Agree Realty: A Wide Moat REIT With A Wider Margin Of Safety (NYSE:ADC)

This article was coproduced with Nicholas Ward.

Volatility is back on the menu.

And generally speaking, when we’re seeing markets sell-off, it’s common practice for investors to duck for cover, hiding out in the most defensive stocks.

This makes total sense, right?

Defensive stocks allow investors to maintain exposure to risk assets and the passive income that they provide (retirees, especially, simply can’t turn this nozzle off; many of them rely on the passive income that their portfolio generates to pay their bills) while taking on relatively lower risk.

With that in mind, we’ve seen the “value” segments of the market outperforming thus far throughout 2022…

The S&P 500 recently fell into correction territory (down more than 10% from its prior highs) and even though we’ve seen a bit of a rally in recent trading sessions, the S&P 500 is down 9.22% on a year-to-date basis.

When it comes to 2022 returns, energy is leading the race thus far, in large part due to supply issues and geopolitical fears (which have the potential to cause even more supply disruption). The Energy sector is up 19.16% year-to-date.

Up next, we have the financial sector, which is widely associated with value and also stands to benefit from rising rates. The Financial sector is down just 2.21% year-to-date.

Consumer staples, the quintessential defensive sector, is up next having posted -3.12% year-to-date performance.

And then we have the utility sector, which is also known for its very reliable cash flows, down 6.18% thus far in 2022.

The rotation away from speculative growth plays and into these areas of the market seems reasonable to us. They’re all areas of the market that should fare relatively well throughout a period of geopolitical uncertainty, rising rates, and potentially slowing economic growth moving forward.

But…when it comes to the market’s rotation into defensive assets, we continue to be perplexed by the relatively poor performance that REITs have posted thus far during 2022 (the real estate sector is down 12.63% on a year-to-date basis).

We understand that certain areas of REITdom are economically sensitive and therefore, we’re not calling for a blanket rally in the sector.

But, as far as reliable cash flows, and therefore safe and sustainably increasing passive income goes, we continue to view the net lease sub-sector of REITdom as very attractive.

The blue-chip net lease stocks appear to be in a classic “babies thrown out with the bath water” situation.

Generally speaking, these companies have performed well throughout a wide variety of economic situations in the past. They’ve proven their abilities to grow cash flows and raise dividends, even in rising rate environments.

And, over the long-term, the top performers in this segment of the real estate sector have posted total returns and reliable passive income growth that exceeds that of the consumer staples and utility sectors.

With all of that being said, today, we wanted to take the time to focus on a net lease REIT, which is likely the most defensive of the entire sub-sector (with regard to its portfolio composition and its focus on investment grade tenants): Agree Realty (ADC).

We published a deep dive article highlighting ADC’s Q3 performance back in November of 2021, so if you’re looking for a detailed overview of the company’s operations, please check out that report.

In general, we think it’s worth re-hashing the fact that ADC has been a top performer in the past, having posted strong double annualized digit total returns since its IPO in 1994 and reliable mid-single digit dividend growth over the last decade.

As you can see on the graphic below, ADC’s portfolio is comprised of tenants from largely defensive industries. Less than 4% of ADC’s portfolio is made up of some of the more worrisome industries within their portfolio, such as the experiential gyms or theaters, which vastly underperformed in recent years.

ADC has clearly prioritized the most defensive cash flows, with large exposure to grocery stores, home improvement retailers, convenience stores, auto parts and service centers, and pharmacies…all segments of the retail space that should continue to perform even during an economic downturn.

Agree Realty posted industry leading rent collection throughout the 2020 pandemic, making a name for itself as one of the high-quality net lease REITs in the entire world, due to its disciplined focus on investment grade tenants.

The company noted in its year-end investor presentation that it has collected at least 99% of its rent payments during each of the last 18 months.

As you can see below, at the end of 2021, 67% of its portfolio was made up of investment grade tenants (and frankly, when looking at its tenants that don’t carry credit ratings, it’s clear to us that this percentage would be even higher if they did because several of the companies in the un-rated category are some of the most sought-after tenants in the net lease segment).

And lastly, in terms of very reliable and predictable cash flows over the long-term, we’d be remiss not to mention that ADC offers investors unique exposure to ground leases (this is something that sets this company apart from its peers in the net lease space).

Once again, you’ll see a strict focus on investment grade tenants within ADC’s ground lease portfolio.

While we associate ADC with defensive holdings, that doesn’t mean that this is a slow growth company…

Agree management has been quite aggressive on the investment/acquisition front in recent years.

As you can see below, the company’s strong operational performance, investment grade rated balance sheet, and relatively low cost of capital has allowed ADC to put a lot of capital to work during the last couple of years.

We believe that by taking advantage of record low interest rates (record low rates mean that even when prioritizing investment grade tenants, which generally have the upper hand at the negotiating table, Agree has been able to lock in attractive lease spreads) ADC has set itself up for nice growth over the medium-to-long-term with these moves.

And, looking ahead, that growth is expected to remain in place. In early January, ADC raised its 2022 investment guidance range to the $1.1b-$1.3 billion figure shown above (up from previous guidance of $0.8b-$1.0b).

When increasing investment guidance, Agree’s CEO, Joey Agree said,

“​Our recent capital markets activities have bolstered our fortress-like balance sheet, providing us with substantial liquidity to execute on our robust investment pipeline.”

In more recent news, we’ve also seen ADC invest in a new 50,000 sq ft. building which will serve as the company’s new headquarters. This new Agree campus will include

“Additional training and development space, health and wellness facilities, and collaborative meeting areas aligned with the Company’s ADC University and ADC Wellness initiatives.”

In short, it’s clear that ADC is bullish on its future prospects and is investing in its own growth.

When asked, “What are they gonna do with 1,000 sq/ft per employee?” on the Seeking Alpha headline highlighting the new headquarters announcement, Joey Agree chimed in, highlighting his plans for future expansion and growth, saying:

And, with these continued growth prospects in mind, we wanted to highlight ADC’s recent sell-off, which we believe to be irrational, based upon both current fundamentals and future growth expectations.

During the last couple of years, ADC has commanded a premium multiple, which we believe has been largely justified, due to the top-notch rent collection and AFFO growth performance that Agree has produced throughout the COVID-19 pandemic period.

As you can see on the F.A.S.T. Graph below, ADC shares have traded with a 20x+ P/AFFO ratio for the majority of the last several years.

Since the start of 2018, ADC’s average P/AFFO ratio has been 20.7x.

However, during the sell-off that we’ve seen in recent weeks, ADC’s valuation has dipped down below the 18x mark (representing a 14% discount to the recent average).

As you can see on the chart above, we’ve highlighted ADC’s pandemic low valuation, of 17.2x, which has clearly served as strong support for the shares throughout the past 5 years.

We’re not quite down to the 17.2x level yet on a blended basis; however, looking at forward AFFO estimates, we see that ADC is currently trading for just 16.6x 2022 expectations.

Looking at ADC’s expected AFFO growth, you’ll see that the analyst community (which we agree with in this instance) expects to see ADC’s AFFO growth slightly accelerate over the coming years (from the 6-7% range to the 8-9%) range. With that in mind, we see an irrational disconnect between the stock’s recent negative volatility and the underlying fundamentals.

Although ADC’s share price has fallen by 12.25% during 2022 thus far, we remain very bullish on the shares. Instead of focusing on short-term share price volatility, we remain focused on fundamental growth, and ADC appears to have that in spades.

Our “Buy Up To” threshold for Agree Realty is $72.00/share. This means that after its recent double-digit dip, ADC shares offer a margin of safety of 14%.

These are exactly the types of moments in the market that we’re looking to take advantage of. It’s wonderful when an irrational market provides us with the opportunity to accumulate shares of a blue-chip REIT at a discount to fair value.

The combination of ongoing fundamental growth, mean reversion back towards our target multiple area, and the stock’s strong 4%+ dividend yield led us to believe that this defensive holding has the potential to generate annual returns of approximately 20% over the short-term.

Therefore, we’re pleased to maintain a “Buy” rating on this blue-chip REIT.

We see an attractive risk/reward scenario in place here as the stock nears strong fundamental support levels. And, while we can’t predict with an irrational market will do in the short-term, we do feel confident that ADC’s dividend is quite safe (the stock’s forward AFFO payout ratio is just 72%) and therefore, we like the proposition of collecting ADC’s 4.37% dividend yield while we wait for the market to come to its senses.

Now, who AGREES with me?