transactions had a purchase price between $2.5 million and $5 million. The relatively small transaction size of retail net lease properties, combined with the locations of many of these properties outside of primary markets, can be a deterrent for larger, institutional buyers that seek to deploy greater amounts of capital in larger markets and assets that generate greater ABR per property.

There is substantial investment opportunity in the net lease real estate market given the $1.5 trillion to more than $2.0 trillion of commercial real estate owned by corporate owner-occupiers.

That high amount of owner-occupied real estate presents particular opportunities for sale-leaseback transactions. In the conference call Mr. Manheimer mentioned their pipeline of opportunities eight times, saying that there is about $507 million worth of potential deals to be made. Their disciplined approach was visible here as well when he mentioned that many of those acquisitions won’t happen because “(they) will not get there on pricing.” So the market of opportunities is large, but they make no intention of employing a shotgun approach and flippantly buying stuff at any price and seeing what sticks.

Capital Allocation

One of my very favorite things about NTST is their attitude towards the dividend. While they are a REIT and a growing dividend is a big part of the story, they have committed to not lose sight of how it is that the dividend grows: i.e., growing their rent collections. It is for this reason that NTST has targeted a specific AFFO payout ratio that will allow some of their free cash flow to be re-invested back into the business. That target is 80%.

This stands in contrast to many businesses, REIT or not, that have a myopic focus on trying to forever grow the dividend, even if the dividend raise is microscopic, seemingly to chase or maintain the useless title of “dividend aristocrat” or any of the lesser designations. And heaven forbid a dividend ever get cut or suspended, even if doing so is demonstrably in the best interest of the entity and its shareholders. With NTST, a targeted payout ratio that returns cash to shareholders while still keeping enough cash to nurture growth is brilliant. If NTST can grow their dividend consistently every year for a long time under this premise, awesome. But if their dividend is lumpy from year to year in accordance with the macro environment and economic cycles, and if they choose to cut the dividend in order to maintain their target payout ratio put that saved money to better use elsewhere, so be it. I love that.

I want prudent capital allocation, bar none. That doesn’t necessarily mean I always get a dividend that gets bigger every year. Such careful cash retaining behavior also prevents the need to raise capital through constant dilution of shareholder value through equity issuances or the constant reach into debt markets. Again I will circle back to what I mentioned at the outset of this article regarding the added risk that constantly tapping capital markets brings. NTST is trying to mediate that tendency. From the prospectus:

We seek to make investments that generate strong current income as a result of the difference, or spread, between the rate we earn on our assets and the rate we pay on our liabilities (primarily our long-term debt). We intend to augment that income with internal growth (i) from cash generated from the 0.93% weighted average annual escalation of base rent, based on contractual rent escalation provisions in our leases specifying a fixed rate of rent increase and (ii) through a target dividend payout ratio that will permit some free cash flow reinvestment. We believe this will enable strong dividend growth without relying exclusively on future common stock issuances to fund new portfolio investments. (emphasis added)

Diversification

The predecessor of NTST had a portfolio that looked wildly different from its current form. A genuine transformation has been ongoing, with $30 million worth of assets currently held for sale. Following is a table showing critical metrics regarding where they sit currently and where they are trying to get in regards to diversification:

Concentration Industry Top 10 Tenants State Single Tenant/Property
Current 17% (Home improvement)

60%

18% (Texas) 12.2% (7-eleven)
Goal <15% <50% <15% <5%

*Data compiled by author

They are not where they want to be, but they are actively working to get there. As it relates to their predecessor, their filings state:

Since June 2018, we have disposed of 35 properties totaling $100.1 million in aggregate sales price and improved portfolio performance by diversifying tenant concentration and improving key metrics such as tenant credit quality, WALT and geographic diversity. Of those properties, three properties were vacant, four were properties with tenants in less e-commerce resistant industries, four had remaining lease terms of 5.7 years or less, and three were Shopko properties.

They gave an update and added some specifics during the conference call Q&A, particularly as it relates to assets held for sale:

The big focus for us is going to be on monitoring risk in the portfolio. So, in most cases it’s going to be kind of getting out ahead of some potential credit risk. We are looking at decreasing our exposure specifically to casual dining, and maybe to a lesser extent our bank exposure over time. We do have a number one tenant (with) outsized exposure in the portfolio, so there could be a little bit of that mixed in there.

The big thing I am looking for is for them to decrease their weighting in 7-eleven substantially, which is what they mentioned at the end of that quote. They have 12.2% exposure to 7-eleven, and you will recall from earlier that 7-eleven is one of their only tenants that has suffered during the pandemic. This makes sense, as the lockdowns mean fewer people on the road. That translates to fewer people going to gas stations, which are often components of 7-eleven convenience stores. I am definitely looking for diversification away from 7-11.

As it relates to heavy concentration in Texas, that bothers me not at all. In fact, the argument could be made that it’s in fact a good thing. Texas is the second largest state in the union by population. Nonetheless, they also consistently rank among the fast growing states in the nation, also by population. More people means more patronage and better rent coverage for businesses there. Furthermore, Texas also consistenly ranks among the highest in the nation for best places to own and operate a business. Viewed from that perspective, the 18% concentration in Texas is either a non-issue or an advantage.

Another interesting bit that we learned about during the conference call was a casual dining restaurant they disposed of recently at a cap rate of 10.4%, which is not a good number. Cap rate is the yield on cost of the property, or net operating income divided by purchase/selling price. If you are selling a property, you want a low cap rate. It means that you were able to sell the property for a high value relative to it’s rent generating power. But that didn’t happen here. While that may not look good at first glance, I think it is extremely positive.

First, we know that the property was of a casual dining restaurant without a drive-through that went dark during the pandemic. In managements estimation, that location was unlikely to re-open. It was in Hutchinson Kansas, a rural community with only 42,000 people. The fact that they were able to sell it at the cap rate they did was a good sign.

Second, management appears to be following the principle of cutting the losers. Many legendary investors have decried those who trim their winners and keep their losers, the gardening equivalent of chopping your flowers then watering the weeds. NTST management is not afraid to dispose of properties that aren’t meeting their criteria, a discipline that will be essential moving forward in our world of rapid innovation and change. From the prospectus:

We use our active portfolio management strategy to (i) regularly review each of our properties for changes in unit performance, tenant credit and local real estate conditions, (ii) identify properties that do not meet our disciplined underwriting strategy, diversification objectives or risk management criteria, including rent coverage ratios below 2.0x or likelihood of non-renewal upon lease expiration, and (iii) opportunistically dispose of those properties and reinvest the proceeds in 1031 Exchanges that will generate higher returns, enhance the credit quality of our real estate portfolio or extend our average remaining lease term.

That 1031 exchange is worth noting. Basically, it is a transaction that allows the seller to not be charged a capital gains tax on the sale of the real estate so long as the proceeds are spent on another property. This is of obvious tremendous advantage to the company and its shareholders, and is a focus of NTST management.

Handling COVID

An exceptionally relevant topic in today’s environment as it pertains to landlords is rent deferral and rent abatement. Rent abatement is when the tenant doesn’t have to pay rent, in whole or in part. Rent deferral is when rent payments are still due but at a later date, often spread out over a period. NetSTREIT has had to make only a small number and dollar amount of these concessions to tenants, in many of which cases it could ultimately benefit NetSTREIT.

Foremost, they have zero bad debt reserves and recognized no bad debt in the most previous quarter. For the year so far they have granted $750,000 in abatements, which amounts to 3.4% of total rent collected thus far this year and 1.9% of Annual Base Rent (ABR). In exchange for those abatements, they extended the lease terms on each of those tenants for an average of 1.4 years, which will total $14.5 million in eventual rent payments. Giving up $750,000 now for $14.5 million in approximately one decade is a trade that benefits NTST, in my opinion. If we view that $750,000 as an investment and the $14.5 million as the payoff, the annualized return over their weighted average lease term of 11.1 years is over 30%. Of course it is more nuanced than that. A lot of it comes down to the tenants themselves and whether or not they could be replaced with a better tenant at the end of their original lease term ten or so years down the road. I would rather have a better tenant than the same tenant for another 1.4 years. But nonetheless, in the precarious current environment, I think NTST negotiated well given the circumstances. Management said it best in the conference call:

….the deals that we did cut we ended up getting a lot of lease extensions, and a lot more value came back to us than what we gave up.

As it relates to deferrals, they gave $261,000 worth of concessions year to date, $75,000 of which has been repaid, the remainder to be paid over the life-time of the respective leases. The third quarter impact of deferrals was $4,000.

Valuation

Since NetSTREIT doesn’t have a long track record, and because their predecessor was so different than who and how they are now, trying to estimate their intrinsic value using any trailing methods is not informative. My simplified model is to use the guidance they have given to project growth in their gross assets, estimate what kind of rent those assets will generate, and then subtract out expenses to come up with adjusted funds from operations (AFFO), or the money available to be handed out to shareholders in the form of dividends. If earnings drive stock prices for non-REITs, funds from operations drives prices for REITs.

We know from the conference call that management expects to acquire at least $65 million in assets in the coming quarter (Q4 2020) and then $80 million in the quarter after that (Q1 2021). Assuming another $80 million for Q2 2021 will give us a full year’s worth of operating results. My estimates are as follows:

– For rent collections I took their implied cap rate from last quarter of 7.38%.

– For G&A expense I went with managements guidance of $12 million a year.

– Interest expense: They have a term loan outstanding of $175 million dollars at a fixed rate of 2.52%. They also may need to start borrowing on their revolver in Q1 2021 in order to take on the full $80 million of acquisitions, and make further borrowings on the same in the quarter after. The interest rate on the revolver is floating, but will likely be around 2.6%. These amounts are calculated, along with fees associated with the unused portion of the revolver, specific to each period.

– I included all outstanding OP units in the shares outstanding number, as the receive a dividend and can be converted to common shares on a 1-for-1 basis.

Here is a table showing all that:

Q4 2020 Q1 2021 Q2 2021
Real Estate 553,898,000 633,898,000 713,898,000
Rent 10,219,418 11,695,418 13,171,418
G&A 3,000,000 3,000,000 3,000,000
Interest 1,258,000 1,305,000 1,775,000
Shares 29,928,225 29,928,225 29,928,225
AFFO per share .20 .24 .28

*Calculations by author. My calculations of AFFO do not reflect how NetSTREIT calculates AFFO.

By mid-year 2021 we will have a full year’s worth of operating results, which my calculations show will result in AFFO of $0.93 per share after adding the $0.21 worth of AFFO from the most recent quarter. On a forward looking basis, Price/FFO is therefore at about 20 based on current trading levels. This looks expensive in context of metrics for the other triple-net REITs, with O, STOR, and NNN all having forward P/FFO below 20. ADC sits with a forward P/FFO of 20 just like NetSTREIT, which is interesting because ADC has a very high percentage of investment grade tenants as well, as mentioned previously when we looked at how similarly ADC and NTST mirrored each other in regards to rent collections in prior months. Both of them have well-surpassed peers in terms of those rent collections. Clearly investors are willing to pay a premium for safety. Will that amount to a durable and sustainable competitive advantage over time? Or will investors dump NTST and ADC for the likes of lower valued peers when the macro environment improves and folks are more risk-on? I can’t say. But I do believe that NTST has something special beyond the safe profile of many of their tenants.

The other thing to note is that a premium is warranted when higher growth is anticipated. Simply by virtue of the fact that the other triple-net REITs in my cohort have higher FFO per share, along with higher market caps/gross assets, they will have a hard time compounding growth at high rates. It’s just the law of large numbers. NTST is tiny compared to these other guys, the smallest of which is ADC whose market cap is $3.5 billion. NTST market cap is $578 million, or a sixth of the size of ADC. They are 1/34th the size of Realty Income. That small size means the potential for higher percentage growth. During the conference call, they mentioned this aspect of being able to grow rapidly without a flurry of acquisition activity due to their small size:

With our smaller asset base relative to other public REITs that focus on acquiring net leased real estate, we believe that superior growth can be achieved through manageable acquisition volume.

If they can execute on their steady strategy, NTST is set up to grow FFO per share in the high teens or low twenties from quarter to quarter over the next year. I am willing to bet that is going to surpass peers. That adds to the premium justification.

Finally, there are some things that simply can’t be quantified and rolled into any valuation metric. It is for these reasons that I am plenty comfortable buying at these levels that the conventional wisdom might say is “over-valued”.

Here I will divert to an episode from the “Invest Like the Best” podcast where host Patrick O’Shaughnessy interviewed David Gardner of Motley Fool fame. Both O’Shaughnessy and Gardner are heavy hitters in the world of active management and stock picking, so to hear both of them talk about investing was a true master class. Gardner went into some detail about this idea of aspects of a business that don’t show up on the balance sheet or income statement and therefore can’t neatly be put into a spreadsheet that spits out intrinsic value. He asked:

What is establishing the proper way to value things?

The key insight that I’ve had is that most valuation techniques are numerical, based on relationships on the financial statements of companies, and involve ratios and comparing those against other such companies. That’s the heart of the way valuation is often taught. But my key insight is, all the really important things that determine what wins in business, many of those things are not captured on the financial statements. A few quick examples: Where’s Jeff Bezos on the financial statements of Amazon? Where’s competitive advantage, sustainable competitive advantage? Where’s the number for that, that I can do a ratio off of? Is there an assumption that all CEOs add value? Or are some CEOs subtractors? Should you be docking numbers on the statements if that CEO is the CEO, as opposed to that other CEO? Maybe most important of all: innovation. Who’s innovating? And by the way, where is that captured on the balance sheet or the cash flow statements? I’ll throw out one more, which is very important to the Motley Fool as well: culture. Do people like to work at this company? Do people love to work at this company? Or is there a very high turnover? Are people flaming their company? Do people say they hate their company? My brother has done some great work in this area. And the way Tom often puts it is, when you look at corporate America, and you think of a canoe with 10 paddlers, and the canoe is a company and the paddlers are the employees. These are the ratios of employees: approximately three out of 10 are paddling forward. About four or five or six are just sitting there. And one or two are in the back, paddling backward. And that’s average corporate American. It is hugely powerful when you actually have seven people paddling forward, and no one paddling backward. And so where is that captured on the earnings, cash flow, or balance sheet statement? And so the key insight, I think, Patrick, is that all the things that really matter, there’s no number for them. Instead, people are using what they can do ratios off of, and then build trading algorithms on top of that. And they’re totally missing, and I know this as an entrepreneur, they’re totally missing how important the vision and the CEO is, the culture of the company, can it innovate or not, etc. And in a world where everybody wants to plug numbers into their spreadsheets, and then start automating stuff, it’s amazing…. One of the great edges left to us, or at least some of us, is that you actually use the right side of your brain. Or you look at the other side of things, in this case qualitative, not quantitative…. All of the metrics that people are using are missing the most important things that actually determine who wins over time.

When it comes to NetSTREIT, I think there are some unquantifiable factors that merit the premium. One of the things is indeed corporate culture, and the other is leadership. The CEO and CFO have had strong careers at very respected REITs before launching NetSTREIT. The CEO, Mr. Mark Manheimer, spent years at Realty Income and Spirit Realty Capital (SRC). The CFO, Mr. Andy Blocher, served also as CFO at Federal Realty Investment Trust (FRT), a dividend king. A few things that were said by each of these men makes me confident in their capacities as leaders and indeed fiduciaries:

Mr. Manheimer:

(To shareholders): We recognize that you are in trusting us with your capital. And we want you to know that you can count on us. We are committed to providing clear, straightforward disclosures, remaining accessible to investors and analysts, and finally to fulfill our obligations as corporate citizens by establishing a strong ESG program.

Regarding ESG, we are committed to creating a strong internal culture that promotes inclusion and employee well-being, and are pleased with the initial steps we have taken to date. Finally, we are proud of our shareholder friendly corporate governance structure, including our diverse majority independent board.

…. we think corporate culture is often overlooked. And it’s something that we focus on every day, making sure that we’ve got people that are excited to come to work, like what they’re doing, and are valued. And we think that will continue to drive them to do the best that they can do. I think we’ve got a lot of momentum behind the culture where people are really excited about what we’ve accomplished. But I think it’s going to get harder and harder as we continue to scale the business to make sure that we’ve got the right people in the right seats that have that team mentality, that aren’t looking to point fingers, that are trying to find solutions to issues as they come up. And so far, so good….. what we’ve been able to accomplish on the acquisitions front, asset management front, very heavy lifting on the accounting side, I don’t think that could have been done in a bad culture. You throw COVID in the mix, it really would have been difficult. But people have held them themselves accountable through this whole process from a lot of working from home. And we think that is a certainly a testament to the culture that we’ve built today.

Mr. Blocher:

….we’re committed to building and maintaining a conservative capital structure and providing transparency with respect to our business.

I would also say, look to the board. As Mark and I were looking to build out the board, basically we kind of broke it down to its simplest forms. There’s three things that we believe make a REIT successful or not, in this order: the real estate, the balance sheet, and the people. And I think that what happens is a lot of time, you get a lot of folks on boards who are super focused on the first two, not a lot on the last. And we have…. I keep calling our secret weapon who is Heidi Everett, one of our new board members on as part of the IPO. (She) is really, really engaged in culture, morale, and employee maximization. And Mark and I very much look forward to working with her in order to make sure that we are getting everything that we can out of our people. And that we are being as responsive as we can to our employees needs.

We’re 19 employees at this point. We’ve raised two rounds of capital. We got our books and records in a place where we were able to report pretty early in the cycle and feel like we’re setting ourselves up for success. You can’t do that without the best quality people. We just couldn’t be prouder of the team that we have.

They are certainly talking the talk. What they have accomplished so far is in line with their core message. They are shareholder friendly, accountable, disciplined, culturally aware, and excited about what they are doing. Those are all ingredients for success that can’t really be quantified in dollars or cents. Paying what may seem like a premium is, in my opinion, warranted. If they are better than peers, why wouldn’t they be priced higher than peers? Time will tell if they will end up leading the pack among REITs, but I think they have the potential to do so.

Slow and Steady

Another thing to be admired about NetSTREIT is that they are in no hurry to grow, at least not in a way that is unfavorable to their business. Their net debt/adjusted EBITDA is at only 1.4X, but they are comfortable with a level between 4.5-5.5X. This is in line with peers. Based on amounts from this quarter annualized, that means they could take on $118-$145 million more worth of debt financed acquisitions tomorrow and still be in that 4.5-5.5X range. Their revolver is fully untapped, so the capital is there to do it. But instead they gave us the metered cadence of $65 million in acquisitions this quarter and $80 million the quarter after. By that time, adjusted EBITDA will have grown substantially, creating even more room for debt financed acquisitions. But they aren’t interested in an explosion of quasi-quality assets. Their active management approach and strict underwriting create growth at a reasonable, healthy rate. On the other side of the capital structure, they don’t care to issue equity any time soon either. When an analyst in the conference call asked them about when they expect to next raise capital, the CFO Andy Blocher responded:

We’re in no rush to raise additional equity at this point. But obviously, we’re constantly evaluating funding alternatives on a go forward basis. Just from where we sit right now, I don’t think it’s in anybody’s best interest to start speculating on what type of capital size, timing or price. But just that, we’re really focused on executing the business, got our eyes wide open and hopefully the markets trust us to make the appropriate decisions at the appropriate time.

For a conservative investor like me, one who is weary of constant capital market activity like I mentioned at the outset of this article, this was music to my ears.

A word on inflation

Perhaps one of the only thing that counters my investment thesis is the rising specter of inflation. I wouldn’t be worried about inflation were it not for Joe Biden winning the presidency. Contrary to conventional wisdom, an abundance of dollars does not automatically induce inflation. That has been apparent since 2008, when dollars have flooded our financial system but inflation has been tepid. No, human beings have to start behaving in certain ways in order for inflation for materialize. Either cost-push or demand-pull powers need to be in play. Part of Joe Biden’s platform has been encouraging unionization and raising the minimum wage. Both of these will rev up cost-push effects and I expect inflation to get significantly higher as President Elect Biden enacts his platform.

Inflation is bad for NTST for two reasons. First, they have floating rate debt on their revolver. Inflation will push rates up, which will make their debt more expensive. Second, with their rent escalations so paltry, any level of inflation above that 0.8% means they will effectively be losing money every year by an amount commensurate with the basis point spread between inflation and their average escalation rate. In this instance, those decade-long leases to Wal-marts where no rent escalations are in place becomes a considerable drag. Inflation makes it more expensive to run a business, and if inflows aren’t rising in line with those rising expenses, then suddenly NTST starts losing money. Not good. The spread between their cap rates and their cost of capital gets narrower and narrower every year that inflation is present. This could be bad news if Biden starts to enact some of his ideas that will heat up inflation. It could be really bad. The good news is that NTST is aware of this threat, as explained in their acknowledgement in the risk factors section:

Increased inflation could have a negative impact on variable rate debt we currently have or that we may incur in the future. During times when inflation is greater than the increases in rent provided by many of our leases, rent increases will not keep up with the rate of inflation. Increased costs may have an adverse impact on our tenants if increases in their operating expenses exceed increases in revenue, which may adversely affect the tenants’ ability to pay rent owed to us.

Hopefully that means the can act quickly to mitigate some of the effects.

Conclusion

Given their triple-net structure, their incredible emphasis on defensive sectors, their conservative stance towards raising capital and paying a dividend, I can think of no investment that more closely resembles the safety of a bond with the growth potential of stock. The management team is stellar. Their small size will allow for robust percentage growth if with metered acquisition activity. Even without factoring in unquantifiable qualities, of which there are many, NTST doesn’t trade at an outlandish multiple. The quality of their assets is incredibly resistant to economic downturns, which has been on full display the past several months. Future additions to the portfolio will continue to feature strong tenants, but more of the sort that don’t have an investment grade credit rating. I expect both average cap rates and rent escalations to go up looking forward as they look to improve their mix between investment grade and high quality un-rated tenants, along with a smattering of select sub-investment grade. Leverage is low and management is in no hurry to change that. I really believe NTST has it all.

Disclosure: I am/we are long NTST. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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