Net Lease REITs: Rising Rates Not A Concern, Yet
- Following a punishing sell-off early in the pandemic, net lease REITs have displayed notable resilience in the face of stiff macroeconomic headwinds and entered 2021 with momentum at their backs.
- Despite their heavy retail and restaurant exposure, net lease REITs - with some exceptions - fared far better than their retail REIT peers with rent collection "normalizing" by late 2020.
- Recent earnings reports confirmed that acquisition-fueled growth kicked back into gear in late 2020 and is expected to power a rebound in AFFO growth after the 7% average decline in 2020.
- Before the pandemic, net lease REITs' performance was largely determined by movements in long-term interest rates due to their bond-like nature and reliance on low-cost capital to fuel external growth.
- For now, macroeconomic conditions remain in the "Goldilocks zone", and net lease REITs should be beneficiaries of the reopening trade so long as rates are rising for the "right" reasons: economic growth expectations rather than inflation.
- This idea was discussed in more depth with members of my private investing community, Hoya Capital Income Builder. Learn More »
REIT Rankings: Net Lease
(Hoya Capital Real Estate, Co-Produced with Colorado Wealth Management)
Net Lease REIT Sector Overview
Following a punishing sell-off early in the pandemic, Net Lease REITs have displayed notable resilience in the face of stiff macroeconomic headwinds and entered 2021 with momentum at their backs as shutdown-sensitive tenants reopened their doors and rent collection normalized. Despite the retail-heavy exposure of many of these REITs, net lease REITs were among the leaders in dividend boosts last year, but several REITs aren't entirely out of the woods yet. Within the Hoya Capital Net Lease Index, we track the sixteen net lease REITs, which account for roughly $85 billion in market value.
"Net lease" refers to the triple-net lease structure, whereby tenants pay all expenses related to property management: property taxes, insurance, and maintenance. This lease-type - which is used to varying degrees across the REIT universe - proved to be particularly durable throughout the pandemic-related turmoil. While nearly every property sector uses the triple-net lease structure to some degree, we focus this report primarily on the free-standing retail" net lease REITs and diversified 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. One of the more "bond-like" property sectors, Net Lease REITs tend to operate more like a financing company than a property manager and have investment characteristics similar to corporate bonds due to the long-term nature of most net leases. Unlike corporate bonds, however, net lease REITs have the ability to grow distributions through a combination of organic (same-store rent increases) and accretive external growth (acquisitions). Additionally, unlike their retail REIT peers, these REITs operate with very high margins and have more limited retail-related risks.
Net lease REITs are a sector where it's especially critical that investors take a look "under-the-hood" to understand the property-level exposures. On that point, no sector has seen a wider disparity in rent collection metrics amid the pandemic from a low of just 46% from EPR Properties to a high of 99% or more from half-a-dozen names. As a whole, rent collection has improved sequentially from a low of 65% in the initial April reporting towards 95% in the fourth quarter as "non-essential" tenants reopened their doors. By comparison, mall REITs reported a collection of roughly 80% of rents in the fourth quarter while shopping center REITs collected roughly 92%.
Recent earnings reports confirmed that acquisition-fueled external growth - which has explained the vast majority of the sector's AFFO (Adjusted Funds From Operations) growth over the last two decades - kicked-back into gear late last year and is expected to power a high-single-digit percentage point rebound in AFFO growth in 2021 following an average decline of roughly 7% in 2020. Among the larger-capitalization REITs, National Retail (NNN), Essential Properties (EPRT), and Realty Income (O) are expected to see the strongest rebound this year followed by STORE Capital (STOR) and VEREIT (VER). Among the net lease REITs that provided full-year guidance, just one - Broadstone (BNL) - sees a slowdown in AFFO growth in 2021.
Fueled by recovering valuations and ample access to capital, several net lease REITs are back to doing what they do best as the vaccine-driven rebound "reopened the spigot" for the well-capitalized REITs at an impressive pace. Led by the Power 4 (O, NNN, STOR, ADC) which have accounted for more than 75% of the total net acquisition activity over the past five years, net lease REITs acquired more than $2 billion of real estate assets, on net, in the fourth quarter, a sharp acceleration following the slowdown in mid-2021 to end the year with net acquisitions of roughly $5.5 billion. Among the seven REITs that provided guidance, these REITs see acquisitions eclipsing $8 billion for 2021.
Historical trends indicate that REITs, as a whole, have performed quite well during periods of rising interest rates, and that commercial and residential real estate have historically exhibited moderate-to-strong inflation-hedging properties. We emphasize that nuance is required in this analysis, particularly when investing in individual securities rather than the broad-based benchmarks. A highly diverse asset class, REITs are "part equity, part bond" and some property sectors skew heavily in either direction. Based on our analysis which calculates each REITs "Beta" to different benchmarks, we present a framework for analyzing each sector based on their sensitivity to long-term interest rates (IEF) and to economic growth expectations (MDY).
Net Lease REIT Stock Performance
Viewed as "bond-proxies" due to their defensive characteristics and high sensitivity to interest rates, net lease REITs hadn't initially performed like the safe-haven they were believed to be amid the ongoing coronavirus pandemic. Net lease REITs were slammed early in the pandemic amid the historic market volatility last March and April with the average net lease REIT plunging more than 50% during those two months. Net lease REITs have rallied back to life over the last six months amid the broader "reopening rally," fueled by the approval and distribution of effective coronavirus vaccines. Net lease REITs ultimately ended 2020 with rather modest declines of -10% compared to the -8% decline on the FTSE Nareit All Equity REITs Index.
At the outset of the pandemic, investors were reminded that many net lease sectors, through their underlying tenant base, have heavy exposure to industries that bore the brunt of the "social distancing" impact of the virus outbreak including restaurants and experience-based categories such as movie theaters, fitness, and education. While the triple-net lease structure has provided a strong degree of protection for most segments, some tenants in these heavily impacted categories continue to struggle to stay afloat.
The relatively steady 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. One net lease REIT - Four Corners Property (FCPT) delivered positive total returns in 2020, but several REITs with heavy exposure to experience-based categories and non-investment-grade tenants were hit especially last year. EPR Properties (EPR) - which owns a large portfolio of movie theaters and theme parks - plunged more than 50% last year while American Finance (AFIN) dipped nearly 40%. The intra-sector performance has reversed this year, however, with these more speculative REITs outpacing last year's outperformers.
Net Lease REIT Dividend Yields
Net Lease REITs were largely unphased by the wave of dividend cuts that swept through the REIT sector last year. As discussed in our recent report Income In the Yield Desert, one of the lasting lessons from a tumultuous 2020 was to "expect the unexpected." While the "essential" property sectors - housing, technology, and logistics - were the clear leaders when it came to dividend growth last year and into 2021, net lease REITs have exhibited surprising resilience with nine of the sixteen REITs paying higher dividends in 2020 and we've seen another two REITs raise their payouts - Alpine Income (PINE), Agree Realty (ADC) thus far this year.
Relatively high dividend yields are one of the key investment features of the net lease REIT sector, and the resilience in maintaining or increasing dividends have helped to push dividend yields towards the top of the REIT sector. Net lease REITs pay an average dividend yield of 4.8%, a premium of 140 basis points over the broader REIT average of 3.4%. Net lease REITs pay out roughly 72% of their free cash flow, also towards the top end of the REIT sector average, but typically make heavy use of secondary equity offerings to raise capital to fund accretive external growth.
Throughout the pandemic, however, it's been a story of "haves" and "have nots" across the broader real estate sector, and net lease REITs are certainly no exception. Four net lease REITs paid lower distributions in 2020 than the prior year and are still paying distributions below their pre-pandemic rates: EPR Properties, Global Net Lease (GNL), and American Finance, and VEREIT. The latter three, however, have each raised their dividends at least following the initial reduction, and we expect that net lease REITs will return to aggregate dividend growth in 2021.
Within the sector, we note the dividend yields and historic dividend growth of each of the sixteen net lease REITs. Of note, a half-dozen of these REITs have delivered consistent dividend growth over the past half-decade, led by Getty Realty (GTY), Four Corners, STORE Capital, Agree Realty, and Realty Income. Several of the highest-yielding names in the sector, however, have seen their dividends decline over this time. Our recent report "The REIT Paradox: Cheap REITs Stay Cheap," suggested that investors should look beyond dividend yield in their REIT selection and put greater emphasis on quality-based metrics and dividend growth potential.
For investors interested in the "preferred route" to invest in these REITs, six of the fifteen REITs also offer preferred securities including one issue from VEREIT (VER.PF), one from National Retail (NNN.PF), one from Spirit Realty (SRC.PA), a suite of three from EPR Properties (EPR.PC, EPR.PE, EPR.PG), two from Global Net Lease (GNL.PA, GNL.PB), and one from American Finance Trust (AFINP), all of which are standard cumulative redeemable preferred securities that currently trade with an average yield of roughly 6.4% and trade at modest premiums to par value.
Another option for investors seeking diversified exposure to the net lease REIT sector is the NETLease Corporate Real Estate ETF (NETL), which includes not only thirteen of these sixteen net lease REITs' common shares but also the common shares of eleven other REITs that utilize the triple-net lease structure in the industrial, office, and gaming/casino sectors including Innovative Industrial (IIPR), Industrial Logistics (ILPT), Gaming and Leisure Property (GLPI), and VICI Properties (VICI). With 25 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.
Deeper Dive: Net Lease Economics
"Cost of capital" is the name of the game in the net lease REIT sector and share price performance 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 net lease 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 while depressed valuations make it difficult to fuel the external growth cycle. For illustrative purposes, we diagram the expected sources of total returns under two valuations scenarios, highlighting our view that the total return potential of the sector is higher when the sector is trading with elevated equity valuations.
Retail Headwinds (Or Tailwinds)?
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. Aided by the WWII levels of fiscal stimulus over the last several months, retail sales jumped to all-time record highs on an annualized basis in January. While several net-lease-heavy categories including home improvement, pharmacies, and auto parts continue to hold up relatively well, other key at-risk retail categories to monitor amid the COVID-19 outbreak are restaurants, movie theaters, and fitness centers.
For restaurants, the single-largest net lease category, we note that the National Restaurant Association's Restaurant Performance Index (RPI) plunged to historical lows in April and remained in contraction territory in February. The index showed that less than half of restaurateurs expect their sales to be higher over the next six months than the prior year. Meanwhile, for movie theaters, which represent roughly 5% of net lease NOI, Box Office Mojo data shows that box office revenue plunged 80% in 2020. The trends in the fitness industry, which also represent about 5% of NOI are equally concerning.
With occupancy at 99%, net lease REITs had defied the retail-related headwinds that have bedeviled other retail REIT sectors before the pandemic. 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" and lingering economic shutdowns. Below, we outlined the strategies that successful brick-and-mortar retailers have utilized to compete, which we call the "4 Critical Cs of Brick & Mortar Competition."
Net Lease REIT Valuations
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 we'll discuss below, 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. While some of the REITs in the sector remain encumbered by an unfavorable cost of capital, several of the highest-quality net lease REITs maintain ample access to low-cost capital, which has helped to reignite accretive external growth.
Bull And Bear Thesis For Net Lease REITs
Below, we outline five reasons why investors are bullish on net lease REITs.
Below, we outline five reasons why investors are bearish on net lease REITs.
Key Takeaways: Rate Worries Premature
While perhaps not entirely justified by fundamentals, prior to the pandemic, the performance of the net lease REIT sector over the past half-decade was ultimately driven by movements in long-term interest rates, specifically the 10-Year Treasury Yield, which in turn is driven primarily by a) growth expectations; and b) inflation expectations. These REITs have seen their momentum cool over the last month as interest rates have climbed to mid-pandemic highs amid accelerating progress on the vaccine distribution and in anticipation of a fresh round of fiscal stimulus. For now, we believe that macroeconomic conditions remain in the "Goldilocks zone" and net lease REITs should be beneficiaries of the reopening trade so long as rates are rising for the "right" reasons: economic growth expectations rather than inflation.
That said, the bifurcation is likely to continue between the "haves" and "have nots" in the post-vaccine world considering the critical importance of "cost of capital" within the net lease sector. High-quality net lease REITs have become adept at swimming upstream against seemingly all of these macro headwinds, and we believe that investors that are willing to "pay-up" for quality will continue to be rewarded while bargain-seekers will continue to pay the price.
For an in-depth analysis of all real estate sectors, be sure to check out all of our quarterly reports: Apartments, Homebuilders, Manufactured Housing, Student Housing, Single-Family Rentals, Cell Towers, Casinos, Industrial, Data Center, Malls, Healthcare, Net Lease, Shopping Centers, Hotels, Billboards, Office, Storage, Timber, Prisons, Cannabis, Real Estate Crowdfunding, High-Yield ETFs & CEFs, REIT Preferreds.
Disclosure: Hoya Capital Real Estate advises an Exchange-Traded Fund listed on the NYSE. In addition to any long positions listed below, Hoya Capital is long all components in the Hoya Capital Housing 100 Index. Index definitions and a complete list of holdings are available on our website.
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