During the Great Recession, most major commercial real estate asset classes were hammered by exposure to a variety of economic conditions such as high unemployment and poor underwriting fundamentals. The assets with shorter lease terms and non-credit tenants were hit even harder with higher vacancy rates and a higher percentage of troubled and distressed loans.
The risk characteristics for a leased asset is directly correlated to the lease contract - that is, does the rental agreement create sustainable revenue for wealth creation? In order to achieve the highest return on investment, most major asset classes require a professional manager to assist with collecting rents, maintenance, and marketing, which eats away a substantial portion of profits. The asset classes with the most extensive management are sometimes referred to as the 3 T's - toilets, trash, and taxes - which keep all landlords awake at night.
One asset class that provides the least risk and management responsibility is the Single Tenant Net Leased category, referred to as STNL. Unlike other asset types, the STNL investor can Sleep Well At Night, thus this low-risk & pain-free investment strategy was coined "SWAN" (as an acronym). The SWAN strategy could be represented by the following formula:
Credit - STNL tenants lease prototypical facilities in order to gain a competitive advantage in the marketplace. For example, the top drug store chains are located on primary intersections with traffic counts adequate for the tenant's business model. Many tenants utilize off-balance sheet lease structures in order to leverage the company's balance sheet with minimum corporate cash invested.
Some retailers guarantee rental payments by a parent company that has an investment grade credit rating of BBB- or better according to Standard & Poor's or Baa3 or better according to Moody's. Below is a partial list of STNL companies with investment grade credit ratings:
Clearly, a company's balance sheet and credit rating are an important component to the SWAN strategy; however, there are two other important legs to the investment stool. In order to balance the strategy, the investor should also consider the lease structures.
Lease Term - Most STNL Retail leases are between 10 and 25 years. As a comparison, hotels typically lease by the day. Mini-Storage rents by the month and Apartments rent by the year. With a long term lease in hand, STNL investors spend considerably less time managing and marketing than owners of other asset classes.
Rental Increases - Most STNL assets have rental increases during the base lease term; however, many of the other asset classes have rental increases that are determined by current market conditions. For example, hotel, multi-family, and mini-storage rents are determined by a variety of factors, including supply & demand.
Many of these operators have had to decrease rents in order to stabilize occupancy rates and to meet debt service and operating expense requirements. On the other hand, most STNL assets provide for fixed rental increases and some include percentage of sales and CPI multipliers. Having growth and income incorporated into a sustainable revenue stream makes the STNL asset class very appealing for many investors.
Sleeping Well at Night with Triple Net REITs
The SWAN investor is seeking a fundamentally safe investment strategy where principal preservation and sustainable income (and growth) are a must. That's why I have a REIT portfolio in my newsletter called the "SWAN" portfolio.
Essentially, this SWAN investor is seeking a bond-type investment in a real estate wrapper. While you can invest in Walgreen's (WAG) stock paying around 1.7%, alternatively, you can acquire an STNL property leased to Walgreen's (with more security than the stock) and achieve an unleveraged return of approximately 6.0% to 6.5%.
Most Walgreen leases are 25 years (excluding options) with minimal to no management responsibilities - making this type of investment comparable to a bond. Of course, the credit profile and lease term of each tenant is directly related to the return, so an investor should consult with a professional advisor to determine investment portfolio strategies.
Superior risk-adjusted returns drove investors to well-tenanted net lease assets during the Great Recession. As the economic outlook and real estate markets have strengthened, the demand has remained robust even in the face of the Federal Reserves announcement in May 2013 that it would taper its quantitative easing measures.
In addition, large sale-leaseback transactions have headlined the triple net market in the end of 2013 and first half of 2014. Other institutional investors have increased their exposure to net lease assets as well, seeking higher yields than fixed income securities with a similar risk profile.
The Triple Net REIT sector is exploding as evidenced by the number of non-listed and publicly-listed entrants including American Realty Capital Properties (ARCP), Chambers Street Group (NYSE:CSG), and even Annaly Capital Management (NYSE:NLY), a mortgage REIT, is now invested in the space.
The most appealing attribute for most Triple Net REIT investors is the high dividend yield and, as illustrated below, the range of opportunities is most compelling with the average yield of the peer group (below) of 5.73%. (Note: That number should be lower but is skewed by ARCP and GOV's risk-adjusted dividend yield).
In regards to valuation, the Triple Net REITs are now trading at fair value - with a peer Price to Funds from Operations (P/FFO) average of 14.5x. There are several REITs trading at attractive value levels including Lexington Realty (NYSE:LXP) and Chambers Street. In addition, Realty Income (NYSE:O) and American Realty Capital Properties are considered attractive, based on risk-adjusted pricing metrics.
In my newsletter this month I plan to provide the best Net Lease bargain in a new column I call "The Thrift Shop". I'll give you a hint, one of these REITs in on that list.
Interview with a Leading Net Lease Investor
Already one of the largest and fastest-growing net-lease REITs in the United States, S|T|O|R|E Capital was co-founded in 2011 by six executives who worked together in various capacities at other organizations. Morton Fleischer, Christopher Volk, Catherine Long, Mary Fedewa, Michael Bennett and Michael Zieg pooled their collective investment, accounting, legal and real estate experience to form Scottsdale, Ariz.-based S|T|O|R|E Capital.
Having supplied more than $11 billion in real estate mortgage and lease solutions to customers across the U.S., S|T|O|R|E Capital's senior leadership team has been investing in single tenant real estate for over three decades. Fleischer was the first to introduce capital, by way of sale-leaseback transactions, to the rapidly growing chain restaurant industry in the 1980s.
Several executives completed the largest U.S. real estate limited partnership rollup taken public on the New York Stock Exchange in 1994. Subsequently, they formed and took public Spirit Finance Corporation (NYSE:SRC), where they created the country's first investment-grade real estate debt program designed to finance net lease investments, and guided the company in completing the largest reported U.S. sale-leaseback transaction of its time.
Chris Volk co-founded STORE Capital in May 2011 and currently serves as the company's President and Chief Executive Officer. In August 2003, he co-founded Spirit Finance Corporation and led the company as its CEO, President and Board member until February 2010.
Prior to that, Volk served more than 16 years in numerous capacities with Franchise Finance Corporation of America and its successor, GE Franchise Finance, including as President and Chief Operating Officer and a member of FFCA's Board of Directors. FFCA was a real estate investment trust that owned or financed more than 5,000 single-tenant properties at the time of its sale to GE Capital Corporation.
Volk continued as Chief Operating Officer with GE Franchise Finance until December 2002. Volk received his Bachelor of Arts degree from Washington and Lee University in Lexington, Va., and his Master in Business Administration degree from Georgia State University.
Recently I sat down with Volk to discuss the "state of the Net Lease industry". You can visit STORE's website HERE.
Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended.
Disclosure: The author is long O, DLR, VTR, HTA, STAG, UMH, CSG, GPT, ARCP, ROIC, HCN, OHI, LXP, KIM, WPC, DOC, UDF, EXR. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.