I am always on the lookout for a good quality business that can provide long-term capital growth and income growth. It's a powerful combination that can grow wealth very pleasingly over the years.
One business that I think really fits this description well is Rural Funds Group (ASX: RFF), which is my favourite real estate investment trust (REIT). It owns farmland and leases it out.
Here are four reasons why I like it:
Diversification
One of the best things about Rural Funds is how diversified its farmland portfolio is. It has 38 properties spread across six different agricultural sectors which includes almonds, poultry, cotton, macadamias, cattle and vineyards.
These properties are spread across different states and different climactic conditions, which improves the risk factor. If there's a storm or drought it's a lot less likely to affect many of the farms.
Weighted average lease expiry (WALE)
Rural Funds has one of the longest weighted average lease expiry (WALE) numbers of the whole REIT industry. At the end of 31 December 2017 its WALE was 12.5 years, which provides excellent long-term certainty for shareholders and the REIT.
The tenants are high quality too, with a lot of them being listed entities in Australia or overseas such as Select Harvests Limited (ASX: SHV) and Treasury Wine Estates Ltd (ASX: TWE).
Acquisition & re-investment strategy
Rural Funds has successfully used an acquisition strategy to expand its portfolio since it listed a few years ago. It has spread into more agricultural sectors, this improves the diversification and is accretive for each shareholder.
A key reason why Rural Funds interests me is that it aims for a payout ratio of only 80%, most other REITs pay out a lot more than this. It re-invests the retained money into improving the productivity of its farms so the rental value and capital value increases.
Income growth
Rental indexation is built into all of its contracts with its tenants. The mechanism for the increase is either linked to a 2.5% increase or CPI related.
The indexation, combined with the other positive reasons I've written about above, allows Rural Funds management to confidently target an annual distribution increase by 4% per annum for the foreseeable future.
Risks
Rural Funds does carry a decent amount of debt. Gearing was 37.4% at the end of December 2017. Debt is expected with a REIT, but debt can be crippling if there's too much. Particularly if interest rates are rising. However, the interest rate on its debt is currently only 4.2%.
Interest rate rises will increase the interest expense for Rural Funds and could also lead to the assets being worth less.
I mentioned diversification is a good thing for the spread of farms, but increasing storm numbers and the strength of them could hurt Rural Fund's farm values. However, it's the tenant that has the operational risk.
Foolish takeaway
Rural Funds is currently trading at a 35% premium to the adjusted net tangible assets (NTA) per security at 31 December 2017. This is pretty expensive and I have held off buying more shares recently because of the high premium.
If Rural Funds dropped to $2 or below I'd be interested in buying more (but not definitely), it would boost the current yield of 4.6% to around 5% or more.
