Net Lease REITs: Overvalued, And That's A Good Thing

Jun. 26, 2019 8:00 AM ETADC, EPR, EPRT, GTY, IYR, NETL, NNN, O, SMTA, SRC, STOR, VNQ, WPC, ICF, SCHH, PPTY, KBWY, SRET, ROOF, FRI, FREL, GNL22 Comments43 Likes

Summary

  • It's been "feast or famine" for Net Lease REITs over the past two years. Facing an existential crisis early last year, the Net Lease sector has been rejuvenated in 2019.
  • With an eroded cost of capital - making accretive external growth all but impossible - and inflation rates outpacing internal property-level growth, the outlook looked rather grim last year.
  • The macroeconomic regime has shifted dramatically over the last twelve months. No REIT sector loves the Goldilocks "lower-for-longer" economic environment more than net lease REITs.
  • The net lease sector has been revitalized by lower interest rates, which has boosted equity valuations and re-opened accretive external growth opportunities that should fuel AFFO growth this year.
  • We expect the net lease REIT sector to be the external growth engine of the REIT sector in 2019. Property-level fundamentals have remained steady but retail risks remain.

REIT Rankings: Net Lease

In our REIT Rankings series, we introduce and update readers to 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 for existing readers.

net lease REITs

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Net Lease Sector Overview

Net Lease REITs comprise roughly 7% of the REIT Indexes (VNQ and IYR). Within the Hoya Capital Net Lease Index, we track the seven largest REITs within the sector, which account for roughly $65 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). Small-cap net lease REITs outside of our index include Agree Realty (ADC), Essential Properties (EPRT), Getty Realty (GTY), and Global Net Lease REIT (GNL).

net lease REITs

Investors seeking diversified exposure to the net lease REIT sector can do so through the NETLease Corporate Real Estate ETF (NETL). Net lease REITs generally rent properties to high credit-quality corporate tenants under long-term leases (10-25 years), predominantly in the retail and restaurant industry. "Net lease" refers to the triple-net lease structure, whereby tenants pay all expenses related to property management: property taxes, insurance, and maintenance. Pharmacies, convenience stores, movie theaters, and single-tenant fast-food restaurants are the most common net lease REIT tenants.

net lease restaurants retailLike 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, and deals are generally sourced through existing relationships, often through sale-leaseback transactions. Access to capital and cost of capital are the defining competitive advantages of the industry. Historically, the advantages of the REIT structure (liquidity, scalability, 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.

net lease REITs overview

Investors should note that macroeconomic trends - particularly movements in interest rates- can have a significant impact on underlying business operations through their effects on the cost of equity and debt capital. As investors saw firsthand over the past two years, net lease REITs thrive in a Goldilocks economic environment of low interest rates, low inflation, and slow but steady economic growth and can struggle mightily when interest rates and inflation rise suddenly and significantly. Most leases have contractual rent bumps, often tied to the CPI index, but some REITs - including industry leader Realty Income - take on more inflation risk than others.

Bull And Bear Thesis For Net Lease REITs

Net lease REITs have been among the strongest long-term performers in the REIT sector since the dawn of the Modern REIT era in 1994, a testament to the inherent structural advantages of the Real Estate Investment Trust model compared to private equity that has allowed REITs to efficiently and accretively grow through acquisitions as a result of their ample access to "cheap" equity capital in the public markets. Net Lease REITs were the best-performing real estate sector in 2018 and have outperformed the broader REIT index by more than 2% per year, on average, since the mid-1990s.

At scale, net lease REITs are "insanely efficient" as Chris Volk of Store Capital noted in their most recent earnings call. Due to the triple-net structure with limited capex requirements and G&A overhead, net lease REITs command some of the highest operating margins across the real estate sector. With a restored NAV premium, net lease REITs are poised to be the external growth engines of the REIT sector in 2019, fueling growth through accretive share issuances. Below we outline the five reasons that investors are bullish on the net lease REIT sector.

bullish net lease REITs

Whether fundamentally justified or not, the performance of the net lease REIT sector over the past half-decade has ultimately been driven almost entirely by movements in the 10-Year yield. While company-specific analysis can be helpful to identify relative outperformance within the sector, net lease REITs are ultimately at the mercy of global macroeconomics over the short and medium term. In many ways, these companies can be viewed as a semi-inflation-hedged, long-duration corporate bond that has additional elements relating to leverage and potential for external growth. Net lease REITs were crushed by the post-tax-reform surge in interest rates that pushed the 10-Year Yield to its highest level since 2011. At this time last year, Realty Income was 40% off its record highs in 2016. Since then, long-term interest rates have receded as inflation expectations moderated, sending the Realty Income and much of the rest of the sector to new record highs.

A case could certainly be made, however, that the outperformance of the net lease REIT sector over the past two decades is more a function of a favorable macroeconomic tailwind of ever-lower interest rates than anything else. The sector faced an existential crisis early last year as rising interest rates and higher inflation stymied external growth by eroding these REIT's cost of capital- the key driver of AFFO growth over the past several decades, as accretive acquisitions are responsible for roughly two-thirds of total growth during this time. With only about 50% of total lease escalators linked to CPI, rising inflation threatened to significantly outpace same-store internal growth. Net lease REITs are quintessential bond alternatives and thus highly sensitive to interest rates. Below we outline the five reasons that investors are bearish on the net lease REIT sector.

bearish net lease REITs

Net Lease REIT Fundamentals And Valuations

Our REIT Rankings reports generally discuss valuations and share price performance towards the end of the report, but considering the paramount importance of equity valuations and cost of capital on the underlying business operations of net lease REITs, any analysis of the sector must begin and end with a look at equity valuations. By many measures, net lease REITs are now overvalued, but paradoxically, that's actually a good thing for the underlying business operations. Or at least, it is certainly better than the alternative, as outlined by a short thesis by Spruce Point Capital published last year.

(Spruce Point Capital Management)

Before the rally began around this time last year, net lease REITs were trading at the lowest valuations of the post-recession period, an issue we discussed in Net Lease REITs Are Too Cheap, And That's A Problem. The macroeconomic regime has shifted dramatically over the last twelve months. Since early last year, inflation expectations and interest rates have fallen dramatically, pulling investor capital back into the yield-sensitive segments of the equity markets and restoring the coveted NAV premium - perhaps the best reflection of the cost of equity capital.

net lease REIT valuations

While the Power 3 - Realty Income, National Retail, and Store Capital - have plowed 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 its share count by roughly 11%, boosted by W.P. Carey's share issuance to fund its acquisition of one of its managed funds, Corporate Property Associates 17.

net lease REITs share count

With external acquisitions being responsible for more than two-thirds of total AFFO growth over the past three decades, the ability to utilize equity capital issued at a premium to NAV as "currency" to fund acquisitions is an absolutely critical component of the underlying investment thesis of net lease REITs. Spurred by rejuvenated valuations, the external growth spigot has re-opened over the past twelve months with net lease REITs acquiring nearly $5 billion in net assets, more than the rest of the REIT sector combined.

Looking at valuations through another lens, net lease REITs are now trading at the tightest spread to the 10-Year Treasury Yield of the post-recession period based on implied cap rates. Compared to a five-year average of around 4.0%, investors are demanding less than 3% in yield premium above the 10-Year yield, the lowest spread since 2008, in-part reflecting investor expectations of "lower for longer" for interest rates and inflation as well as expectations of strong external growth prospects of these net lease REITs.

net lease REITs implied yieldFirst quarter earnings results were generally in-line with expectations with all seven REITs maintaining full-year guidance apart from a mild AFFO boost by Spirit. Occupancy remained steady at 98.6% and same-store rent growth generally improved over last quarter, averaging roughly 1.5% in 1Q19. Given the improved cost of capital conditions discussed above, we expect these REITs to smash through full-year acquisition targets. Through one quarter, the sector has already acquired more than 33% of their full-year targets.

We are keeping an eye on occupancy, which has dipped a bit over the past several quarters after hitting record highs in mid-2018. By virtue of their experiential-oriented tenant mix, net lease REITs have so far been largely immune from the pressures of the so-called "retail apocalypse." As we discussed in Retail REITs: Fears of Apocalypse 2.0, the retail real estate sector is not out of the woods yet as store closings have again picked-up this year.

Sometimes lost in the macroeconomic analysis, investors seem to forget about the potential retail risks faced by the net lease sector as the sector is particularly exposed to retail trends in the restaurant, pharmacy, and movie theater segments. While restaurant sales continue to be very strong, pharmacy sales have softened over the past several quarters while box office revenue was weak in 1Q19 following a strong year in 2018.

As counterintuitive as it may be for equity analysts and value-oriented investors, elevated valuations are actually welcome news for REITs, particularly those in the net lease REIT sector. Net Lease REITs have proven over the past three decades that elevated valuations (particularly NAV-based valuations) are no hindrance to outperformance and the sector performs best on a fundamental-basis when valuations are indeed elevated. We expect the net lease REIT sector to be the external growth engine of the REIT sector in 2019. Property-level fundamentals have remained steady but retail risks remain and should be monitored for signs of cracks in the critical retail segments for net lease REITs.

Recent Stock Performance

The REIT Rejuvenation of 2019 has been a tide that has lifted all boats with net lease REITs climbing more than 18% so far this year, roughly in-line with the broader REIT average. As shown above, in the sector performance chart, net lease REITs jumped 14% last year, outperforming the REIT average by 20%. The 10-Year yield has plunged by 69 basis points since the start of the year and is roughly 125 basis points below its peak last November around 3.25%.

The relatively lower-quality REITs have been the winners so far this year with VEREIT, W.P. Carey and Spirit each jumping more than 24% since the start of the year. Struggling with a NAV discount last year, the improved macroeconomic environment has pulled these companies out of "REIT purgatory" and given them new life to do what net lease REITs do best: grow externally. The "Big 3" were the relative outperformers of 2018, but Realty Income and National Retail have lagged so far this year.

Net Lease REIT Dividend Yields

Relatively high dividend yields are the key investment feature of the net lease REIT sector. Net Lease REITs pay an average dividend yield of 4.5%, a premium of roughly 1% over the broader averages. (Note: Our indexes exclude small-cap REITs, which generally pay higher dividend yields) Net lease REITs pay out less than 80% of their available 2019 cash flow, which leaves plenty of cash for acquisition-fueled growth this year.

net lease REIT dividends

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. VEREIT tops the yield-rankings, paying a 6.0% dividend yield.

Interest Rates And Net Lease REITs

Net lease REITs are among the most interest-rate-sensitive sectors and one of the least sensitive to broader equity market movements. High interest rate sensitivity is a result of longer-than-average lease terms, limited internal growth, and high dividend yields. Net lease REITs are nearly twice as sensitive to movement in the 10-year yield than the broader REIT index.

interest rates net lease REITs

Bottom Line: Overvalued, But That’s A Good Thing

It's been "feast or famine" for Net Lease REITs over the past two years. Facing an existential crisis early last year, the Net Lease sector has been rejuvenated in 2019. With an eroded cost of capital - making accretive external growth all but impossible - and inflation rates outpacing internal property-level growth, the outlook looked rather grim for the sector.

The macroeconomic regime has shifted dramatically over the last twelve months. No REIT sector loves the Goldilocks "lower-for-longer" economic environment more than net lease REITs. The net lease sector has been rejuvenated by lower interest rates, which has boosted equity valuations and re-opened accretive external growth opportunities that should fuel AFFO growth this year.

Ultimately, the stock price performance of net lease REITs will be largely dictated by macroeconomic trends. Regardless, if conditions remain somewhat steady through the end of 2019, we expect the net lease REIT sector to be the external growth engine of the REIT sector in 2019. Net lease REITs have proven over the past three decades that elevated valuations (particularly NAV-based valuations) are no hindrance to outperformance and the sector performs best on a fundamental-basis when valuations are indeed elevated.

If you enjoyed this report, be sure to "Follow" our page to stay up-to-date on the latest developments in the housing and commercial real estate sectors. For an in-depth analysis of all real estate sectors, be sure to check out all of our quarterly reports: Homebuilders, Apartments, Student Housing, Single Family Rentals, Manufactured Housing, Cell Towers, Healthcare, Industrial, Data Center, Malls, Net Lease, Apartments, Shopping Centers, Hotels, Office, Storage, and Real Estate Crowdfunding.

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