Net Lease REITs: Analyzing Inflation Risk

Summary

• Despite a wave of dividend hikes and robust external growth, net lease REITs have been among the weakest-performing property sectors this year amid concerns over soaring inflation and rising interest rates.
• Despite their reputation as bond substitutes, net lease REITs have historically delivered above-average earnings growth as accretive external growth has more than offset the drag from muted property-level growth.
• Thriving in the "lower for longer" macroeconomic environment that defined the 2010s, the new regime of higher inflation rates has raised questions about these REITs' ability to continue to outperform.
• We’ve developed additional metrics to measure the inflation-hedging characteristics and potential risks. Since net lease REITs are among the more bond-like sectors, the need for diversification becomes especially important.
• Net lease REITs are currently firing on all cylinders, taking full advantage of cheap capital to fuel a "buying spree" of property acquisitions. We see recent underperformance as a buying opportunity, particularly for net lease REITs that provide better inflation protection.
• This idea was discussed in more depth with members of my private investing community, Hoya Capital Income Builder. Learn More »

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REIT Rankings: Net Lease

Within the Hoya Capital Net Lease Index, we track the sixteen net lease REITs, which account for roughly $100 billion in market value. Despite a wave of dividend hikes and robust external growth, net lease REITs have been among the weakest-performing property sectors this year amid concerns over soaring inflation and rising interest rates. Thriving in the 'lower for longer' macroeconomic environment that defined the 2010s, the new regime has raised questions about these REITs' ability to continue to outperform given the long-duration nature of their lease structure, which we analyze in this report.

"Net lease" refers to the triple-net lease structure, whereby tenants pay all expenses related to property management: property taxes, insurance, and maintenance. One of the most "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 and the underlying "credit" exposure through their tenants' ability to pay rent. Unlike corporate bonds, however, net lease REITs have the ability to grow distributions through a combination of organic growth (rent escalators) and accretive external growth (acquisitions).

Triple net leases - which are used to varying degrees across the REIT universe including the Casino and Healthcare REIT sectors - proved to be particularly durable throughout the pandemic-related turmoil regardless of the headwinds endured by their tenants. 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.

Back To Business For Net Lease REITs

As discussed in our Real Estate Earnings Recap, following a lackluster second-quarter earnings season, net lease REITs got "back to business" in Q3 with strong beat-and-raise reports. STORE Capital (STOR) and National Retail (NNN) led the way with upward revisions to FFO growth of 190 bps and 180 bps, respectively while Spirit Realty (SRC) raised its outlook by 80 bps and Realty Income (O) hiked its outlook by 50 bps. Getty Realty (GTY) was also an upside standout, boosting its full-year FFO growth outlook to 5.5% - up 190 basis points from last quarter while Alpine Income (PINE) hiked by 630 bps.

Among the nine REITs that provided acquisition guidance, these REITs see acquisitions eclipsing $11 billion for 2021 with most REITs likely to report their highest full-year acquisition volumes on record. Six of the nine REITs that provide guidance raised their full-year FFO growth outlook as more than half the sector now expects its 2021 FFO to be above pre-pandemic levels while 2022 guidance from several REITs indicated building momentum.

Nearly all net lease REITs are now back on the offensive as rent collection has now fully normalized aside from EPR Properties (EPR) - which owns an "experience-heavy" portfolio including movie theaters, theme parks, and gyms. EPR - which was among the hardest-hit REITs by the pandemic - reported that rent collection improved to a respectable 90% in Q3 and boosted its full-year outlook by nearly 1,000 bps. Net lease REITs collected 99% of rents in Q3 which is in-line or even slightly above pre-pandemic averages.

Acquisition-fueled external growth - which has explained the vast majority of the sector's FFO ("Funds From Operations") growth over the last two decades - kicked back into gear late last year and is expected to power a double-digit percentage point rebound in AFFO growth in 2021. Net lease REITs - which account for just 7% of the Equity REIT Index - accounted for over a third of total REIT acquisitions over the past twelve months and acquired more than $3B in real estate assets, on net, in the third quarter, pushing their twelve-month total to over $9B - the highest level since 2014.

Fueled by improved operating performance, fourteen of the sixteen net lease REITs have boosted their payouts in 2021, joining a total of more than 125 REITs that have hiked their dividends this year. Net lease REITs were largely unfazed by the wave of dividend cuts that swept through the REIT sector last year and with the wave of increases this year, the sector is now on pace to achieve cumulative dividend growth of roughly 7% over the baseline 2019-levels. Net lease REITs are now among the highest-yielding REIT sectors with average yields around 5%.

Net Lease REIT Inflation Risk

With the Consumer Price Index soaring to the fastest rate of growth in four decades last month, and the Producer Price Index setting all-time highs as well, how concerned should net lease investors be about inflation given their long-duration leases and modest 1-2% average annual rent escalators? To help address this question, we developed additional metrics for Hoya Capital Income Builder members to measure REITs' inflation-hedging characteristics.

In developing our Inflation Hedge Factor metric, we analyzed research from Nareit, AllianceBernstein, and others that looked at the long-term performance of REITs in periods of high inflation relative to other asset classes. REITs are "part equity, part bond" with characteristics that blend features of both, underscoring their value in a balanced investment portfolio.

The Inflation Hedge Factor is an "adjusted Beta" calculation utilizing inflation expectations as the benchmark. REITs with higher Inflation Hedge Factors are more positively affected by rising inflation, while REITs lower on the scale are less effective inflation hedges. While all REIT sectors provide significantly better inflation-hedging attributes than bonds and other fixed-income asset classes, several of the more "bond-like" REIT sectors - including net let lease REITs - have historically exhibited more muted inflation-hedging attributes with some of the larger REITs exhibiting negative "Inflation Beta."

The Risk Profile below reveals several key findings. Consistent with the patterns we observe across the REIT sector, mid-cap and small-cap REITs tend to exhibit better inflation-hedging characteristics than large-cap REITs. While these characteristics reflect some fundamental causes - higher levels of operating and/or financial leverage typically associated with smaller REITs - the findings nevertheless indicate that investors should: 1) be aware of their exposures to different risk factors; and 2) be diligent to diversify across not only property sectors, but also across market capitalization tiers.

The bottom line - macroeconomic trends and "regime shifts" are notoriously difficult to predict. Understanding how REITs respond to factors outside of one's control - and diversifying the portfolio to manage those risks - gives that control back to investors. We construct our Income Builder REIT Portfolios to perform favorably in a wide range of economic environments and even in the face of higher levels of inflation, we continue to see the bond-like nature of net lease REITs as a dependable 'anchor' for income-oriented REIT portfolios.

Net Lease REIT Stock Performance

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. These REITs rallied back to life amid the broader "reopening rally" and on improving fundamentals, but concerns over rising rates, inflation, and potential tax code changes have pressured net lease REIT valuations since mid-2021. Net lease REITs are higher by 12.6% this year, lagging the broad-based Vanguard Real Estate ETF (VNQ), which has gained 30.4% this year while the S&P 500 ETF (SPY) is higher by 25.9%.

The relatively muted 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. EPR Properties, which dipped more than 50% last year, has been among the leaders this year but remains more than 50% below its pre-pandemic level despite this year's 45% surge. Small-cap One Liberty (OLP) - which focuses largely on industrial net lease properties - is the best-performer this year with gains of nearly 70%. Four Corners Property (FCPT) - the lone net lease REIT to deliver positive total returns last year - is one of two REITs in negative territory this year along with Global Net Lease (GNL).

Net lease REITs thrive in the "lower for longer" macroeconomic environment, so concerns over rising rates, inflation, and potential tax code changes have pressured valuations over the past two quarters. 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.

Deeper Dive Into Net Lease REITs

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 - such as movie theater chain AMC Entertainment (AMC) and Planet Fitness (PLNT) - still face an uncertain future, particularly if pandemic-related restrictions continue to linger.

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 restrictions. Additionally, unlike their retail REIT peers, these REITs operate with higher margins and have more plentiful acquisition opportunities due to the smaller size of the average net lease property which may be especially true given the uncertainty over the potential repeal of the 1031 or 721 exchanges as part of the Biden Administration's tax plan. Private real estate owners are currently able to defer capital gains by selling their property to a REIT in exchange for common stock units, a "tax break" that faces scrutiny from the new administration, forcing many property owners to seek potential exchanges before the changes potentially take effect.

Net Lease REIT Dividend Yields

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 has helped to push dividend yields towards the top of the REIT sector. Net lease REITs now pay an average dividend yield of 4.8%, a premium of 200 basis points over the broader market-cap-weighted REIT average of 2.8%. Net lease REITs pay out roughly 80% 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.

For investors interested in the "preferred route" for investing in these REITs, five of the sixteen net lease REITs also offer exchange-traded preferred securities as tracked in our REIT Preferred Stock & Bond Tracker, a database of all 175 REIT preferred and exchange-listed bonds. These securities include one from Spirit Realty (SRC.PA), one from Agree Realty (ADC.PRA), a suite of three from EPR Properties (EPR.PC, EPR.PE, EPR.PG), two from Global Net Lease (GNL.PA, GNL.PB), and two from American Finance Trust (AFINP, AFINO). All of these are standard fixed-rate cumulative preferreds with the exception of EPR-C and EPR-E which have conversion options.

The Bull And Bear Thesis For Net Lease REITs

Below, we outline the bullish case for Net Lease REITs.

Below, we outline the bearish case for Net Lease REITs.

Takeaway: Positive Outlook Despite Inflation Risk

Thriving in the "lower for longer' macroeconomic environment that defined the 2010s, the new regime of higher inflation rates has raised questions about net lease REITs' ability to continue to outperform. We developed a new metric - the Inflation Hedge Factor - which measures how effective REITs are at providing inflation protection. Since net lease REITs are among the more bond-like sectors - and provide only muted or even negative inflation protection - the need for diversification becomes especially important.

Macroeconomic trends and "regime shifts" are notoriously difficult to predict. Understanding how REITs respond to factors outside of one's control - and diversifying the portfolio to manage those risks - gives that control back to investors. We construct our Income Builder REIT Portfolios to perform favorably in a wide range of economic environments and even in the face of higher levels of inflation, we continue to see the bond-like nature of net lease REITs as a dependable 'anchor' for income-oriented REIT portfolios.

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, and Cannabis.

Disclosure: Hoya Capital Real Estate advises two Exchange-Traded Funds 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 and in the Hoya Capital High Dividend Yield Index. Index definitions and a complete list of holdings are available on our website.

Disclosure: I/we have a beneficial long position in the shares of RIET, HOMZ, STOR, NNN, WPC, FCPT, PSTL, GTY, OLP, SRC, PINE, GOOD, EPR, GNL, AFIN, GNL.PB, AFINP either through stock ownership, options, or other derivatives. 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.