Rural Funds Group (ASX: RFF) is my favourite real estate investment trust (REIT) and one of my favourite businesses overall on the ASX.
It's a REIT that focuses purely on agricultural property. It listed in February 2014 and now has a market capitalisation of $395 million. The share price has grown by 153% in that time.
There are a number of reasons why I like Rural Funds so much, here are five of them:
Diversified property portfolio
Rural Funds has a diverse property portfolio, it owns farmland which includes almonds, poultry, vineyards, cattle, macadamias and cotton. Rural Funds only added the cattle, macadamia and cotton properties to its portfolio since the start of 2016.
It also owns 8.96% of Perth's Market City, the central wholesale market and trading hub for Western Australia's fruit and vegetables.
Rural Funds' properties are spread across four different states. This results in good climactic diversification and protects in-case of any particularly troublesome weather that occurs.
Water entitlements
The REIT structure means that Rural Funds benefits from income and capital growth without the operating risk of managing agricultural property. However, it does maintain an appropriate level of water entitlements for tenants.
For example, it has water entitlements for 78,640 megalitres for its almond orchards. Of this figure, management deem 65,974 megalitres as high security. High security is management's assessment of the average annual allocation based on historical data.
Good quality tenants
Rural Funds has a solid list of tenants. Rural Funds Group is operated by Rural Funds Management Limited (RFM) who also operate several of the farms owned by Rural Funds Group. This creates a pleasing relationship between the two.
Some of its almond farms are leased by Select Harvests Limited (ASX: SHV), Australia's largest nut and health food company. Other almond farms are leased by Olam Orchards Australia Pty Ltd, a subsidiary of Olam International Ltd (the second largest almond grower in the world).
The vineyards are leased to Treasury Wine Estates Ltd (ASX: TWE), the world's largest pure-play wine company.
These are just some of the high-quality tenants. All the properties are leased by a listed entity or an entity that is managed by RFM.
Attractive rental contracts
Nearly all of Rural Funds' rental contracts have a built-in annual indexation method. Based on the forecast FY17 revenue, 49% of revenue indexation is CPI or CPI-linked, 7% is CPI-linked with a market review, 11% is a fixed increase at 2.5% and 29% is a 2.5% fixed increase with a market review. The other 4% is mostly plant & equipment leasing which isn't indexed.
Rural Funds has an attractive weighted average lease expiry (WALE) of 13.1 years. This is longer than nearly all other listed REITs.
Growing distribution and reducing payout ratio
Rural Funds has increased its distribution every year since it listed. During FY17 it increased its quarterly distribution by 8%. Management have confidently pencilled in a 4% increase to the FY18 distribution due to its agreed rental indexation contracts.
Rural Funds is trading with a distribution yield of 4.97%. Management are forecasting that it will only pay out 9.64 cents out of its 12.42 cents of adjusted funds from operations, equating to a cash payout ratio of 77.6%. This ratio is fairly low for a REIT and provides a strong position for re-investing back into the business.
Risks
Climate is a big risk for farmland, but I think management have covered this with diversification and water entitlements.
Debt is an important factor for any REIT. Rural Funds has reached a gearing of 40.1% at 31 December 2016 due to its recent acquisitions. It's planning to use the cash it isn't distributing to strengthen its balance sheet. However, with an interest cover ratio of 6.07x and an effective interest rate of 4.16% on its debt, I think Rural Funds is in a comfortable position.
Foolish takeaway
Rural Funds isn't going to be a fast-growing business, but it's been very dependable so far. It could be the perfect addition to any income portfolio looking for a yield greater than 4.5% and it should grow in the long-term. I wouldn't describe the share price of $1.90 as cheap, but it could still be a great entry price for a long-term investor.
