NETSTREIT (NYSE:NTST) is a relatively new REIT that IPO’ed in 2019, but is showing a lot of promise in terms of its growth and strategy. While it might not (yet) be as safe as a Realty Income (O), we think that given its solid strategy and growth potential it deserves its place in many portfolios.

The cornerstone of its strategy is to be as defensive as possible with respect to the tenants and locations it chooses to invest in. In fact its investment-grade percentage remains one of the highest in the net lease space, and its portfolio is largely made up of tenants in defensive industries. Additionally, being a young REIT it does not have any legacy issues with its assets, and was able to buy many of them once the impact of the pandemic was known.

NETSTREIT continues building its portfolio, and CEO Mark Manheimer had this to say during the most recent earnings call:

We acquired 34 properties for $90 million at an initial cash capitalization rate of 6.3% and a weighted average lease term of 8.2 years. In addition, rent has commenced on two development projects that had total cost of $7.6 million and had a weighted average investment yield of 7.6%.

Notice how they managed to secure pretty decent cap rates of 6.3%, and even better for the development projects with average investment yields of 7.6%. Investments like these are what will propel adjusted FFO higher. At the same time, they are seeking to reduce even further their exposure to higher risk categories, including casual dining, banking, and health & fitness. The CEO summarized their defensive strategy quite nicely when he responded to an analyst question:

…I don’t think that our investment criteria has changed really in any way when we formed the company back in 2019. We really wanted to focus on tenancy that’s going to do very well in any economic cycle and certainly what we’re seeing and what we’re predicting here for the next several quarters, is there is going to be some pressure on the consumer?

I think anything discretionary is going to be a little bit more difficult. We went through our entire portfolio and really tried to think through, what’s the most discretionary within our portfolio. Fortunately, we don’t — most of it’s going to be a necessity-based and really defensive types of categories.

Yeah, absolutely. So, we’re always opportunistic when we’re thinking about dispositions. We added a portfolio within this quarter, which included a bank so we’re looking to sell that pretty quickly. We think we can do that pretty accretively and then, casual dining, we’ve gotten it down under 1%. I think that’s probably a healthy area to stick around for us. We did add one location at Chili’s that does over $4 million in sales.

So, we’re a little bit less concerned about that particular location with really low rents. So, each situation is kind of we underwrite to its individual characteristics. But, I think — I would think about casual dining likely to hang around that 1% of our portfolio but really be very selective of what we’re willing to keep in the portfolio and then banks, I think you’ll likely see that eventually get down to zero.

Portfolio

As part of this defensive strategy the company has assembled a portfolio that is 63.9% investment grade tenants, and another 16.7% have an investment grade profile (even if they are not rated). Just as important, 86.6% is defensive retail tenancy, which means it is mostly necessity-based or e-commerce resistant retail. Reflecting this defensive nature of the portfolio, and the fact that it was constructed fairly recently, the company currently has an enviable 100% occupancy.

Growth

NETSTREIT has been building its portfolio at an average rate of ~$110 million per quarter, and by the first quarter of 2022 it has invested almost a billion dollars. Coincidentally, that is currently very close to its market cap.

The company has started to leverage its balance sheet and also has done secondary share sales to finance the next round of acquisitions, which we expect will be accretive to FFO per share, thus providing growth to the company.

It will take some time, however, to see exactly how it all plays out, and the price at which it is able to sell secondary shares will also affect its cost of capital and how accretive the new investments turn out to be.

Underwriting Philosophy

The company has a three part underwriting philosophy where they first evaluate a potential tenant at the corporate level, and for non investment grade tenants NETSTREIT establishes an implied rating. Then they evaluate the particular real estate in question, seeking to maximize the re-leasing potential if it became necessary, where they perform both a location analysis and an alternative use analysis. Finally they analyze the unit-level profitability, and the specific location’s rent coverage (where they look for a minimum of 2.0x) and that the location rank in the top half of the tenant’s store portfolio. They also account for variability in the business model cost structure to make sure the location will not struggle to pay rent.

An interesting note is that Mark Manheimer, the CEO used to work for Realty Income as Director of Underwriting, where he probably learned a lot about their underwriting strategies.

Since NETSTREIT is not compromising on quality, what they are doing to get good deals is focusing on smaller transactions that are not highly marketed.

Balance Sheet

The balance sheet is undergoing a leveraging up process, as can be seen by the increasing net total long-term debt.

As the company starts generating earnings from its investments, debt to EBITDA has started to stabilize, and it is currently at a very reasonable 4.9x for this type of REIT.

Valuation

Given that most of the portfolio has been recently acquired price/book can be more telling than for other REITs that have already significantly depreciated their properties. We therefore think that paying close to book value is fair. We’ll wait till shares are below 1.1x book before we consider investing.

Taking a look at FFO per share, as the company has built its portfolio, Funds From Operation have significantly increased. With the FFO per share getting close to $1, and the share price a little above $20, we get a roughly 20x multiple that does not scream cheap, but can be argued as reasonable. Especially since the company keeps investing in an accretive manner and FFO can continue increasing (although we do not expect anything like the growth shown below continuing, since that was at the very beginning of using IPO proceeds to build the portfolio).

Forward EV/EBITDA is around 19x, which again we find reasonable, but it does not scream cheap either. Overall we see the company as fairly valued, and would wait for a pull-back before initiating a position.

Shares are yielding ~3.75%, and this is a relatively safe dividend for a couple of reasons. One, as we saw the company is utilizing a very defensive strategy to avoid potential rent loss, and second, the payout ratio last quarter was just under 69%.

Conclusion

NETSTREIT learned the lesson of the importance of a defensive strategy when building a commercial real estate portfolio by watching many REITs struggle with rent collections during the pandemic. As it entered the public markets, it defined its strategy to be incredibly defensive to avoid the risk of losing rent. Given that properties with high-quality tenants are expensive, NETSTREIT is focusing on smaller less marketed transactions to be able to still obtain attractive cap rates. Overall, we like the strategy and think this REIT has a promising future. The valuation is currently reasonable, but we will be waiting for a pullback before we consider initiating a position.