Net Lease REITs: Revival Amid Rate Retreat
Summary
- Net Lease REITs, among the most interest-rate-sensitive real estate sectors, were left for dead in early 2018 as interest rates surged and NAV premiums eroded, seemingly stifling external growth plans.
- Signs of slowing global growth, along with retreating commodity prices, have put downward pressure on inflation and interest rates in recent months. Net lease REITs have surged 15% since May.
- “Goldilocks” economic conditions- low interest rates along with solid, but unspectacular growth- are ideal for these REITs. The recent share price surge has restored their coveted cost of capital advantage.
- 3Q18 earnings were strong across the sector. Spirit and Vereit appear to have put their troubles behind them. Realty Income, National Retail, and STORE continue to power ahead.
- Net lease REITs are among the only sectors still growing via acquisitions, on pace for nearly $5B in net acquisitions in 2018, more than the entire REIT sector combined.
REIT Rankings: Net Lease
In our REIT Rankings series, we analyze each of the commercial and residential 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.
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Net Lease Sector Overview
Net Lease REITs comprise roughly 7% of the REIT Indexes (VNQ and IYR). Within our Hoya Capital Net Lease Index, we track the seven largest REITs within the sector, which account for roughly $55 billion in market value: National Retail (NNN), Realty Income (O), Spirit Realty (SRC), STORE Capital (STOR), Vereit (VER), EPR Properties (EPR), and W.P. Carey (WPC).
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. Most leases have contractual rent bumps, often tied to the CPI index, but some REITs take on more inflation risk than others. Like a ground lease, triple-net leases result in long-term, relatively predictable income streams. These companies hold the long-term, capital-intensive real estate assets that other companies prefer not to hold on their balance sheets. Assets are often acquired in sale-leaseback-type transactions through existing relationships, thus avoiding brokerage fees and other transaction-related costs.
Similar to a bank, net lease REITs essentially capture the "spread" between the acquisition cap rate and their cost of capital. Access to capital and cost of capital are the defining competitive advantages of the industry. Historically, the advantages of the REIT structure (liquidity, reliable dividends, ability to diversify, good corporate governance) have allowed these REITs to command favorable costs of equity capital relative to their private market peers. As we'll discuss throughout this report, changes in the cost of capital (higher interest rates and/or declining equity valuations) can have significant ramifications for the underlying business performance.
Above we show the size, geographical focus, leverage, and quality focus of the seven 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 smaller, non-investment grade tenants and thus acquire properties at higher initial yields. We also the credit rating and industry diversification of these seven net lease REITs.
Recent & Long-Term Stock Performance
The competitive advantages inherent in the REIT model are perhaps best illustrated through the long-term performance of the net lease REIT sector. Since the dawn of the Modern REIT Era in 1994, the net lease sector has produced an average annual total return of roughly 14% per year, which is nearly 200 bps higher than the REIT average.
Net lease REITs were crushed by the post-tax-reform surge in interest rates that pushed the 10-Year Yield to it's highest level since 2011. In our February 2018 report, Net Lease REITs Are Too Cheap, And That's A Problem, we discussed how the 25% plunge across the net lease REIT sector between December 2017 and February 2018 had the potential to be self-reinforcing.
Fears of surging inflation and higher "real" rates, however, have subsided in recent months, allowing net lease REITs to regain their footing. The sector is now among the best-performing REIT sectors this year, returning 7% on a price-basis and nearly 10% on a total return basis so far in 2018.
Investors continue to be rewarded for spurning the critics and sticking with the “big three” net lease REITs: Realty Income, National Retail, and Store Capital. EPR Properties, bolstered by strong box office performance, has also delivered a nice 2018 following a plunge to start the year. Spirit, Vereit, and WP Carey remain the laggards on the year but showed signs of stabilization over the last two quarters following a brutal 2017.
Recent Fundamental Performance
The net lease REIT sector delivered a strong quarter in 3Q18 as four of the seven REITs beat AFFO estimates and three REITs boosted full-year AFFO estimates. Solid retail performance and a slow-down in the pace of store closings helped to keep occupancy near record-high levels at 98%, flat from last quarter. Despite the lingering issues at Spirit, AFFO per share grew an impressive 6.1% over 3Q17 while dividends grew by 3.5%, on average.
Most surprising, in our view, was the increased pace of acquisition activity in the face of perhaps the most challenging environment for net lease REITs in the past decade. Earlier this year amid plunging valuations and an impaired cost of capital, we applauded the sector for responding to the signals from the capital markets by significantly scaling back their acquisition targets for the year. Highlighting the nimbleness of the sector (or perhaps simple luck), the external spigot has seemingly re-opened just as valuations began to recover in early summer as interest rates and inflation expectations peaked. Third quarter net acquisition volume was the highest since mid-2015.
Net lease REITs have been one of the few REIT sectors in "buy-mode" in 2018, a strategy that appeared ill-fated earlier in the year given the disadvantageous cost of capital conditions. Upward revisions to net acquisitions guidance from National Retail, Realty Income, Store, and WP Carey pushed the full-year pace to $4.3B from these seven REITs alone with several hundred million more coming from the handful of smaller net lease REITs outside of our coverage. The sector is on-pace to acquire nearly $5 billion in net assets in 2018, which would be as much as the rest of the REIT sector combined.
While these past two quarters have been a very encouraging sign that net lease REITs can weather the storm of a temporarily impaired cost of equity capital, these REITs are not out of the woods yet. Net Lease REITs have historically relied on equity issued at a NAV premium to accretively fuel their acquisition pipeline. On average, AFFO per share growth has cooled since peaking in 2014, weighed down by weak performance from Vereit and Spirit. However, it appears that fundamentals bottomed in 2017 with AFFO/share growing at below 3%. The sector is expected to see 3-5% growth in AFFO/share in 2018, a solid upward inflection from 2017.
While the "big three" continue to plow ahead with external growth, Spirit and Vereit have prudently shrunk their respective firms in an effort to regain the critical NAV premium, a strategy that appears to be successful thus far. Investors have applauded the share buyback implementation of Spirit and Vereit and the moderate pace of acquisition activity. Overall, over the last year, the sector has expanded their share count by roughly 3%.
While we're on the topic of scale and efficiency, we highlight that that these REITs continue to make progress in shrinking their overhead load. With most net lease REITs scaling back acquisition plans, and some being outright sellers of assets, changes in the operational efficiency profile of these REITs have become a focus for analysts. At 6%, the overhead efficiency of these REITs is generally better than the broader real estate average.
Bull And Bear Thesis For Net Lease REITs
Net lease REITs are the most polarizing real estate sector given their exposure to interest rates and retail, two factors that many investors deliberately avoid. 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, assuming more interest rate risk than other real estate sectors. Historically, external growth fueled by a favorable cost of capital has contributed to the sector's significant outperformance relative to other REIT sectors.
Net lease REITs are quintessential bond alternatives and thus highly sensitive to interest rates, and less sensitive to fluctuations in economic growth expectations relative to other REIT sectors. In many ways, these companies can be viewed as an inflation-hedged, long-duration corporate bond that has additional elements relating to leverage and potential for external growth. For most net lease REITs, the underlying "credit" relates to the health of the retail industry. As a result, valuations are sensitive to movements in risk-free yields, credit spreads, and the health of the retail sector.
For the past several quarters, we have discussed our "lower-for-longer" outlook for US interest rates, a function of downward pressures on inflation from productivity gains, energy prices, and moderating housing rents. At the same time, we continue to have a positive outlook on the US retail sector despite the negative headlines and pressures from e-commerce. Given that net lease REITs thrive in a "Goldilocks" economic environment of low interest rates and steady economic growth, our economic outlook is consistent with net lease REIT outperformance.
Ultimately, absent a significant policy mistake by the Federal Reserve, we believe that inflation expectations are likely to drive the relative performance of net lease REITs over the next several years. Higher inflation expectations, through its impact on long-term interest rates and valuations of net lease REIT equity prices, remain the key risk to valuations.
Net Lease REITs Valuation & Yields
Even after the recent rally, net lease REITs remain one of the "cheapest" REIT sector based on Free Cash Flow (aka AFFO, FAD, CAD). Trading at a 16x FCF multiple, the sector trades at a wide discount to the 20x REIT average. When we factor in the below-average growth expectations, however, net lease REITs look expensive based on FCF/G. Importantly, we estimate that the sector now trades at a 30% premium to NAV, a healthy premium that should allow these REITs to continue to find accretive acquisition spreads.
Based on dividend yield, net lease REITs rank towards the top, paying an average yield of 5.2%. Net lease REITs payout 81% of their available cash flow, which leaves enough cash for acquisition-fueled growth and enough wiggle-room to buy back stock as needed to close a potential valuation dislocation.
Within the sector, we see the yields and payouts of the seven names. The "big three," STORE Capital, Realty Income, and National Retail pay the lowest yields but have the largest buffer for future dividend increases and external growth.
Net lease REITs are the most interest-rate-sensitive sector and one of 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. Net lease REITs are nearly twice as sensitive to movement in the 10-year yield than the broader REIT index.
We separate REITs into three categories: Yield REITs, Growth REITs, and Hybrid REITs.
All seven names in the space are Yield REITs and should be used by investors seeking immediate income and are willing to assume a high degree of interest rate risk. Store Capital, however, is among the more growth-oriented names in an otherwise bond-like sector.
Bottom Line: Net Lease Revival
Net Lease REITs, among the most interest-rate-sensitive real estate sectors, were left for dead in early 2018 as interest rates surged and NAV premiums eroded, effectively stifling external growth plans. Signs of slowing global growth, along with retreating commodity prices, have put downward pressure on inflation and interest rates in recent months. Net lease REITs have surged 15% since May.
“Goldilocks” economic conditions- low interest rates along with solid, but unspectacular growth- are ideal for these REITs. The recent share price surge has restored their coveted cost of capital advantage. Net lease REITs are among the only sectors still growing via acquisitions, on pace for nearly $5B in net acquisitions in 2018, more than the entire REIT sector combined. 3Q18 earnings were strong across the sector. Spirit and Vereit appear to have put their troubles behind them. Realty Income, National Retail, and STORE continue to power ahead.
Given that net lease REITs thrive in a "Goldilocks" economic environment of low interest rates and steady economic growth, our economic outlook is consistent with net lease REIT outperformance. To see where net lease REITs fit into a diversified real estate portfolio, be sure to check out all of our quarterly updates: Data Center, Manufactured Housing, Student Housing, Single-Family Rentals, Apartments, Cell Towers, Manufactured Housing, Malls, Shopping Centers, Hotels, Office, Healthcare, Industrial, Storage, and Homebuilders.
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.
Disclaimer: All of our research is for informational purposes 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.
This article was written by
Alex Pettee is President and Director of Research and ETFs at Hoya Capital. Hoya manages institutional and individual portfolios of publicly traded real estate securities.
Alex leads the investing group Hoya Capital Income Builder. The service features a team of analysts focusing on real income-producing asset classes that offer the opportunity for reliable income, diversification, and inflation hedging. Learn More.
Analyst’s Disclosure: I am/we are long VNQ, 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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