REIT Rankings: Triple Net Lease

| About: Realty Income (O)


Net Lease REITs have been the hardest-hit REIT sector from rising interest rates. The Net Lease Index is down 25% since reaching record highs in late August.

Net Lease REITs are the most bond-like REIT sector: a function of their long lease terms, relatively slow growth, and highly predicable income streams usually linked to inflation.

The election introduced uncertainty, but the sector has held up well during the post-election surge in interest rates. A possible repeal of the 1031 Exchange could hurt near-term values.

After trading at elevated valuations for the past year, net lease REITs now appear attractive across most valuation metrics. The selloff appears overdone considering the healthy fundamentals of the sector.

We provide an overview of the Net Lease REIT sector and analyze recent developments over the past quarter.

REIT Rankings Overview

In our "REIT Rankings" series, we introduce readers to one of the thirteen REIT sectors. We rank REITs within the sectors based on both common and unique valuation metrics, presenting investors with numerous options that fit their own investing style and risk/return objectives. We update these rankings every quarter with new developments for existing readers.

We encourage readers to follow our Seeking Alpha page (click "Follow" at the top) to continue to stay up to date on our REIT rankings, weekly recaps, and analysis on the REIT and broader real estate sector.

Net Lease Sector Overview

Net lease REITs comprise roughly 7% of the REIT Index (NYSEARCA:IYR). Within our market value-weighted net lease index, we track the six largest REITs within the sector, which account for nearly $55 billion in market value and 16,000 total properties: National Retail (NYSE:NNN), Realty Income (NYSE:O), Spirit Realty (NYSE:SRC), Store Capital (NYSE:STOR), VEREIT (NYSE:VER), and W.P. Carey (NYSE:WPC).

Click to enlarge

Net lease REITs generally rent properties with long-term leases (10-25 years) to high credit-quality tenants, usually in the retail and restaurant spaces. "Net lease" refers to the triple-net lease structure, whereby tenants pay all expenses related to property management: property taxes, insurance, and maintenance. Like a ground lease, triple-net leases result in long term, relatively predicable income streams.

Average remaining durations of net lease REITs range from 10-15 years, and most leases have contractual rent bumps, often tied to the CPI Index. By the nature of the portfolio, compared to other REITs, net lease REITs typically function more like a financing company rather than an operating company. These companies hold the long-term, capital-intensive real estate assets that other companies prefer not to hold on their balance sheets. Assets are typically acquired in sale-leaseback-type transactions through existing relationships.

As we'll see, net lease REITs are quintessential bond alternatives and thus highly sensitive to interest rates, and less sensitive to fluctuations in economic growth expectations. In many ways, these companies can be viewed as an inflation-hedged, long-term corporate bond that has additional elements relating to leverage and potential for external growth.

Recent Developments and Performance

Net lease REITs have declined 17% over the past 13-week quarter and are down 25% from their recent highs. Despite the recent struggle, the sector is still up 6% over the past year on a price-basis, and up 11% on a total return-basis.

Click to enlarge

Net lease REITs are among the most interest-rate-sensitive REIT sectors, and nearly all the stock performance over the past several years is attributable to movements in treasury yields. Below we chart the net lease index with the medium-term treasury bond ETF (NYSEARCA:IEF) to show just how closely the two are correlated. The Net Lease Index peaked just after yields bottomed in late-July. Also of note is the price-action since the election. Yields have continued to surge higher (indicated by the falling price of the medium-term treasury ETF) but net lease REITs have actually increased, a sharp reversal of recent correlations.

Click to enlarge

The sharp reversal in correlations since the election may be concerning. If net lease REITs "catch-up" to the treasury price benchmark that they have closely mirrored, it would imply 15% more downside. We think this concern is unwarranted, as it ignores the true investment properties of these companies, namely the inflation-hedging qualities. By our estimates, more than two-thirds of leases from these six REITs are linked to inflation.

To the extent that rising interest rates are a result of rising inflation expectations and not higher "real" interest rates (which reflect the true cost of borrowing), net lease REITs should not be negatively impacted. In fact, these REITs could see increased attention from fixed income investors seeking inflation-hedged alternatives.

Click to enlarge

Over the past two years, price action in net lease REITs has been entirely dominated by interest rates and macroeconomic fluctuations, which has made fundamental analysis rather fruitless. This may change if, in fact, we are entering a new regime of lower correlations. That would be a positive change considering the strong operating fundamentals currently exhibited by the sector.

Q3 earnings were generally quite good. Of the six net lease REITs, 3 beat expectations, 2 met, and 1 missed. WPC, VER, and STOR beat, SRC and O met, while NNN missed expectations. For all six, 2016 and 2017 guidance was generally as expected. Average occupancy exceeds 98% and same-store rent growth continues to be healthy.

Despite the recent decline, these REITs still trade at premiums to Net Asset Values, which means that external growth- the fuel that has powered the relentless dividend growth for many years- will continue to be accretive. The cost of capital advantage of these REITs has been driven by solid balance sheets resulting from low leverage and disciplined portfolio management. While moderate NAV premiums are good for net lease REITs, these premiums got excessive during the run-up in valuations earlier this year and have returned to appropriate levels.

The election has introduced some uncertainty into the sector. A complete tax-code overhaul aimed at "broadening the base and eliminating loopholes" could catch the 1031 Like-Kind Exchange in its net. The 1031 allows property owners to sell their asset to the REIT in exchange for REIT shares rather than cash, allowing the owner to defer taxes on the sale. 1031 Exchange deals are especially common in the net lease sector, and particularly on smaller transactions. If repealed, acquisition volume could decline and valuations could be impaired.

Holistically, if Trump's policies do indeed promote faster economic growth, these net lease REITs would certainly benefit from the better credit quality of their tenants, but on a relative basis, the sector would likely underperform. With occupancy near 100% and tenant credit quality already quite good, there is little to gain from a more robust economy compared to other more economic-sensitive REIT sectors.

Below is our REIT Heat Map, showing the quarterly performance in relation to other sectors. Net lease REITs have declined 17% over the prior 13-week quarter. We highlight the weakness of treasury notes, as well as investment grade bonds, which explain much of the sector's performance.

Click to enlarge

Valuation of Net Lease REITs

Compared to the twelve other REIT sectors, net lease REITs appear attractively valued, but slightly less so when growth expectations are factored into the metrics.

Net lease REITs are the third cheapest sector based on current Free Cash Flows and the second cheapest sector based on forward 2017 FCF. At 16x current and 15x forward AFFO, net lease REITs are trading at discounts to the sector average of roughly 22x and 20x, respectively. The net lease sector has gotten cheaper since our last update when the sector traded at 19x current and 18x forward FCF. Click to enlarge

(Hoya Capital Real Estate estimates, Company Filings)

When we factor in two-year growth expectations, the sector appears slightly less attractive. We use a modified PEG ratio, using the forward FCF multiple divided by the expected 2-year growth rate which we call FCFG. Based on FCFG, net lease REITs are the eight cheapest REIT sector. Expected to grow FCF at roughly 5% over the next two years, net lease REITs are among the slowest growing REIT sectors, below the REIT average of 7%.

As we mentioned, for net lease REITs, FCF multiples have added operational significance. As REITs must raise equity capital to fuel growth, equity that can be sold at a premium is cheaper and thus more likely to result in NAV accretion. In that way, equity valuations for REITs have self-reinforcing characteristics. Thus, cheap REITs tend to stay cheap, and expensive REITs tend to stay expensive.

We saw this taken to the extreme earlier this year, seeing many investors in Realty Income (and even the company itself) touting its clearl y extended valuations and steep premium to NAV as justification for buying the stock, as these premiums would fuel accretive external growth. At one point, O traded for a 50% NAV premium by many estimates. Everything in moderation! We see a 10-20% premium as more appropriate and sustainable whereby the company can still fuel external growth and investors can still get their required rate of return.

Click to enlarge

Within the sector, STOR appears to be the most attractive at these valuations given its projected double-digit growth over the next two years. O and NNN trade at premiums to the sector averages, but have healthy mid-single-digit growth expectations over the next two years and have the highest quality portfolios. VER, SRC, and WPC trade at the cheapest valuations, but this is largely a result of the higher than average leverage and the associated cost of capital disadvantages of this strategy. That being said, executives at these three REITs have prioritized balance sheet improvement.

Dividend Yield and Payout Ratio

Based on dividend yield, net lease REITs rank second only to healthcare REITs, paying out an average yield of 5.3%. Net lease REITs payout roughly 84% of their available cash flow, the fifth highest payout sector, but leaving enough wiggle-room for increased dividend distribution and external growth.

Click to enlarge

In a similar pattern to the FCF valuations, there are two tiers within the sector. The higher quality (lower leverage) names NNN, O, and STOR pay lower dividend yields while the lower quality names pay higher yields. O pays out 87% of FCF towards dividends, which may limit future dividend growth, whereby STOR, another high-quality name, pays out just 72%.

Click to enlarge

Sensitivities to Equities and Interest Rates

Net lease investors are all too familiar with interest rate sensitivity. Followers of our research know that we put a lot of emphasis on factor analysis, specifically looking at how REITs have historically responded to changes in the broader equities market, interest rates, and to movements in the REIT index itself. We believe it is critical that investors understand how their investments will respond in different economic environments.

Using our Beta calculations, we show that net lease REITs are the second most interest-rate-sensitive sector and the least sensitive to broader equity market movements. High interest rate sensitivity is a result of longer than average lease terms and high dividend yields.

Since our last update, the yield sensitivity of the sector has increased slightly from 1.18 to 1.23. As we mentioned, though, the interest rate correlations have broken down since the election and even reversed in some cases. That said, we don't think correlations are gone for good. Rather, we expect the high degree of sensitivity to resume after a period of re-pricing driven by heighted inflation expectations.

For more detail on these calculations, we highlighted the dynamics of bond-like and equity-like REITs in our previous articles,"Are REITs Bond Substitutes" and"REITs Without Interest Rate Risk."

Click to enlarge

Within the sector, NNN, O and SRC are all in the top-5 most interest-rate-sensitive REITs in any sector. Click to enlarge

Interestingly, VER and WPC stand out for their lack of strong interest rate sensitivity. WPC trades far more like an equity-like REIT than a bond-like REIT, due in large part to its significant foreign exposure.

We highlighted in a previous article that investors can effectively hedge the interest rate sensitivity of their REIT portfolio by investing in international real estate. Click to read:"International Real Estate: REIT Investors Can Avoid 'Home Country Bias." We see this effect quite clearly in the case of WPC.

Bottom Line

Without question, the past quarter has been painful for net lease investors. A 25% decline from record highs was rather predicable in hindsight given the extended valuations in the face of record low Treasury yields, and it was an important reality check for many of us.

Most notably, it reminded investors that being "right" about fundamentals doesn't necessarily mean that good performance will follow over the near-term. Net lease REITs continue to be leading real estate operators and have shown admirable discipline in balance sheet and portfolio management. At 98% occupancy, the sector is healthier than ever and balance sheets are well equipped to handle rising interest rates.

The correction also taught a lesson about NAV premiums: everything in moderation. During the peak in August, there was a bubble-sentiment in the sector. It was common to see investors and REITs citing extended valuations as a justification for continued price appreciation as, in theory, the premium fueled external growth. While it is true that a NAV premium is a signal that the REIT commands a cost of capital advantage, a moderate premium is just as adequate for acquisitions to be accretive. 50%+ NAV premiums simply were not justified.

The election appears to have ushered in a new interest-rate-correlation regime, at least in the near-term. Net lease REITs have held up well in the face of the post-election surge in rates, as much of the surge has been a result of higher inflation expectations rather than increased real cost of borrowing.

Click to enlarge

10-Year yields have risen roughly 100 basis points off the mid-summer lows, while TIPS yields have risen just 40 basis points, a reflection that rising rates are largely attributable to rising inflation expectations. To the extent that this continues, net lease REITs should be protected to some degree and expected to trade more like TIPS than nominal bonds, as most cash flows are inflation-protected.

Please add your comments if you have additional insight or opinions. Again, we encourage readers to follow our Seeking Alpha page (click "Follow" at the top) to continue to stay up to date on our REIT rankings, weekly recaps, and analysis on the REIT and broader real estate sector.

Disclosure: I am/we are long STOR, SRC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: All of our research is for educational purpose only, always provided free of charge exclusively on Seeking Alpha. Recommendations and commentary are purely theoretical and not intended as investment advice. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. For investment advice, consult your financial advisor.