Rural Funds Group (ASX: RFF) is a real estate investment trust (REIT), it's one of my favourite REITs on the ASX.
The share price has done exceptionally well since February 2014, it's up by 196%. Yet I believe it is actually one of the best income stock ideas for the following reasons:
Solid income
The first thing any income investor wants to know about is the current income potential. Rural Funds is trading with a distribution yield of 4.7%.
Management have also pencilled in that the distribution in FY19 will be 10.43 cents per unit, meaning it's trading on a future distribution yield of 4.9%.
Payout ratio
The above yields don't sound that high, but it has to be taken into account with the payout ratio. Some REITs have payout ratios that are 90%, 95% or even higher. Rural Funds only has a payout ratio of around 80% of its net rental income. If it paid out 100% of its rental earnings it would have a FY19 yield of 6.13%.
The 20% that it isn't paying out is being saved for capital improvements for its farms, which will generate more rental income over the long-term.
Growth
Rural Funds has a few different ways it can grow earnings. It can improve the farms, as I just mentioned. It can acquire more farms, which it has been doing regularly since it listed.
My favourite way it grows earnings is the rental indexation built into its contracts. All the contracts are linked to either a 2.5% annual increase or a CPI-related increase. This allows management to confidently predict a long-term growth rate of 4% of the distribution.
If a 4% increase doesn't sound like huge growth, it isn't. This isn't likely to be a 10 bagger over the next decade. However, it offers a starting yield better than the interest rate from the bank and the distribution will increase at a rate faster than inflation.
Farms
The farms Rural Funds owns are spread across different climactic conditions in different states. Rural Funds owns substantial water credits to support its tenants, but it's the tenants themselves that have the operational risk.
It currently has a variety of farm types including cattle, poultry, macadamias, almonds, cotton and vineyards. I like the current mix, but it would be good if Rural Funds also entered other growth farm types such as avocadoes.
Risks
There are a few major risks with Rural Funds. The first near-term risk is that it's trading at a significant premium to its NTA. The adjusted NTA per unit was $1.60 at the end of December 2017, whereas the share price is currently $2.13.
Another risk is that Rural Funds now is quite geared again. Debt is currently manageable with a low interest rate, but interest rates are now rising globally and this could cause earnings to fall due to higher interest charges in time and also make investors less willing to pay such a high premium.
In the longer-term there is a growing buzz around 'lab meat', which could become a problem to the cattle and poultry farms that Rural Funds own. Obviously, this is not an imminent threat but you only have to look at something like solar power to see how quickly production costs can come down when a lot of smart minds and big companies work on it.
Foolish takeaway
Rural Funds is my favourite REIT and one of the best income stocks on the ASX in my opinion. It may not offer the biggest yield, but it's one of the shares most likely to increase its distribution to shareholders each year over the next decade. I'd be happy to consider adding more Rural Funds shares to my portfolio at under $1.90.
