Agree Realty: What Next?

Agree Realty Investor Presentation

My question for a couple years now has been how Agree Realty would adapt to changes in the capital and real estate markets. They avoided decisions to grow in ways that hurt per-share earnings. But at one point in an earnings call, there was concern that CEO Joey Agree might have to take up golf. More on that below.

Agree Realty specializes in owning top-quality retail properties operated by top-quality retail tenants. One consequence is that most (~2/3) of their tenants are investment-grade, but Joey emphasizes on earnings calls that what they target is quality real estate and quality operators, NOT investment grade as such.

Agree has a lot of positive aspects that I will not discuss at length here. Among them:

• Investing in fungible properties with excellent potential for reuse. They avoid single-use properties that would be expensive to retenant, such as car washes and TopGolf.

• Investing with quality tenants early in their growth and remaining a partner for the long term. Examples in their investor deck include Tractor Supply, Gerber Collision, Sunbelt Rentals and TJX.

• Maintaining a stellar balance sheet with long-term debt at about a third of gross assets.

• Maintaining well-laddered debt maturities. At present these are also distant; the nearest significant maturity is in 2028.

• Strong credit ratings of BBB from S&P and Baa1 from Moody’s.

• Using forward equity offerings, which they pioneered in net lease, to lock in a known cost of that capital.

• Often using ground leases, which simplify the relationship of landlord and tenant.

Agree also develops properties for tenants and supports developers via their Developer Funding Platform. We will not discuss these aspects further here since while they are profitable, they are also small, as you can see in this graphic:

Emphasizing External Growth

Joey followed his father as head of the company, which had been mainly a development company. He started their acquisition platform in 2010. This was optimum timing to emphasize what REITs call “external growth.”

On external growth business models, REITs issue new stock and use the funds (plus leverage-neutral debt) to acquire more properties. When the stock price is high enough (see below), this leads to an increase in per-share earnings.

We can see here that Agree did well at this:

Definitions here are

• NOI is Net Operating Income

• Adjusted CfO is Cash from Operations less changes in working capital

• AFFO is Adjusted Funds From Operations from their SEC filings

AFFO is intended to remove GAAP distortions and give a better picture of actual cash flows from real estate operations. For Agree it comes in near Adjusted CfO. The adjustments used seem reasonable to me.

These curves are based on annual values. The bumps and wiggles sometimes just reflect variations in the cadence between raising funds, investing them, and seeing the results. In 2020 and 2022 the treatment of deferred rent across the pandemic produced the downs and ups of CfO and meant that NOI and AFFO did not reflect actual cash coming in.

Overall what we see is these CAGRs:

Note first that the CAGR for total AFFO is huge, nearly 30%. But that is largely driven by the growth of total shares outstanding, near 22%. That is a lot of increase to generate the modest per-share growth obtained, on which more below.

The CAGR of 5% for NOI/sh is strong performance for a REIT. As I discussed recently, it is NOI/sh growth that limits the possible long-term growth of the dividend.

The per-share AFFO and CfO growth is faster than the growth of NOI for the period shown, as is the growth of the dividend. Agree has been quite proud of reducing their fractional expenditure on G&A costs, This enabled the faster growth of the dividend over this interval.

Also shown here is the ratio of Long-Term Debt to Gross Assets. Typical Net Lease REITs run 40%; Agree has pushed theirs down closer to 30% over recent years. This is more secure and is comparable to what the A-rated multifamily REITs do.

So what we saw until recently was total growth of AFFO/sh and the dividend at near a 6% CAGR. Of this about 1% is a one-time benefit from reducing corporate costs with scale and the rest tracks growth of NOI. Let’s look at where that has come from, which will inform our view of the future.

The Business Model

We seek to understand the components of their growth. Since G&A expenses are already small and interest expenses are locked in until 2028 (their nearest material debt maturity), growth of all the earnings measures is in proportion. Specifically, growth of NOI/sh and of AFFO/sh are in proportion.

Growth from Rent Bumps and Reinvestment

This aspect of growth is addressed by these quotes from CFO Peter Coughenour on the Q3 2023 earnings call:

… rent bumps in the portfolio, which should drive about 1% of growth next year. We typically see about 1% of growth from internal lease escalators in the portfolio.

… we have free cash flow, which is approaching $100 million annually that we can use either to pay down amounts outstanding on the line or reinvest those proceeds. And so those are the primary drivers of the 3% plus growth in AFFO per share next year.

In any year, including 2024, Agree has NOI (and AFFO) growth thanks to investments from the prior year. Here let’s look forward.

As to reinvesting that $100M, Agree can add leverage-neutral debt to have $150M to invest. At current cap rates near 8%, that will boost NOI by about 2.6%.

If you allow for the 50 bps of credit losses cited by Coughenour in that same call, then with the rent bumps you would net 3.1% growth of NOI/sh and AFFO/sh. Left out of that is the reinvestment of dispositions, which also generates small tens of bps of growth.

There are a few things to say about this growth. It is not negligible, it is comparable to likely long-term inflation, and it would support dividend increases at that level. In addition, it is smaller than what other Net-Lease REITs with larger escalators achieve, at least before one allows for increasing interest expenses.

Joey has spoken at some length when we chatted about why his properties are better and likely to retain more value. I’m sure he also would argue that his properties carry less risk and I tend to agree.

Joey particularly likes “fungible boxes.” A distant example is the K-Mart his dad built up here in Gaylord Michigan long ago. It was easily repurposed to become a big-box sporting goods store. [The property today is owned by Poets of Gaylord LLC, probably not connected with Agree Realty.]

Stock-Driven Growth

The rest of that historical NOI growth, nearly half, came from issuing stock, pairing it with leverage-neutral debt, and investing the proceeds. Here is how that actually works.

An investment of new equity produces a Return on Equity (ROE) as follows.

• Debt increases the funds available for buying property.

• The purchased property has a cap rate.

• The leverage produces a larger, effective cap rate so that resulting NOI is a larger fraction of the invested equity.

• The AFFO is NOI less the interest expenses and other costs (in this case G&A). One can express AFFO/NOI as a fraction.

• ROE is the leveraged cap rate times the ratio AFFO/NOI.

Here is how that stacks up for Agree for three cases.

In the table, the rows shaded blue show the calculation of the leveraged cap rate. Those shaded pink show the remaining parameters that let one evaluate AFFO/NOI. And the row shaded green shows the resulting ROE.

The first case is numbers that are typical of the 2010s. Interest rates are taken to be 4% and the ROE comes out at 7.1%.

The rightmost column shows numbers for what might not be uncommon today among net-lease REITs, but using Agree’s 33% debt ratio. Cap rates are pushing 8%. Interest rates on a lot of new debt are coming in near 6%. The resulting ROE looks like 7.7%

But Agree has done better than that. Recently placed debt, after the impact of some (inexpensive) credit swaps, has come in with an effective interest rate of 4.52%. This, with their achieved cap rate of 7.7%, produces a ROE of 8.5%. We will see in a moment how impactful this is.

When Agree (or any REIT) sells stock stock to get money for investment, this amounts to selling part of the company and it reduces the immediate per-share earnings. I like to express this impact as an AFFO Yield. Here is the history of AFFO Yield for Agree (numbers from TIKR):

The AFFO yield dropped to below 5% during the ZIRP era. But with the bear market after 2021 it has increased to around 7%, not far from where it was in 2014. If you multiply that yield by the cash raised from issuing, you get the amount of AFFO that is sold to the buyers.

The spread that actually matters for REITs is the spread between the ROE and the AFFO Yield. If the AFFO gained exceeds that lost, the net is a win.

Here is where Agree was smart. You can see above that AFFO yields up near 7% have been common for a year.

But market prices fluctuate. Agree managed during 2023 to issue forward equity at a price near $68, achieving an AFFO Yield of 6.1%.

Joey commented, in the Q3 2023 earning call, about the importance of AFFO Yield: “if you're deploying capital inside of your forward AFFO yield, it's not going to work and it's going to drive no shareholder accretion on an AFFO per share basis.”

Well yes, and what matters is the spread between ROE and the AFFO yield, not something based on some WACC (the math proving this is not hard). Here is how this translates into AFFO/sh growth:

One sees in the rows shaded orange that the spread between ROE and AFFO Yield was above 100 bps in the 2010s. For typical current numbers (rightmost column), it would be down to 60 bps.

But with their recent transactions, Agree pushed this up to about 240 bps (ignoring the cost of the credit swaps). That is pretty remarkable.

The row shaded purple shows the dilution from shares issued. This ran in the high 20s in the 2010s but is only 3.8% this year, based on the forward equity sold in 2023.

The rows shaded blue show the external and internal contributions to growth and (darker blue) the total undiluted growth. Then the row shaded green shows the diluted total increase in AFFO/sh.

The guided growth this year is now 4.2%, and so the calculation shown slightly overestimates it. What is remarkable, though, is that to get the same amount of growth from “typical” interest rates and 8% cap rates would require dilution by 25%.

I personally like the model for the present year better than the massive expansion of the 2010s. There are risks that come with such rapid accumulation of property.

Among them, eventually you would get driven, like Realty Income (O) did, to acquiring huge portfolios. At that point your property quality would drop.

Cap Rates

The cap rates achieved by Agree have long impressed. I asked Joey about this and he emphasized a couple things.

Agree is rarely buying properties offered through brokers. One way and another, they are relying on existing relationships and establishing new ones outside that market.

As an example, they often buy properties with relatively short remaining lease terms or pending loan maturities. One can imagine that many owners of such properties like the income but have little experience at dealing with lease renewals and/or difficulties in absorbing the rate increases likely required to roll debt.

These aspects enable Agree to buy below replacement costs. Joey mentioned that they have been buying boxes used by a well known retailer with 2-4 years of lease term remaining, paying $12 while the construction cost would be $17 (per square foot).

Recent History

Considering their 2010s business model, I was uncertain at the time how Agree would respond to the difficult conditions that began in 2022. The bear market dropped AFFO yields even as the rise in interest rates increased those costs. It is times like these when you find out what a company is really made of.

In the Q1 2023 Joey had quite a bit to say about their path to success:

On earlier calls, I stressed that we would avoid moving up the risk curve or shifting our strategy. We have been very successful leveraging our relationships and core competencies to identify extremely high-quality opportunities as economic and geopolitical uncertainties remain.

The art of net lease investing is understanding what that residual real estate is and what the demand for that is. … Our long-term vision, that of a full-service real estate focused net lease retail REIT and not simply a spread investor has accelerated due to the capital-constrained environment and our team's hard work across multiple fronts.

In the Q2 2023 earnings call Joey responded to a question as follows:

we're going to stick to our sandbox, and that's the 30 to 35 best retailers in the country. We are seeing disruption amongst merchant builders today. … We have a $1 billion revolver and obviously, plenty of access to capital. So no, we're going to stick to the top 30 or 35 retailers. I don't think it makes any sense to go up the risk curve today to achieve or obtain a few extra basis points.

To me, this position was comforting. The contrast with Realty Income (O) is notable. They went scrambling up the risk curve to find opportunities that “would pencil” for them.

But interest rates kept moving up, cap rates were slow to respond, and by Q3 2023 things seemed pretty uncertain. Agree made their case for 3% AFFO/sh growth while “doing nothing.” And this is Joey’s response to a question about that:

In the unlikely event or I'll tell you most likely impossible event that we're unable to find any [adequate] opportunities across those 3 platforms … [then we will produce] over 3% AFFO growth, delevering or leverage neutral, not investing any capital, not raising any capital, and I start taking golf lessons.

Those golf lessons came up another time or two in that call. But when I asked him a bit later how his golf lessons were going, Joey was adamant that he would NOT be taking up golf.

Instead what happened was what we saw above. The Agree team achieved outstanding results with both forward equity and new debt, enabling them to push up AFFO/sh growth this year by more than a third. I strongly approve of this outcome.

Leaving out one-time gains, the reproducible growth rate across the past 10 years was only 5%. I’d rather have 4.2% AFFO/sh growth with a 4% CAGR of gross assets than 5% with a 27% CAGR. But Joey still seems focused on getting bigger fast, when the markets permit.

Takeaways

The past couple of years seem to me to demonstrate a couple things:

1. Agree is focused taking only actions that are accretive to shareholder value.

2. Simultaneously Agree is committed to maintaining property quality

3. Agree will be clever and aggressive in enabling investments that do that.

What Joey seems to expect is that cap rates and interest rates will adjust to more steadily enable Agree to use their 2010s external growth methods. Joey is a young guy; he almost can’t expect anything else.

That said, there is no guarantee that there will be a return to business as was normal in the 2010s. The market historically has had long periods where price-to-earnings ratios were 2x or more lower than they are now.

For ADC, P/AFFO could end up at 10x or less instead of the 17x Joey sees as normal. If that happens, cap rates might or might not increase enough to make 2010s-type external growth workable.

But the internal growth described above will still be feasible. The rate could be increased with a lower payout ratio and larger rent escalators (likely if we have sustained inflationary times.)

The risk for REITs is whether or not their managements will perceive whatever reality turns out to be and adapt in a way that sustains good shareholder outcomes, or at least avoids bad ones. The past three years have convinced me that Agree management is very likely to make good decisions for shareholders.

Alas, for me personally the dividend yield remains below my threshold. But not by a whole lot. As relative yields change over time, which happens, I may end up in a favorable position to move some money into ADC. If so, I will do it.