What are inflation and deflation? And what cause them? I offer an explanation that forms the basis for the rest of the article.
Five underlying economic forces are driving the disinflationary trend and could cause the economy to dip into deflation. In any case, the lower-for-longer trend will continue.
There *are* a few things that could cause a sustained rise of inflation, but they do not seem likely to occur at this point.
Long-duration Treasury bonds offer very little income, and corporate bonds do not adequately compensate investors for the risk.
Triple-net lease REITs, on the other hand, are very attractive long-term investments and bond alternatives from a risk-adjusted standpoint.
With the federal government running a huge fiscal deficit in order to fund relief spending and the Federal Reserve creating trillions of dollars to inject into the financial system via asset swaps, many worry that a sustained rise in inflation is just around the corner. But what exactly is inflation? And what causes it?
In what follows, I explain inflation, what causes it, and why even these massive government responses to COVID-19 are not likely to result in a sustained rise in it. There are five primary reasons why we're more likely to see continued disinflation (falling rate of inflation) or even deflation than we are to see inflation anytime soon. But I also explain what changes to government policy could — and almost certainly would — result in an uptick of inflation.
Given that the fiscal and monetary responses are basically more of the same thing that we've seen for decades, I don't expect the prevailing environment of lower inflation and falling interest rates to change. Since long-duration Treasuries no longer offer much income, and long-duration corporate bonds bear more risk than they compensate for, I explore what I consider to be the perfect investment for the inflation-less, low-rates environment that is likely to persist for a long time: net lease REITs.
Note: This is a longer piece (about 7,000 words) that could take a half an hour to read (or longer, if you're a slow reader like me), but I believe it's worth your time. This article explains my highest conviction "Buy" idea right now, connecting the macroeconomic environment to individual stocks that should perform well in it. I hope you find value in it.
What Are Inflation And Deflation?
There is some fairly widespread confusion about how exactly to define "inflation" and "deflation." The most common definition of inflation is basically what happens when the prices of the same set of various goods and services across the economy rise over time and thus the currency used as a medium of exchange for those goods and services correspondingly drops in value. Deflation is just the flip side of inflation: prices of goods and services falling and rendering currency more valuable.
Inflation, here, is typically caused by bottlenecks in which supply cannot keep up with demand, or by simple scarcity of resources. Growing economies, it is widely thought, generally result in some measure of inflation. Meanwhile, deflation can be caused by either increased efficiency in the delivery of those goods and services (allowing sellers to lower their prices in order to capture greater market share) or by a drop in demand (due, for instance, to a recession) that forces sellers to lower prices in order to generate sales.
Notice that this definition includes nothing about the money supply. A second meaning of inflation and deflation is as the direct result of changes in the monetary supply. By this definition, any time money is created and pushed out into the economy, the currency is devalued. Likewise, any time money is destroyed or retired, the currency rises in value. In either case, economic distortions result, even if those distortions are not uniform rises in prices across the economy.
The shape that these distortions take depend a lot on how the newly created money is distributed in the economy. The uneven and ad hoc effects on the economy caused by the specific initial recipients of new money and the mechanism of new money distribution is called the "Cantillon effect."
Imagine if the Treasury Department printed a trillion dollars and dumped it — all of it — in, let's say, the small city of Cedar Rapids, Iowa. Every resident, business, and non-profit organization of Cedar Rapids got an injection of funds directly into their bank accounts, equally distributed between everyone. Would this cause the prices of goods and services to rise immediately across the nation? No, of course not. All else being equal, they would first rise in Cedar Rapids. Then they would rise in the surrounding towns as Cedar Rapids residents sought to arbitrage by taking advantage of the "normal" prices outside the area that got the new money injection. Then they would begin to trickle out to other businesses and individuals with ties to Cedar Rapids.
Ultimately, it might have very little effect on the personal consumption expense index used by government officials to measure consumer prices, because most of that new money would remain concentrated in and around Cedar Rapids, or in the hands of those associated with Cedar Rapids. It would likely have little to no effect on prices in Miami, Florida, or Hoboken, New Jersey, or Seattle Washington.
Richard Cantillon, the 18th century French-Irish economist who wrote about this subject, used the analogy of honey being poured into a bowl. It does not fill the bowl evenly as water would. It's sticky, and thus it will form a large mound and only slowly spread out from the central point receiving the inflow of honey.
Money is likewise "sticky." When it is injected into the economy, it tends to remain in and around the direct recipients of it, and also in the areas most closely associated with the direct recipients.
The ~$4 trillion dollars of quantitative easing by the Fed from 2008 to 2015 was injected into the banking system. Admittedly, it was basically an asset swap rather than free money dumped onto the banks. The banks got cash for their Treasuries or mortgage-backed securities. Nevertheless, this new money creation effectively supported the prices of safe-yielding assets while giving banks liquidity to clean up their balance sheets.
Like honey, these money injections didn't spread very far from their original recipients. Banks became much better capitalized, but they didn't make many new loans that they wouldn't have made otherwise. And safe-yielding asset prices were supported, which pushed investor capital further out on the risk spectrum to higher yielding assets like real estate, stocks, and private equity.
In other words, the newly created QE money remained in and around the financial economy, rather than the real ("main street") economy. Holders of risk assets got richer, but most average folk didn't see much of that newly created money. Hence we find the stark divergence between "asset inflation" (represented below by the price performance of the S&P 500) and consumer price inflation over the past decade:
You'll find many financial pundits positing that the massive fiscal and monetary stimulus being injected into a largely frozen economy right now will — eventually — lead to an uptick in inflation. And by "inflation," these pundits mean consumer price inflation. What is often left out is the mechanism by which this newly created money gets transferred to consumers who will then spend it at a rate faster than supply is able to keep up.
Right now, the Treasury is issuing debt that will need to be serviced in the future by taxpayers, which is essentially a form of borrowing from future consumption to pay for today's consumption. And this new debt is not even enough to keep up with the fall in consumer and business spending in the economy. Unemployment checks are not enough to replace the lost income from the jobs that have been destroyed the past few weeks, and many businesses are still forced to engage in layoffs even in the midst of government loans/grants. In other words, fiscal policy does not appear to be inflationary; it is not creating demand for consumer goods and services above and beyond the level that prevailed prior to the shutdown, and it isn't likely to do so after the economy is reopened either.
What about monetary policy? The Fed does not have the legal ability to engage in actual "helicopter money," where it prints new money and distributes it directly to consumers. It must operate through the financial system. As such, the Cantillon effect is likely to remain in force for this new money, just as it did for the QE money from 2008 to 2015. Banks are tightening their lending standards even as they sell their Treasuries and MBSs to the Fed. The effective suppression of yields on safe assets does not cause sellers to cash out and go spend more money in the real economy. Rather, on a net basis, it causes them to reinvest the proceeds into higher yielding or higher potential return assets.
This is true also of those who sell shares of the iShares iBoxx High Yield Corp Bond ETF (HYG) or downgraded "fallen angel" corporate bonds to the Fed. Are they going out and buying airplane tickets and new smartphones with the proceeds? For the most part, no. They're holding them in cash or reinvesting them in other high-yielding or high potential return assets. The money builds up in the financial system while the total amount of financial assets remains as it otherwise would (i.e. scarcity), causing asset inflation.
Why would this not continue? No matter how much money is printed by the Fed, it simply does not have the legal mechanisms available to it to spread this newly created money into the real economy. It can't force banks to give more loans. It can't force sellers of assets to go out and buy consumer goods and services. And it can't (by law) send checks directly to households, businesses, and non-profit organizations.
Until either the Fed's legal capabilities are expanded to include true helicopter money or the federal government begins a new, permanent program of universal basic income (that does not replace existing welfare benefits) funded by debt issuance, I contend that no significant uptick of inflation is on the horizon — except in those areas in, around, and associated with the financial system.
More likely, in my estimation, is a persistent flirtation with mild deflation, where consumer prices as measured by the PCE hover around or slightly below zero for a sustained period. There are five underlying forces driving the economy in a deflationary direction even as fiscal and monetary policymakers do everything in their power to generate inflation.
1. Technology & AI Are Deflationary
Technology and the various forms of artificial intelligence that are already in use (don't think of a Matrix-style machine super-intelligence) are systematically lowering prices (and labor hours/wages) across virtually all sectors and industries. You might think of the obvious case: TVs and other consumer electronics, which have fallen dramatically in inflation-adjusted prices over the years because advances in technology have made them cheaper to produce.
But technology and computer intelligence is suppressing prices in countless other ways as well. Think of the Amazon (AMZN) effect. Consumers have access to multiple sellers of the same item at once and are able to choose the cheapest provider (or the best-reviewed provider offering the cheapest price). This makes the market more efficient, removing opportunities for sellers to take advantage of arbitrage opportunities.
Technology has made all workers and businesses more efficient. As Kurt Cagle writes in Forbes:
From word processors that went from simple spell check to office suites that now have a significant hand in the production process, from cruise control to self-driving vehicles, from halting speech recognition software to fully integrated video/audio concept recognition, AI and its related technologies have quietly but perhaps irrevocably changed our relationship with computers far more than most people realize.
Greater efficiency makes input costs lower than they otherwise would be, which in turn allows sellers to either reduce prices or raise them less than they would otherwise be raised. This also makes some workers unnecessary, leading to job losses in the most technologically advanced industries. Cagle, again, writes:
Ironically, at a time where the political rhetoric seems to be all about immigrants taking away jobs, the reality is far more sobering. Re-onshoring, where companies are reducing offshoring after a couple of decades, is gaining momentum primarily because finishing companies are reducing their supply chain exposure by incorporating both AI and 3D manufacturing to reduce the overall costs below that necessary to import the intermediate components from overseas.
Put another way, it's cheaper to manufacture in the US again, not because of labor costs, but because of the lack of need for labor, and a significantly reduced supply chain, in the first place.
As I noted in "COVID-19 Will Accelerate These Preexisting Trends," the trend of de-globalization that existed before the pandemic will almost certainly accelerate as nations seek to domesticate their supply lines, at least for certain industries and products. This is not likely to result in a meaningful wave of new US jobs because, as Cagle explains, this new domestic production will mostly be completed by robots and automated systems.
In other words, the widespread fear that re-onshoring will result in a significant increase in wage costs for businesses that gets pushed out to consumers in the form of price increases is likely overblown. The industries most likely to bring back production from overseas are those that are able to do so without dramatically increasing their labor costs.
Technology systematically lowers consumer prices, and, for the most part, de-globalization won't change that.
2. Lingering Demand Destruction
The unemployment rate has already jumped into the double digits, and that percentage is likely to grow in the near term. It's highly doubtful that the recovery from the current slump will be V-shaped. Like stocks, the employment rate takes the stairs up and elevator down. Crashes are hard and swift, and recoveries are slow and arduous. Always. The cause of the crash scarcely matters.
Across history, we find that it typically takes at least two or three times as long for the unemployment rate to fall back to its previous level than it does for it to spike up to its high during a crash.
The economy cannot just be turned off and back on like a light switch. The jobs already lost are not, for the most part, going to simply reappear as soon as the economy reopens. Are movie theaters, hotels, bars, restaurants, malls, or entertainment venues going to be packed again by June or July? Probably not. Lots of people are still going to be afraid to go to crowded public places. And other people won't have the disposable income to spend. That means those businesses won't need to hire back the same number of people they employed before the pandemic.
This, in turn, means that consumers will be spending less, in aggregate, than they did before the coronavirus pandemic. A quicker rebound in supply of goods and services than demand for goods and services is a recipe for deflation or "disinflation" (a reduced rate of inflation).
3. Debt Deflation
The combined effects of technology-driven deflation and demand destruction threaten to spur a third cause for deflation: the unraveling of large debt burdens. The renowned Great Depression-era economist Irving Fisher wrote in his seminal essay on deflation that “if the over-indebtedness with which we started was great enough, the liquidation of debts cannot keep up with the fall of prices which it causes. In that case, the liquidation defeats itself.”
When consumer prices fall, the currency (US dollars) effectively rises in value. That makes existing debt obligations more costly, as they must be repaid with more valuable dollars. This leads to a drop in consumer and business spending, as everyone begins to prioritize paying down debt. And, of course, with the further drop in spending (i.e. demand destruction) comes further pressure on prices. More deflation results.
Deflation also results in falling asset and property values. This has some negative effects on the debt associated with those assets. Homeowners who took out mortgages, for instance, will be irked to repay the same principal for a house that is slowly losing value. It could put some homeowners underwater on their mortgages and lead to an increase in foreclosures, which further dampens housing prices. Corporations will see their profit margins compress when they are stuck paying back their debt with more valuable dollars, and then they are less inclined to use either free cash flow or new debt to invest in new assets. This leads to a decline in business assets such as plants and equipment as well.
We saw these cases happen, to some degree, in both the Great Depression and the Great Recession of 2008-2009. Think of the many homeowners who walked away from their homes in the late 2000s because they were so highly levered that a small dip in the home's price wiped out their entire equity. The increased foreclosures that resulted from falling housing prices caused housing prices further. That's debt deflation.
Carrying a modest amount of debt on one's balance sheet, whether one is a homeowner or a business, wouldn't be that detrimental in a deflationary environment, but the greater the debt burden, the larger the negative impact. And after decades of pro-inflation monetary and fiscal policies from governments around the globe, the world is awash in debt. Of course, central banks across the world are ramping up their pro-inflation policies again, which should lessen the economic destruction wrought by debt deflation by propping up asset prices.
The demographic point is well-known to most investors, so I will be brief here. For cultural and economic reasons, along with advances in contraceptive technology, the birth rate has declined significantly in advanced economies. Moreover, the large Baby Boomer generation is either in or approaching retirement, and the United States is currently governed at the federal level by an immigration restrictionist administration that seeks to curtail immigration. Even setting anti-immigration policies aside, immigration into the US has slowed in the last few decades.
These three factors (declining birth rate, aging population, and slowing immigration) are the formula for very low population growth. Lower population growth naturally results in less consumer spending than higher population growth. Less spending > less demand > less inflation.
5. Precautionary Saving
Olivier Blanchard points to the high unemployment rate, collapsed oil and commodity prices, and the sudden propensity to save all but ensuring sustained low inflation for the foreseeable future.
Despite governments sending out hundreds of billions of dollars directly to citizens, people have been far more inclined to hoard the money in preparation for worse events to come than to spend it immediately. Besides, there are far fewer outlets at which to spend this money. But even after businesses reopen, Blachard doesn't see consumer demand bouncing back to previous levels.
Precautionary saving is likely to play a lasting role, leading to low consumption. Uncertainty is likely to lead to low investment; unlike a regular war, there is no capital to rebuild. The challenge for monetary and fiscal policy is thus likely to be to sustain demand and avoid deflation than the reverse.
The Class of Real Estate Best Positioned For Deflation & Persistently Low Interest Rates
The situation described above, in short, is one in which we get deflation or disinflation in the real economy and inflation in the financial system. This is essentially just an exaggerated form of the economic conditions present since the Great Recession — and more broadly since the Fed chairmanship of Alan Greenspan. As Joseph Lupton of JP Morgan Chase put it, "a powerful disinflationary tide is now rising," and yet, as Simon Maierhofer articulated: "Courtesy of the Federal Reserve, rising stocks and a shrinking or stale economy are not mutually exclusive."
Traditionally, the best long-term investment for such an environment has been long duration Treasuries. Since 1990, for instance, we find that the 30-year Treasury rate has steadily fallen along with the YoY inflation rate that the Fed uses. In other words, the prices for these long-term bonds have risen to the point where loaning one's money to the federal government for thirty years yields less than a 1.2% annual return.
Obviously, investors who are willing to pay such a price for safe yield do not expect any inflation to arise anytime soon.
But a 1.2% annual yield is an incredibly small amount of income offered by what is traditionally considered a good income investment. Historically, investors go to equities for higher total returns and bonds for higher income. Today, that truism has been flipped on its head: stocks offer significantly more income than even the longest duration Treasury yields. But not all equity yields are equal, and not all of them are suitable as income alternatives to bonds.
What about long-term corporate bonds? While one can get around a 3.5% yield from a long-duration, investment-grade corporate bond ETF right now, the trouble is that roughly half of the holdings of these ETFs are BBB-rated — one step above junk. If there is a wave of credit downgrades in the near future, these ETFs will need to sell these "fallen angel" bonds at a discount to the price paid for them (although the loss might not be so bad with the Fed buying fallen angels). Besides, for these corporations, rent obligations have higher seniority than debt service payments, since rent is an operating expense. Most of the time, the new owners of the tenant-company remain obligated to the existing lease contract even after coming out of bankruptcy.
In an article from April, 2019, I explained why triple net lease REITs (ETF: NETL) are the closest thing to a "bond alternative" in the world of equities. The cap rates (unlevered cash yields) on triple net leased real estate properties closely tracks the 10-year Treasury rate during normal economic environments. As Ryan Lorey of the CCIM Institute put it in June of 2017, "research shows triple-net transactions have traded in a fairly tight range of 350 to 540 basis points above the 10-year Treasury during the last several years."
Why is this the case? The reasoning is simple. In my November, 2019 article on the two layers of recession-resistance afforded by net lease REITs, I wrote:
The initial lease terms are long (typically 10-20 years with multiple 5-year options), and the landlord bears no responsibilities for property maintenance, taxes, or insurance. The result is a portfolio of properties generating steady, ultra-reliable cash flows for the publicly traded landlord and its shareholders.
Triple-net leased properties that are occupied by investment-grade tenants such as Walmart (WMT), Walgreens (WBA), CVS (CVS), Home Depot (HD), and TJ Maxx (TJX), among others, are more like financial assets than traditional commercial real estate. The landlords have very few (if any) property expenses and high EBITDA conversion ratios. In many ways, triple-net REITs are more like banks than landlords. They borrow relatively short and cheap and buy properties (often through sale-leasebacks directly from the tenant) with long lease terms. And REITs are as loath to take over the ongoing expenses of vacant properties as banks are for owned real estate.
I go on in that November piece to write:
Triple net leases are mostly concentrated in the single-tenant space, since it is easier to determine responsibilities with fewer parties involved. While single-tenant net lease ("STNL") REITs have historically focused on retail, there has been increasing expansion into office, restaurant, and industrial as new retail development has slowed.
That expansion into office and restaurant space by some REITs has caused unexpected issues during the current pandemic lockdowns. Most net lease REITs have at least some exposure to movie theaters, fitness centers, and casual dining, three sectors that are particularly hard hit by the shutdown. I suspect that the highest quality net lease REITs will all be lowering their exposure to movie theaters, casual dining, and certain forms of office space going forward.
Despite the short-term pain endured by net lease REITs who will need to grant rent deferrals to a certain minority of tenants, the medium- to long-term financial hit to most of these REITs should be relatively minimal. One important reason for this is that these landlords are not giving anything away for free, even (and especially) for the tenants that need immediate relief. For those tenants that are being granted deferrals, their net lease landlords are requiring store-level financials to give greater clarity on historical vs. COVID-19 performance. This provides more transparency for the tenants that did not previously provide store-level financials.
More importantly, landlords are requiring lease term extensions equal to (or even greater than) the number of months of deferred rent. This effectively adds value to these properties should the REIT decide to sell them in order to reposition its portfolio.
Perhaps this is why Moody's has stated that most net lease REITs' credit ratings will remain largely intact. These companies have diversified property portfolios with tenants in a wide variety of industries and geographies. This will help them bounce back quickly once the economy reopens.
There are five net lease REITs that I believe will emerge from the coronavirus pandemic as the high-quality leaders in the space, two more that I would consider somewhat higher risk but still solid buys, and five more that I'll highlight as requiring more clarity before they become clearly good buys.
The Net Lease Top Tier
1. Agree Realty (ADC)
ADC has transformed itself since its 22% dividend cut during the Great Recession into a mini-Realty Income, with the lowest cost of capital and the highest percentage of investment grade tenants among its peers. Today, ADC is the most financially strong net lease REIT on the market, with 59.4% of rents derived from investment-grade rated tenants like Walmart (WMT), TJ Maxx (TJX), Walgreens (WBA), Dollar General (DG), CVS Pharmacy (CVS), Home Depot (HD), and Lowe's (LOW).
In my March 20th article on ADC, I wrote that the REIT
owns a portfolio of 864 properties across 46 states. Its properties are made up of freestanding/single-tenant buildings, multi-tenant shopping centers, urban town centers, and ground leases, mostly leased to national, investment-grade credit corporations. Most pertinent to the current market, ADC focuses specifically on tenants that are recession-resistant and relatively insulated from e-commerce disruption.
The REIT's net debt to EBITDA is very low at under 4x, it has no debt maturities until 2023, and it is the only net lease REIT (so far, anyway) to announce during the COVID-19 outbreak that they are increasing acquisition guidance for 2020. ADC is quickly becoming the gold standard net lease REIT in my mind, and its relatively small size and low cost of capital should allow it to continue growing quickly.
2. Realty Income (O)
Realty Income, the longstanding gold standard of net lease REITs, owns 6,483 properties across 49 states plus Puerto Rico and the United Kingdom that are 98.6% leased, with a weighted average remaining lease term of 9.2 years. Almost half (49%) of rent is derived from investment-grade tenants, and due to its large size, Realty Income enjoys a class-leading EBITDA margin of 93.9%.
The stock selloff happened largely because of Realty Income's 6.7% exposure to movie theaters and 7.3% exposure to fitness centers. The REIT will surely take some short-term hit from rent deferrals for some tenants, but it is well-positioned to bounce back strongly from the crisis. It also proved in 2008-2010 that it can significantly reposition its portfolio away from lower-quality tenants into higher-quality properties while continuing to grow its dividend.
With an A- credit rating, ample liquidity, and a "sacrosanct" dividend, Realty Income's 25-year dividend growth streak will almost certainly continue for many years to come.
3. W.P. Carey (WPC)
WPC owns 1,214 properties in the United States and Europe, with roughly 60% located in the US with the other 40% across the pond. The portfolio is 98.8% leased at a weighted average remaining lease term of 10.7 years. With net debt to EBITDA at 5.4x, the company is well-capitalized to take out more low-cost debt (weighted average interest rate of 3.2%) to make more acquisitions down the road.
WPC has an extremely diversified portfolio encompassing retail, industrial, warehouse, office, and some hotel tenants across two continents. And its dividend has grown for 23 years straight. Insiders bought a significant amount of common stock recently.
4. National Retail Properties (NNN)
NNN owns 3,118 properties across the United States that are 99% occupied. Prior to COVID-19, the REIT was paying out only 72% of AFFO, which afforded it ample retained cash flow to use toward new acquisitions. Net debt to EBITDA (including preferred stock) stood at a modest 5.5x at the end of 2019 and the fixed charge coverage at 4x, giving ample room for further expansion once we come out of the present crisis.
NNN also enjoys a strong, BBB+ balance sheet and has almost no debt maturities until 2022. The company will need to overcome the meaningful hurdle of short-term rent deferrals, though. Full-service restaurants, family entertainment, health & fitness, and movie theaters collectively account for 27.7% of rent. Short-term headwinds due to dealing with these tenants as the economy gradually reopens will be no small task, and I would expect NNN to bounce back slower than the previous three REITs.
But the company has raised its dividend for 30 years straight, and I think management will do everything in their power to preserve and extend that streak.
5. Spirit Realty Capital (SRC)
After spinning off its lower quality properties and selling them to Hospitality Properties Trust (SVC), SRC has transformed itself into a much financially stronger, higher quality REIT. It owns 1,772 properties across 48 states that are 99.4% occupied and have a weighted average remaining lease term of 9.8 years. Though only 23.5% of tenants are actually investment-grade rated, 43.7% are either investment grade or would be investment grade if they had credit ratings. Net debt to EBITDA is in the low- to mid-5x range, fixed charge coverage sits between 4.3x and 4.5x, and liquidity is strong at $830 million versus $6.1 billion in real estate assets.
In my April 15th article on Spirit, I highlighted how the CEO, Jackson Hsieh, commented on the recent conference call that they "have the wherewithal to maintain [the dividend]." I also modeled a base case projection for SRC's payout ratio this year, and I believe the company will be able to keep the payout below 90% of full-year AFFO. Like all other net lease REITs, much of the 20.8% of rent that comes from health & fitness, movie theaters, and casual dining will be deferred, but SRC has granted no rent forgiveness or abatements.
Insiders have also been buying significant chunks of stock in the past few weeks, which I consider a bullish signal.
Mid-Tier Solid Buys
1. STAG Industrial (STAG)
STAG owns 450 industrial and warehouse properties across 38 states that are 95% occupied and have 5.2 years of weighted average remaining lease term. Warehouses make up 88.3% of rent, while light manufacturing accounts for 9.8%. The REIT is unique in that it tends to focus on secondary markets or suburbs/exurbs of primary metro markets. Occupancy tends to be similar between primary and secondary markets, and yet the cap rates are higher for secondary markets.
Source: Q4 2019 Earnings Presentation
Though only 32.8% of STAG's tenants are investment grade rated, industrial and logistical properties have held up better than retail in terms of rent collection. Less than 5% of STAG's tenants asked for rent relief. The REIT itself enjoys a BBB investment grade rating and fairly low net debt to EBITDA at 5.1x. Only $150 million in debt comes due in 2020, compared to $755 million in total liquidity as of the end of March.
2. Monmouth Real Estate (MNR)
MNR is a fellow industrial and warehouse landlord that has had its eye on the e-commerce trend for a long time. The REIT's ~120 single-tenant, net lease properties are spread across 30 states but mostly concentrated on the eastern half of the United States. Its properties are 99% leased, and leases representing only 11% of rent are coming due in the next three years.
The REIT is unique in that it primarily uses property-specific, amortizing mortgages to finance its acquisitions. Its weighted average remaining lease term of 14 years compares favorably to its weighted average mortgage maturity of 11 years.
There are two primary downsides to MNR, but neither of them deter me from owning the stock. First, a little over half of rent comes from properties leased to FedEx (FDX), which strongly ties MNR's financial health to that of FedEx. The second downside is that MNR maintains an equity portfolio that includes some lower quality REITs such as UMH Properties (UMH) and mall/retail REITs. That holds back the stock's return potential, and I would love to see this REIT securities portfolio sold off so that MNR becomes a pure-play industrial/logistics property landlord.
Even so, I like MNR's focus on positioning for e-commerce, the family business nature of the company, and its long-term track record of dividend sustainability.
Wait For Clarity On These
1. STORE Capital (STOR)
STOR boasts over 2,500 properties across 49 states that are 99.5% occupied and have ~14 years of weighted average remaining lease term.
My main concern about STOR (and the main reason I never bought the stock) has always been the tenant mix. Art Van, STOR's second largest tenant by revenue at 2.5%, declared bankruptcy at the very beginning of the pandemic shutdown, and AMC Theaters (AMC) has only narrowly avoided bankruptcy for now. Meanwhile, 7.2% of the portfolio is in some form of childhood education, which cannot operate in-person classes for the remainder of this Spring. And Bass Pro Shops (third largest tenant at 1.9% of revenue) may have strong brands, but its stores are huge and would be difficult to release to a different tenant.
In my April, 2019 article on net lease REITs, I wrote:
Though it insists that three-fourths of its leases are "investment grade," its tenants are mostly in the lower-middle and middle market space and are largely unrated. Seventeen percent of its portfolio is made up of restaurants — two-thirds of that full service. The next 16% of tenants are in the early childhood education, fitness center, or movie theater spaces. When forced to endure an economic downturn, the strength of these properties will boil down to the strength of the franchisee or corporate guarantee.
Sure, 91% of STOR's portfolio is subject to master leases, but the same could be said for many senior housing and skilled nursing REITs that are struggling right now. As Warren Buffett says, it's only when the tide goes out that we find out who's been swimming naked.
In my November 2019 article on net lease REITs, here's what I said about STOR:
STOR has proven that its business model works well, at least during a strong economy. It boasts a fast average annual rent escalation of 1.8% as well as one of the longest weighted average remaining lease terms. Plus, most of its properties (90%+) are secured with master leases which prevent tenants from abandoning any one of their locations with STOR. I worry, however, that the market values STOR much more highly than it deserves, largely due to the wave of coattail-riding ever since Warren Buffett's Berkshire Hathaway (BRK.B) took a ~10% stake in the company. The current stock price is almost double what Berkshire paid, and STOR's dividend yield is lower than those of its top-tier peers:
Well, since I wrote that article, STOR has been dramatically repriced:
At this point, I feel good about my decision not to buy shares of STOR, although it could very well be the case that shares have been adequately punished at this point to create a margin of safety. If I wanted to take a position in STOR, I would first wait until the May 5th earnings conference call to hear from management about their performance during COVID-19.
2. Essential Properties Realty Trust (EPRT)
EPRT owns 1,000 properties across 44 states that are 100% occupied and have 14.6 weighted average years of remaining lease term. I cover EPRT right after STOR because I consider them very similar to each other, even with some of the same tenants. While 65% of STOR's portfolio is devoted to service-based tenants, for EPRT it's 80%. Retail and experience-based tenants make up the remainder of each. Art Van is one of EPRT's top ten tenants as well, representing the same percentage of rent (2.5%).
Casual dining and family dining together represent 9.2% of the portfolio, while movie theaters and entertainment make up 7.6% and health and fitness make up 6.6%. With this in mind, it's no wonder that, as of April 14th, only 53% of rent had been collected. Deferral agreements were reached for 29% of leases by rent, and the remainder was still under negotiation.
On the positive side, EPRT enjoys lower leverage (net debt to EBITDA in the mid-4x range) than STOR (5.3x) and a stronger liquidity position. Plus, EPRT's modest payout ratio of 77% provides a decent buffer against dividend cuts, and less than 3% of leases by rent expire before 2024.
I am nibbling at shares around these levels, but more clarity on near-term results and their long-term consequences is needed before having a clear stance on how to move forward.
3. Innovative Industrial Properties (IIPR)
IIPR's portfolio is made up of specialized greenhouses entirely net-leased to state-licensed marijuana growers. It owns 55 properties that are 99.1% leased across 33 states and Washington D.C. At the end of March, IIPR had a weighted average remaining lease term of 15.6 years.
Due to the unique legal situation surrounding marijuana in which it remains illegal at the federal level but legalized (at least for medical use) in many states, IIPR has very little competition for the financing of these buildings. Banks can't provide loans for regulatory reasons, which leaves specialized REITs like IIPR as their only option to pull cash out of their real estate for other uses.
IIPR typically acquires properties at cap rates (unlevered cash yields) in the low-to-mid-teens (13.3% average yield on invested capital), compared to most net lease REITs acquiring at cap rates between 6-8%. These leases also come with 3-4% annual rent escalations, on average, which ensure class-leading organic revenue growth.
The issue with IIPR is that the legal situation for marijuana could change in the near future. If other financing options became available to medical cannabis growers, surely the cap rates would be bid down very quickly. It could also hurt IIPR's tenants by increasing competition in the space. More competition would surely push some of IIPR's already unprofitable tenants toward financial peril. In any case, there is a lot of uncertainty about how IIPR will perform if/when medical marijuana is legalized at the federal level, which makes it difficult to price the stock.
4. Vereit (VER)
VER is the phoenix that is in the process of rising from the ashes of the old American Realty Capital REIT that got in trouble in 2014 for securities fraud. The company has spent years paying off the legal repercussions of ARCP's securities fraud (which is now completed), as well as repositioning the portfolio after some unfortunate empire-building that was done by ARCP. VER is also trying to reshape the company's image, which is partly why it changed its name to "Vereit," a combination of the Latin word "veritas" (i.e. "truth") and "REIT."
VER owns 3,858 properties across 49 states that are 99.1% occupied and have a weighted average remaining lease term of 8.3 years. About 39% of tenants are investment-grade rated, which should help stabilized rent during this difficult time. VER also has an excellent retail portfolio, with Dollar Tree, Dollar General, Walgreens, CVS, LA Fitness, Albertson's, Tractor Supply, BJ's Wholesale Club, At Home, and Advanced Auto Parts as its top ten tenants. But retail is only 44% of the total portfolio.
Another 20% are restaurants, of which most are casual dining such as Red Lobster (VER's largest tenant by rent at 4.7%) and Bloomin' Brands (i.e. Outback Steakhouse). The restaurant exposure, perhaps along with VER's office buildings at 18.6% of the portfolio, is why the market has halved the REIT's stock price over the past few months. How much exactly VER will be hurt in the short to intermediate term is unclear, and unfortunately the REIT went into the COVID-19 crisis with a somewhat elevated payout ratio of 84.6% of expected 2020 AFFO.
Still, VER's modest debt load (net debt to EBITDA of 5.7x), good fixed charge coverage of 3.0x, and strong portfolio outside of the restaurants may mean that the stock selloff thus far is adequate to produce a margin of safety.
5. EPR Properties (EPR)
EPR owns entertainment, recreation, and education real estate properties across the United States. Its top tenants include movie theaters, ski resorts, private schools, theme parks, and gold recreation facilities (Topgolf).
Source: EPR Presentation
Despite a payout ratio that hovered around 80% in 2019, that ratio is set to spike above 100% this year. AMC Theaters (AMC), which represents 17.7% of EPR's rent, has already declared that they will not be paying rent for at least April or May. Other theater chains are undoubtedly doing the same. Though EPR did not cut its dividend for May, instead keeping it in-line with the previous, I have very little confidence in that dividend going forward.
In my view, almost all of EPR's tenants will struggle to pay rent for the foreseeable future, even with government help and a gradual reopening of the economy soon. Is this already priced into the stock after the sharp drop? Maybe, but I personally do not want to be the owner of these highly specialized real estate properties going forward anyway.
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Disclosure: I am/we are long ADC, O, NNN, WPC, SRC, MNR, VER, EPRT, NETL. 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.