REIT Rankings: Net Lease
In our REIT Rankings series, we introduce and update readers each of the residential and commercial real estate sectors. We focus on sector-level fundamentals, analyzing supply and demand conditions and macroeconomic factors driving underlying performance. We update these reports quarterly with a breakdown and analysis of the most recent earnings results.
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Net Lease REIT Sector Overview
Net lease REITs comprise roughly 8-10% of the broad-based REIT ETFs (VNQ and IYR). Within the Hoya Capital Net Lease Index, we track the ten largest net lease REITs, which account for roughly $85 billion in market value: Realty Income (O), W.P. Carey (WPC), VEREIT (VER), National Retail (NNN), STORE Capital (STOR), EPR Properties (EPR), Spirit Realty (SRC), Agree Realty (ADC), Four Corners (FCPT), and Getty Realty (GTY). Investors seeking diversified exposure to the net lease REIT sector can do so through the NETLease Corporate Real Estate ETF (NETL).
"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, high-margin, relatively predictable income streams and, as a result, the sector is viewed seen as more "bond-like" than other REIT sectors. 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, which has facilitated acquisition-fueled external growth.
Typically considered part of the retail real estate sector, net lease REITs generally own single-tenant properties leased to high credit-quality corporate tenants - primarily in the retail and restaurant industries - under long-term leases (10-25 years). Several of the REITs within the sector focus almost exclusively on a single industry (FCPT on restaurants, GTY on gas stations), while other REITs own diversified portfolios of both retail and non-retail properties. All ten net lease REITs command investment-grade bond ratings from at least one of the three major credit rating agencies.
Despite mounting concerns of a “Retail Apocalypse 2.0” given the unexpected surge in store closings this year, net lease REITs have bucked the negative retail trends and continue to outperform. Coresight Research has tracked more than 7,500 closings so far this year, already outpacing the full-year count for 2018, and estimates that up to 12,000 could announce closings by year-end. While nearly two-thirds of a net lease REIT’s revenue comes from retail-based tenants, it’s primarily the “right kind” of retail. Restaurants, convenience stores, fitness, and home improvement retailers are the top tenants across the industry, sectors facing less e-commerce competition. Amid the search for yield, however, we think that investors discount the retail-related risks in other critical net lease sectors, including pharmacies and movie theaters, with a higher risk of disintermediation which we discuss in more detail below.
Compared to malls and shopping centers, net lease REITs typically own and lease smaller properties (generally single-tenant) under longer lease terms. Because the tenant is responsible for most expenses, these REITs operate with significantly higher gross margins and have lower capital expenditure requirements. Most leases have contractual rent bumps, often tied to the CPI index or a fixed annual percentage. Because of this structure, property-level upside potential is generally retained by the tenant and net lease REITs are more sensitive to changes in interest rates and inflation. Below we discuss the advantages and disadvantages inherent with these different retail models.
Operating more like a financing company than other REIT sectors, external acquisitions are a critical component of the business model. With an active transaction market for single-tenant properties, 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. Acquisition-based growth has been responsible for more than two-thirds of total AFFO growth over the past decade and 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.
Recent Stock Performance & Valuation
Considering the critical importance of equity market valuations on net lease REIT operations and external growth potential, we begin our analysis with a review of recent stock performance and current valuations. The performance of the net lease REIT sector over the past half-decade has ultimately been driven by movements in the 10-year Treasury yield. The domestic-focused, defensively-oriented net lease sector has been revitalized this year by the plunge in global interest rates as the 10-year yield has dipped more than 170 basis points since peaking last November.
The REIT Rejuvenation of 2019 has been a tide that has lifted (almost) all boats across the REIT sector. While the Hoya Capital Net Lease Index has jumped 26% so far this year, the other retail REIT sectors have not enjoyed the windfall from lower rates as store closings have unexpectedly surged this year after some relative reprieve in 2018. Malls are the lone real estate sector in negative territory this year, dipping 14% and underperforming the best-performing sector (cell towers) by a staggering 60%. Specific to net lease REITs, stock performance this year has boosted equity valuations and re-opened accretive external growth opportunities that have fueled AFFO growth this year.
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.
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 REITs now trade at an estimated 25-35% premium to Net Asset Value.
Recent Fundamental Performance
Second-quarter earnings results were generally in line with expectations with seven of the ten net lease REITs maintaining full-year AFFO guidance. Spirit and Getty provided mild guidance boosts while W.P. Carey brought down the top-end of their guidance range. AFFO per share is expected to grow less than 1% this year, on average, but like the rest of the retail sector, there continues to be a bifurcation between the top-performers and the stragglers. The "Power 3" net lease REITs (O, NNN, STOR) are expecting AFFO to grow an average of 4.4% this year and are expected to account for more than 80% of the total net acquisition activity this year.
Property-level fundamentals remain steady despite the headwinds across the broader retail sector. Occupancy ticked higher by roughly 10 basis points from last quarter to end the period just shy of 99%. Pressured by the unexpected wave of store closures in 2019, however, the rest of the retail sector has seen an average 50 basis point dip in occupancy in 2Q19 from the same period last year. Same-store rents, typically linked to CPI or a fixed-rate escalator, grew an average 1.5% in the quarter, which was generally steady from Q1. This compares to an average same-store NOI of roughly 1% in the mall sector and 2.5% in the shopping center sector, according to the latest data from NAREIT. The weighted average lease term remained steady at just shy of 11 years.
With external acquisitions being responsible for more than two-thirds of total AFFO growth over the past decade, the focus of investors remains on acquisition activity far more than property-level metrics, which will remain the case until the retail-related risks begin to bleed into the generally healthier net lease retail industry segments. Spurred by rejuvenated valuations, the external growth spigot has re-opened over the past twelve months. At more than $2 billion, 2Q19 was the biggest quarter for net acquisition activity since 2015. Through the first half of 2019, the sector has already acquired nearly 75% of current full-year guidance, so we expect some healthy guidance boosts in 3Q19, particularly from the "Power 3."
As predicted earlier this year, given the restored NAV premium, we expect the net lease REIT sector to be the growth engine of the real estate sector this year. Net lease REITs have acquired nearly $6 billion in net assets over the last twelve months, more than the rest of the REIT sector combined. As we discussed in our recent report, Earnings Recap: The REIT Revival Is Real, the $5.9 billion in net acquisitions across the sector in 2Q19 was the largest quarterly "buy" since 4Q17, and we expect this trend to continue into 2020 given the favorable valuation environment which bodes well for sector-wide AFFO growth.
The Power 3 - Realty Income, National Retail, and STORE Capital - have plowed ahead with external growth, expanding their share count by 9%, 5%, and 14%, respectively, from the same quarter last year. Spirit and VEREIT have prudently shrunk their respective firms over the last three years in an effort to regain the critical NAV premium, a strategy that appears to be successful thus far. Overall, over the last year, the sector has expanded its share count by roughly 17%, boosted by W.P. Carey's share issuance to fund its acquisition of one of its managed funds, Corporate Property Associates 17.
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", but we continue to keep an eye on the critical net lease retail sectors. After reaching the fastest rate of growth since 2012 in the middle of last year, retail sales growth has generally moderated over the past several months, but data has been relatively strong this summer despite the volatility seen in the financial markets. Brick-and-mortar retail sales have been decent but clearly slowing this year with the performance of individual retailers continuing to diverge.
While we're comfortable with the exposure to restaurants, auto parts, fitness, and home improvement, amid the search for yield, we think that investors discount the retail-related risks in other critical net lease sectors, including pharmacies and movie theaters, with a higher risk of e-commerce-related disintermediation. Following a strong year at the box office in 2018, movie ticket sales are down 6.5% YTD, a group that we follow closely considering the clear headwinds from streaming services which has helped to shave two-thirds of market value from AMC Entertainment (AMC) since 2017. On a similar note, CVS Health (CVS) and Walgreens (WBA) are each more than 40% below their all-time record highs. While the Power 3 have shown an ability to adapt and recycle capital into stronger-performing sectors over the past decade, we are cautious on REITs like EPR with heavy exposure to movie theaters, as well as REITs like VER and SRC with more limited access to equity capital given past issues related to complexity and tenant issues, respectively.
As we’ve discussed in our weekly macroeconomic reports, for retailers and restaurants, the more significant issue over the last two years has not been on the demand-side, but rather on the expense-side. Before even considering the margin hit from tariffs and excess inventory, labor costs have risen considerably over the last two years as eighteen states raised their minimum wage in 2018 and many cities (largely in already high-cost markets) have raised minimum wages over the last two years, oftentimes far above market rate, which has begun to result in retail job cuts and store closures. Hourly earnings surged to 5% in early 2019, outpacing the roughly 3% growth in retail sales, while retail job growth has been negative on a year-over-year basis for all of 2019.
While we are bullish on the long-term outlook for the quick-service restaurant business, we should note restauranteurs have lowered their expectations for near-term growth through the end of the year on fears of slowing global economic growth affecting the US consumer. According to Restaurant.org, The Expectations Index, which measures restaurant operators’ six-month outlook for four industry indicators (same-store sales, employees, capital expenditures and business conditions), dropped to its lowest level since December 2015.
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 4.3%, a premium of nearly 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.
Within the sector, we see the yields and payouts of the ten names. The "power three," STORE Capital, Realty Income, and National Retail, pay the lowest yields but have the largest buffer for future dividend increases and external growth. EPR and VEREIT top the yield rankings, paying a 5.8% and 5.6% dividend yield, respectively.
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. Only the healthcare and student housing REIT sector are more bond-like than net lease REITs in their response to interest rates (IEF) and movements in the S&P 500 (SPY).
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.
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 REITs' 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. Spruce Point Capital Management published a much-discussed bear thesis on Realty Income, noting this potential negative feedback loop.
Additionally, with only about 50% of total lease escalators linked to CPI, rising inflation threatens to significantly outpace same-store internal growth if inflation rises above current expectations. 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.
Bottom Line: The Right Kind of Retail?
Despite mounting concerns of a “Retail Apocalypse 2.0” given the unexpected surge in store closings this year, net lease REITs have bucked the negative retail trends and continue to outperform. While nearly two-thirds of net lease REITs’ revenue comes from retail-based tenants, it’s primarily the “right kind” of retail. Restaurants, convenience stores, fitness, and home improvement are top tenants.
Amid the search for yield, however, we think that investors discount the retail-related risks in other critical net lease sectors, including pharmacies and movie theaters, with a higher risk of disintermediation. Net lease REITs have become adept at swimming upstream against these retail-related currents. The top net lease REITs command clear competitive advantages over the private market through access to capital.
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. Investors that have been willing to pay up for quality through the Power 3 - Realty Income, National Retail, and STORE Capital - have been rewarded over the past half-decade and we expect this trend to continue. These three 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.
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Disclosure: I am/we are long VNQ, STOR. 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.
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