Net Lease REITs: A Safe Haven Amid Coronavirus Turmoil
Summary
- Net Lease REITs have been a relative safe haven amid historic market volatility related to the COVID-19 outbreak. Performance from these "bond proxies" hasn't been quite as strong as many expected, however.
- Social distancing? Investors are reminded that the net lease sector has heavy underlying exposure to the retail, restaurant, and experience-based categories, which may bear the brunt of the virus impact.
- Thriving in the 'Goldilocks' economic environment, these REITs had reasserted themselves as the "external growth engine" of the REIT sector and were poised for a strong 2020 before recent turmoil.
- With occupancy at 99%, net lease REITs have proven their ability to defy the retail-related headwinds that have bedeviled other retail REIT sectors, but this will be tested in 2020.
- Quality is critical in the REIT sector, particularly with net lease REITs, where "cost of capital" is paramount. Cheap REITs tend to stay cheap and expensive REITs stay expensive.
- Looking for a helping hand in the market? Members of iREIT on Alpha get exclusive ideas and guidance to navigate any climate. Get started today »
REIT Rankings: Net Lease
In our Real Estate Rankings series, we introduce and update readers to 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.
(Hoya Capital, Co-Produced with Brad Thomas through iREIT on Alpha)
Net Lease REIT Sector Overview
Within the Hoya Capital Net Lease Index, we track the twelve largest net lease REITs, which account for roughly $90 billion in market value: Realty Income (O), W.P. Carey (WPC), VEREIT (VER), National Retail Properties (NNN), STORE Capital Corp. (STOR), Spirit Realty Capital (SRC), EPR Properties (EPR), Agree Realty Corp. (ADC), Essential Properties Realty Trust (EPRT), Four Corners Property Trust (FCPT), Global Net Lease (GNL), and Getty Realty Corp (GTY).
"Net lease" refers to the triple-net lease structure, whereby tenants pay all expenses related to property management: property taxes, insurance, and maintenance. While nearly every property sector uses the triple-net lease structure to some degree, we focus this report specifically on net lease REITs with heavy retail exposure - referred to as the "free-standing retail" - and REITs that don't otherwise fall neatly into one of the other property sectors. These 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, while other REITs own diversified portfolios of both retail and non-retail properties.
Net Lease REITs have been one of the stronger-performing REIT sectors over the last decade and now comprise 3-7% of the broad-based Core REIT ETFs. Investors seeking direct exposure to the net lease REIT sector can own the NETLease Corporate Real Estate ETF (NETL), which includes not only these twelve net lease REITs but also eleven other REITs that utilize the triple-net lease structure in the industrial, office, and gaming/casino sectors. With 23 holdings in all, NETL is the only REIT ETF focused on this particular lease type. Compared with broad-based real estate ETFs, NETL tilts more towards mid- and small-cap companies, and the index is rebalanced quarterly.
Net Lease REITs - one of the most interest-rate-sensitive REIT sectors - have been a relative safe-haven amid the COVID-19 panic. 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 as more "bond-like" than other REIT sectors. With these bond-like lease characteristics, naturally, comes a higher level of sensitivity to movements in interest rates and relatively more muted sensitivity to movements in the broader equity market. As exhibited below, net lease REITs are the third least economically-sensitive real estate sector and the third most sensitive to movements in the 10-year Treasury yield. Net lease REITs generally perform best in the "Goldilocks" macroeconomic environment of low rates and steady economic growth.
Performance hasn't been quite as strong as many investors expected, however. Over the last few weeks, investors have been reminded that the net lease sector, through their underlying tenant base, has heavy exposure to industries that may bear the brunt of the "social distancing" impact of the virus outbreak including the restaurant, pharmacy, and experience-based categories such as movie theaters and fitness. While the triple-net lease structure gives these REITs protection in the event of a "garden-variety" economic slowdown, the COVID-19 outbreak presents a potentially unknown risk in both magnitude and duration. As a result, we "upgraded" the risk-level of three retail categories: restaurants, pharmacy, and fitness.
That said, net lease REITs have proven their ability to defy the retail-related headwinds that have bedeviled other retail REIT sectors, but this will be tested in 2020. Compared to malls and shopping centers, net lease REITs typically own and lease smaller properties (generally single-tenant) under longer lease terms in sectors that are relatively less exposed to the "retail apocalypse" e-commerce-related headwinds. 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 inflation index or a fixed annual percentage. Because of this structure, property-level upside and downside potential are generally retained by the tenant.
"Cost of capital" is the name of the game in the net lease REIT sector and share price performance actually plays a critical role in the underlying business operations. Operating more like a financing company than other REIT sectors, external acquisitions are a critical component of the net lease business model. Among other advantages of the REIT structure (liquidity, scalability, reliable dividends, ability to diversify, and good corporate governance), access to the public equity markets to fuel accretive acquisitions (funded with secondary equity offerings) has been the defining competitive advantage for these REITs, explaining much of the consistent outperformance over the last three decades.
Counterintuitively, the evidence suggests that these REITs are fundamentally at their best when share price valuations are slightly elevated, as measured by the share price premium to Net Asset Value (NAV). Net lease REITs essentially capture the spread between their cost of capital (equity and debt) and the capitalization rate of their acquired properties. Higher share prices combined with lower interest rates give these REITs the "ammunition" to grow AFFO and dividends via accretive external acquisitions. For illustrative purposes, we diagram the expected sources of total returns under two valuations scenarios, highlighting our belief that the total return potential of the sector is higher when the sector is trading with elevated equity valuations.
Recent Stock Performance and Valuation
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. As discussed in our REIT Decade in Review, net lease REITs were among the better-performing REIT sectors during the 2010s, producing an average compound annualized total return of 13.7% compared to the 12.6% total return from the NAREIT All Equity REIT Index. After three years of middling performance, the "Goldilocks" macroeconomic environment of lower interest rates and moderate domestic-led economic growth powered a strong year in 2019 for net lease REITs with average total returns of nearly 25%.
Amid the historic market volatility and plunge in interest rates related to the COVID-19 virus outbreak, net lease REITs have proven to be a relative safe haven, but perhaps not quite to the extent that many investors would have hoped from their trusted "bond proxy." Net lease REITs are lower by 8.0% so far this year compared to the 9.4% decline from the broad-based commercial Real Estate ETF (VNQ) and the 14.8% decline from the S&P 500 ETF (SPY). Meanwhile, the 7-10 Year Treasury Bond ETF (IEF) has surged more than 25% since the start of the year as the 10-year Treasury yield has declined by a staggering 142 basis points since the start of the year to historic lows.
The relatively strong performance of the market cap-weighted net lease index, however, does mask some of the bifurcations in the performance between sub-segments of the sector. Naturally, REITs with heavy exposure to restaurants and experienced-based categories have been hit especially hard this year. EPR Properties, which owns a large portfolio of movie theaters and theme parks, has plunged more than 30% this month while STORE Capital and Spirit Realty, which are overweight in the restaurant and pharmacy categories, have also dipped more than 20% over the last month. Realty Income and Agree Realty, which have two of the highest-quality portfolios, have been the top performers so far this year.
As discussed above, equity market valuations can and do have a meaningful impact on the underlying business operations of these companies, a rather unique phenomenon among publicly traded companies. Despite the recent sell-off, net lease REITs still trade at sizable premiums to Net Asset Value - estimated at 25-35% - which would allow these REITs to keep the external growth spigot turned on in 2020 absent a further intensification of the COVID-19 sell-off. All bets are off, however, given the extreme volatility we've seen across the global equity markets over the last month, and we may indeed see net lease REIT scale back acquisition targets amid the uncertainty.
Net Lease REIT Fundamental Performance
Thriving in the 'Goldilocks' economic environment, these REITs had reasserted themselves as the "external growth engine" of the REIT sector and were poised for a strong 2020 before the recent market turmoil. Fourth-quarter earnings results were generally stronger-than-expected across the sector, particularly in the closely-watched acquisition metrics. With the wind finally at their backs with a favorable cost of capital, AFFO and dividend growth was poised to turn decidedly positive in 2020 after a challenging year that saw just 0.3% AFFO growth and 2.2% dividend growth.
Similar to the trends we've observed in the retail space, we continue to note a significant bifurcation in operating performance between the two tiers of the net lease REIT hierarchy. Over the last several years, four REITs have separated themselves from the pack, which we dub the Power 4: Realty Income, National Retail Properties, STORE Capital Corp., and Agree Realty. Unlike some of the smaller-cap names and their mid-cap peers, the Power 4 have kept their hands clean of accounting issues, tenant bankruptcy problems, and non-traded REIT complications. This Power 4 tier has widened their relative spread in AFFO growth above the rest of the sector in recent years, and recognized nearly 6% growth in 2019 compared to the -4.7% growth from the rest of the net lease REIT sector.
Led by the Power 4 which accounted for more than 75% of the total net acquisition activity, net lease REITs were back to doing what they do best in late 2019. Strong share price performance in 2019 allowed these REITs to re-open the acquisition channel in the back-half of 2019, acquiring more than $11 billion in assets last year, representing more than 10% of their market value, which was the biggest year of acquisitions for the sector since 2014. Initial 2020 guidance, which was provided before the COVID-19 outbreak, forecast an even bigger year in 2020 led by the recently resurgent VEREIT and Spirit, which had finally caught their stride after years of struggles.
Property-level fundamentals remain steady despite the headwinds across the broader retail sector. Occupancy ticked higher by roughly 15 basis points from last quarter to end the period at 99%. Pressured by the unexpected wave of store closures in 2019, however, the rest of the retail sector has been under-occupancy pressure. 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 Q3. This compares to an average same-store NOI growth of roughly -0.2% in the mall sector and 2.1% in the shopping center sector, according to the latest data from NAREIT. The weighted average lease term remained steady at just above 11 years.
We can't talk about net lease REITs without also discussing broader trends in retail. After all, in many ways, the underlying leases that these companies hold can be viewed as an inflation-hedged, long-duration corporate bond backed by brick-and-mortar retailers. The key retail categories to monitor amid the COVID-19 outbreak as it relates to net lease REITs are the restaurant, pharmacy, auto parts sectors, as well as movie theater revenue. The restaurant and auto parts showed notable strength in 2019, and pharmacy sales also held-up rather well despite a broad decline in brick-and-mortar retail sales, which ended the year with growth of just over 2%. Following a strong year at the box office in 2018, movie ticket sales ended 2019 lower by 4.8% YTD according to Box Office Mojo and are likely to face even more significant headwinds in early 2020 amid the COVID-19 outbreak.
With occupancy at 99%, net lease REITs have defied the retail-related headwinds that have bedeviled other retail REIT sectors. While net lease REITs have heavy retail exposure, it’s primarily the “right kind” of retail, at least under normal environments that don't involve "social distancing." In our recent article on the mall REIT sector, we outline the strategies that successful brick-and-mortar retailers have utilized to compete, which we call the "4 Critical Cs of Brick & Mortar Competition" which we outline in the chart below. With restaurants, convenience stores, fitness, and home improvement as top tenants, many of these net lease retail categories fall into the Competitive Advantage and Convenience segments, offering an experience or service that is unable to be replicated online.
Net Lease REIT Dividend Yields
Relatively high dividend yields are one of the key investment features of the net lease REIT sector. Net lease REITs pay an average dividend yield of 5.1%, a premium of more than 1% over the broader REIT average of 3.9%. Net lease REITs pay out roughly 80% of their free cash flow, towards the top-end of the REIT sector average, but make heavy use of secondary equity offerings to raise capital to fund accretive external growth. 
Within the sector, we note the yields and payouts of the twelve names. As with most sectors, the highest-quality names tend to pay the lowest dividend yields, and vice-versa. In our recent report, "The REIT Paradox: Cheap REITs Stay Cheap", we discussed our study that showed that lower-yielding REITs with lower leverage profiles have historically produced better total returns, on average, than their higher-yielding counterparts, suggesting that investors should look beyond dividend yield in their REIT selection and put greater emphasis on quality-based metrics and growth potential.
Bull And Bear Thesis For Net Lease REITs
As one of the most interest-rate-sensitive real estate sector, the sharp plunge in global interest rates should provide a tailwind for the net lease REIT sector in 2020 if the economy can avoid a worst-case scenario outcome related to the COVID-19 outbreak. The sector's high dividend yield and bond-like characteristics should be attractive for investors that are looking for a bond proxy, but willing to take on some credit risk in the retail, restaurant, and experienced-based categories. Due to the triple-net structure associated with limited capital expenditure requirements and G&A overhead, net lease REITs command some of the highest operating margins across the real estate sector. Below, we outline five reasons why investors are bullish on the net lease REIT sector.
If indeed we experience a worst-case scenario recessionary outcome from the COVID-19 outbreak, we could very well see a slowdown in leasing activity and an uptick in retail and restaurant bankruptcy which may hit the net lease sector particularly hard. As discussed above, equity valuations are especially important to the net lease REIT sector and a continued sell-off could eat away at the NAV premium and diminish external growth prospects. Additionally, while fears over higher interest rates and elevated inflation seem like a distant memory, a return of the "rising rate environment" or an uptick in inflation would be expected to pressure these yield-sensitive REITs. Below, we outline five reasons why investors are bearish on the net lease REIT sector.
Key Takeaways: A Safe-Haven Amid COVID-19 Fear
Net Lease REITs, along with the broader real estate sector, has been a relative safe-haven amid historic market volatility related to the COVID-19 outbreak. Thankfully for REIT investors, the "rising interest rate environment" and "rates up, REITs down" paradigm that dogged the sector from 2016 to 2018 appears to have given way - at least temporarily - to a new economic reality of "lower for longer." The strength of the real estate industry - which helped to power the economy up the "wall of worry" last year - will be asked to shoulder even more of the burden of global economic growth in the early stages of 2020.
Performance from net lease REITs, however, hasn't been quite as strong as many expected from these "bond proxies." Investors are reminded that the net lease sector has heavy underlying exposure to the retail, restaurant, and experience-based categories, which may bear the brunt of the virus impact. With occupancy at 99%, net lease REITs have proven their ability to defy the retail-related headwinds that have bedeviled other retail REIT sectors, but this will be put to the test in early 2020.
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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 STOR, SRC, NNN. 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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