Net Lease REITs Are Too Cheap, And That's A Problem

Feb. 28, 2018 5:45 AM ETO, VNQ, WPC, STOR, NNN, IYR, SRC, RQI, SCHH, RNP, RFI, KBWY, DRN, NRO, URE, ICF, XLRE, JRS, RWR, SRS, FREL, DRA, DRV, SEVN, LRET, REK, RIT, FRI, PSR, USRT, WREI, IARAX, RORE57 Comments

Summary

  • Net Lease REITs have been crushed by rising interest rates. Since interest rates bottomed in 2016, the sector has dipped more than 30%. Valuations are the cheapest of this recovery.
  • Low valuations, however, can become a problem for the business model. Net Lease REITs have historically relied on equity issued at a NAV premium to accretively fuel their acquisition pipeline.
  • The positive feedback loop that fueled the stellar performance of these REITs over the past decade may be reversing. Without the external growth pipeline, these REITs become even more bond-like.
  • Several net lease REITs are better-positioned to weather the storm if interest rates and inflation continue to rise in 2018. We favor the REITs that utilize CPI inflation-linked rent escalators.
  • Despite the headwinds from interest rates, the selloff appears overdone as there are also strong tailwinds associated with a stronger economy, tax reform, and temporary dislocations in the private market.

REIT Rankings: Net Lease

In our REIT Rankings series, we analyze one of the 15 real estate 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.

net lease REIT Rankings

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Net Lease Sector Overview

Net Lease REITs comprise roughly 6% of the REIT Indexes (VNQ and IYR). Within our Hoya Capital Net Lease Index, we track the six largest REITs within the sector, which account for roughly $40 billion in market value: National Retail (NNN), Realty Income (O), Spirit Realty (SRC), Store Capital (STOR), VEREIT (VER), and W.P. Carey (WPC).

net lease sector overview

Above we show the size, geographical focus, leverage, and quality focus of the six net lease REITs. Note that the "quality focus" is based on the credit quality of the tenants. High-quality tenants tend to be larger, more established companies with investment-grade credit ratings. Realty Income has the highest percentage of investment-grade tenants followed by National Retail. Spirit Realty and STORE Capital focus on non-investment grade tenants and thus acquire properties at higher cap rates.

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 predictable income streams. Similar to a bank, net lease REITs essentially capture the "spread" between the acquisition cap rate and their cost of capital. As we'll discuss throughout this report, changes in the cost of capital (higher interest

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