NNN

Business Context and Reporting Period

Company: National Retail Properties, Inc. (NNN REIT, Inc.)
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: June 30, 2008
Business Overview: NNN is a fully integrated REIT owning and managing single-tenant retail properties leased primarily under long-term net leases. Operations are divided into two segments: Investment Assets (operating portfolio) and Inventory Assets (development and resale). As of June 30, 2008, the company owned 959 Investment Properties with approximately 98% occupancy.

Key Financial Metrics

Note: Q2 2007 Net Earnings were significantly higher due to discontinued operations gains ($27.9M vs $5.1M in Q2 2008).

Material Changes vs. Prior Period

• Revenue Growth: Revenues from continuing operations increased 26.7% in Q2 2008 and 32.0% for the six months ended June 30, 2008, compared to the prior year. This is primarily driven by the acquisition of 61 Investment Properties ($253.8M invested) in the first half of 2008.
• Net Earnings Decline: Net earnings decreased significantly year-over-year (Q2: -36.5%; 6 Months: -15.1%). The decline is largely attributable to a reduction in gains from discontinued operations (property sales) rather than a deterioration in core operating performance.
• Expense Increases: Operating expenses rose 24.1% in Q2 2008, driven by a 43.8% increase in depreciation and amortization due to new acquisitions. Interest expense increased 17.9% in Q2 2008 due to new debt issuances, partially offset by lower rates on the credit facility.
• Debt Restructuring: The company issued $234M in 5.125% Convertible Senior Notes in early 2008 and repaid $100M in 7.125% notes and a $12M secured note. Total debt increased from $1.06B (Dec 2007) to $1.18B (June 2008).

Guidance, Outlook, Risks, and Unusual Items

• Unusual Items:
  • Discontinued Operations: Significant earnings volatility is driven by the classification of sold properties as discontinued operations. Gains on disposition of Investment Properties were $2.7M in Q2 2008 compared to $22.6M in Q2 2007.
  • Impairment: The company recorded a $758,000 other-than-temporary valuation impairment on commercial mortgage residual interests for the six months ended June 30, 2008.
  • Hedge Loss: A $804,000 loss was recognized on the termination of an interest rate hedge in February 2008.
• Risks and Contingencies:
  • Tenant Bankruptcy: In May 2008, major tenant Uni-Mart, Inc. (leasing 69 Investment Properties) filed for Chapter 11. In July 2008, Uni-Mart rejected leases for 13 properties ($786k annual rent). The company is marketing these properties but notes no assurance of continued rent payments for remaining leases.
  • Market Risk: Exposure to interest rate fluctuations on variable-rate debt (Credit Facility). A 1% increase in rates would increase interest expense by approximately 2%.
• Outlook: Management anticipates rental income growth will continue to come primarily from additional Investment Property acquisitions. The company maintains a 98% occupancy rate and a weighted average remaining lease term of 13 years.

Investor Verification Checklist

• Discontinued Operations Impact: Verify the extent to which reported Net Earnings are driven by one-time property sales versus recurring rental income.
• Uni-Mart Exposure: Assess the financial impact of the 13 rejected leases and the potential vacancy risk for the remaining 56 Uni-Mart properties.
• Debt Maturity Profile: Review the maturity schedule of the new $234M Convertible Notes (due 2028) and the $400M Credit Facility to understand refinancing risks.
• Commercial Mortgage Residuals: Monitor the valuation of the $22.3M commercial mortgage residual interests, which are subject to market volatility and impairment risks.
• Dividend Coverage: Confirm that Funds From Operations (FFO) continue to support the declared dividend of $0.375 per share (payable August 2008) amidst the decline in net earnings.