My Biggest Investments In 2022 Might Surprise You

Summary

• Many investors are expecting cryptocurrency and high-growth tech stocks to outperform over the coming years.
• But 25% of my net worth is in an entirely different kind of investment: net lease REITs.
• I explain why they offer some of the best risk-adjusted returns available in 2022, and highlight a few of our Top Picks for high yield and upside.
• Looking for a portfolio of ideas like this one? Members of High Yield Landlord get exclusive access to our model portfolio. Learn More »

William_Potter/iStock via Getty Images

Some of the most popular investments recently have been Tech stocks (QQQ) like Apple (AAPL), which just crossed the three-trillion-dollar market cap, and cryptocurrencies like Bitcoin (BTC-USD) and Ethereum (ETH-USD).

And it’s understandable.

After all, they’ve performed extremely well in recent years:

Data by YCharts

However, I prefer to look for contrarian investments that are outside of the spotlight, as opposed to Bitcoin and Apple, which everyone and their neighbor are already talking about.

One of my favorite under-the-radar assets to invest in is net lease REITs. In fact, they are the largest sector by allocation in my personal portfolio, comprising around 25% of my net worth.

This may seem like a very large position, but I’m betting on these REITs for good reasons. I’ll present them below, and encourage you to look into considering these REITs as part of your own wealth strategy.

What are Net Leases REITs?

Many investors are familiar with the basics of REITs - or Real Estate Investment Trusts. But the majority of investors don’t understand what a net lease is, or why they’re beneficial. In fact, most investors look at net lease properties in a negative fashion.

This is because we’ve been told that many net lease properties are supposedly doomed from the growth of Amazon (AMZN) and the impending “retail apocalypse.”

However, this is a very superficial way of thinking about net lease properties. Net leases fall under a wide umbrella and are used by properties like:

Grocery stores: Walmart (WMT), Target (TGT), Dollar Tree (DLTR):

Source: Realty Income (O)

Fast food chains: McDonald's (MCD), Burger King (QSR), Domino's (DPZ):

Source: LoopNet (CSGP)

Home improvement stores: Home Depot (HD), Lowe's (LOW), Tractor Supply (TSCO):

Source: Spirit Realty Capital (SRC)

Pharmacies: Walgreens (WBA), Rite Aid (RAD), CVS (CVS):

Source: LoopNet (CSGP)

Other examples would include gyms, gas stations, car washes, auto repair shops, and even water parks and golf complexes.

But what's so appealing about these real estate investments?

1. Exceptionally Long Leases: Net leases are often over a decade long, resulting in highly consistent and predictable cash flow. Leases are so long because the tenant's entire business relies on that one property. They are highly dependent on it and need the safety of a long lease.
2. Predictable rent hikes: Rent increases are agreed to from the start and added to the lease. A typical rent hike is 2% per year and some net leases also have periodic CPI adjustments to add further inflation protection.
3. Tenants foot the bill: Something unique thing about net leases is that the tenants are responsible for maintenance, repairs, and other expenses. This means very little overhead and great margins for the landlord.
4. E-commerce proof: Ok, let’s address the Amazon fears. The fact of the matter is that most net lease properties involve service, experience, or expertise. You cannot fuel your car or get fresh tacos on Amazon.
5. Large land value component: The raw land of these properties is itself extremely valuable. This is because these properties are typically located in highly desirable areas with lots of traffic. Land acts as an inflation hedge, and also as a built-in margin of safety even in worst-case scenarios.

In order to lay these advantages out more clearly, just compare the criteria for owning an apartment community, to owning a net lease:

	Net Lease Property	Apartment Building
Lease term	15 years	1-year
Property expenses	Tenant's responsibility	Landlord pays them
Repairs	Tenant's responsibility	Landlord's responsibility
Rent hikes	~2% annual escalators and/or CPI adjustment	Periodic and irregular
Tenant turnover	Very low	Very high
Land value component	High	Moderate

Click to enlarge

These benefits have allowed net lease properties to achieve impressive returns for many years. To this day, you could buy a net lease property at a ~6.5% cap rate, finance half of it with a ~3.5% mortgage, and earn ~12% average annual returns once you factor in the rent increases and appreciation. That's extremely compelling coming from a lower risk, management-free, bond-like real estate investment.

What's the catch?

Unless you are worth $100s of millions, you won't be able to build a well-diversified portfolio on your own. Since each property only has one tenant, you need a significant amount of capital to diversify your risks.

Fortunately, net lease REITs solve that issue for you. You can invest in them with even a small amount and the two oldest net lease REITs, National Retail Properties (NNN) and Realty Income, have generated 12-15% average annual returns over the past 20+ years.

Just look how they compare to the S&P 500 (SPY):

Data by YCharts

But best of all, they achieved these superior returns with lower risk and higher income, resulting in exceptionally strong risk-to-reward.

The business model is so resilient that NNN and O have never missed a dividend payment. Not even during 2000, 2008, 2020, or any of the financial crises:

Data by YCharts

And it gets even more fascinating.

Net lease REITs have even outperformed private equity deals in the net lease space. That's because they enjoy significant economies of scale, superior tenant relationships, and have access to lower costs of capital to pursue faster growth.

That's how Realty Income, the largest net lease REIT, has managed to earn 15% per year on average by following a simple net lease investment strategy:

source

So with net lease REITs, you’re basically buying net lease properties on steroids because you get higher returns with lower risk and the added benefits of diversification, professional management, and liquidity.

Not surprisingly, net lease REITs are very popular during most times and trade at expensive valuations.

Today is the exception!

Because of the pandemic, the market has soured on all retail-exposed businesses, including net lease REITs.

As a result, these REITs have dropped to historically low valuations and still haven't recovered from the initial covid sell-off:

Data by YCharts

The 15-20% discount is especially baffling when you consider that:

• They have kept growing cash flow to new record highs.
• They have kept growing dividends to record highs.
• Cap rates have compressed to record lows, meaning their properties are worth more than ever before.
• Interest rates have dropped significantly, meaning that they can refinance debt and increase profits.
• Today, investors have even fewer alternatives to earn steady, inflation-protected income.
• The rest of the market is historically expensive and priced at a huge premium to pre-covid levels.
• Real interest rates are deeply negative and expected to remain so even after several hikes, an ideal environment for real estate.

Therefore, you can objectively say that net lease REITs are more valuable than ever and that the discount makes little sense. They are producing more cash flow than ever, paying higher dividends than ever, and their assets are more valuable than ever.

Ultimately, we think that they are discounted due to the perception that they are hurt by the pandemic, which clearly isn't the case. This provides a window of opportunity for investors to buy these highly-desirable REITs at historically low valuations relative to most other segments of the market.

The pandemic won't last forever and in a world of ultra-low interest rates, we think that it is only a question of time before net lease REITs recover to new all-time highs:

Data by YCharts

But before you rush to buy just any net lease REIT (NETL), you need to consider that some of them are better positioned than others. As an example:

• Some enjoy better inflation protection
• Some are growing far faster than others.
• Some are more steeply discounted.
• Etc.

You could buy the largest and best-known net lease REITs like Realty Income and National Retail Properties and be done with it. But you would potentially leave money on the table as some of their peers are even more compelling.

Below we highlight VICI Properties (VICI).

It is one of our largest holdings at High Yield Landlord because we believe that it offers the best combination of yield, growth, value, and safety.

What sets it apart?

As we explain in a recent article on the company, VICI is in a class of its own:

Unlike most REITs that target traditional net lease properties like Dollar General (DG) convenience stores and compete with a vast world of family offices, private equity funds, and high net worth individuals; VICI is taking a more strategic approach of buying specialty net lease properties such as casinos that lack competition. To give you an example: VICI is the owner of the Caesars Palace in Las Vegas and it is leased on a triple-net basis to Caesars (CZR):

Source: VICI Properties

The market perceives this strategy as much riskier and as a result, it has priced VICI at a discount to peers.

But in reality, VICI has proven that this approach is not only more rewarding but also potentially safer. That's because the lack of competition in this segment of the market puts it in a stronger position to negotiate even safer lease terms with tenants.

• Leases are even longer.
• Rent coverage is even greater.
• Rent increases are greater.
• A large portion of its leases has CPI-rent adjustments.
• Purchase prices are below replacement cost.
• The investment spreads are much greater.

The proof is in the results: During 2020, VICI was one of only two net lease REITs to earn 100% of its rents in full and on time. (The other one is Safehold (SAFE), a ground lease REIT)

Not only that, it managed to hike its dividend by 11% in 2020, and another 9% in 2021. Going into 2022, we expect this rapid growth to continue because VICI is about to close the largest acquisition in its history (MGP buyout).

Despite enjoying superior growth, VICI is today priced at one of the lowest multiples in its peer group at just 14x estimated forward FFO and it yields nearly 5%. That's deep value for a REIT of this quality.

We think that as we move past the pandemic, the market will reprice VICI at closer to 20x FFO, unlocking ~40% upside and while you wait, you earn a 5% yield, and the company's cash flow continues to grow at a rapid pace.

It is hard to beat that in terms of risk-to-reward. High yield, steady growth, upside, and safety. If the pandemic couldn't take it down, then what will?

Bottom Line

For all these reasons, we believe that net lease REITs offer some of the best risk-adjusted returns of any asset in today's environment.

The market is inefficient and emotional in the short term, but it is only a matter of time before it realizes that these resilient REITs are trading at a serious discount. The key is to get in before this awakening happens.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of VICI; O; NNN; QSR 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.