Net Lease REITs: Exploiting A Competitive Advantage (2024)

REIT Rankings: Net Lease

In our REIT Rankings series, we analyze REITs within each of the commercial and residential sectors, focusing on property-level fundamentals and the macroeconomic forces driving overall supply and demand conditions. We then analyze REITs based on both common and unique valuation metrics, presenting investors with numerous options that fit their own investing style and risk/return objectives.

(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 retail-focused 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), EPR Properties (EPR), Spirit Realty Capital (SRC), 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 REITs comprise roughly 8-10% of the broad-based REIT ETFs (Vanguard Real Estate ETF (VNQ) and iShares U.S. Real Estate ETF (IYR)).

"Net lease" refers to the triple-net lease structure, whereby tenants pay all expenses related to property management: property taxes, insurance, and maintenance. 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 seen 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. One of the most interest rate-sensitive REIT sectors, net lease REITs generally perform best in the "Goldilocks" macroeconomic environment of low interest rates and steady economic growth. 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 has been the defining competitive advantage for these REITs, explaining much of the consistent outperformance over the last three decades. Counterintuitively, we believe that these REITs are fundamentally at their best when equity valuations are slightly elevated. For illustrative purposes, we diagram the expected sources of total returns under two valuations scenarios. While yield-focused investors tend to view the sector less favorably when valuations are extended (and dividends lower), we believe that the total return potential of the sector is higher when the sector is trading with elevated equity valuations, as these REITs are able to grow AFFO and dividends via accretive external acquisitions.

While nearly every REIT sector uses the triple-net lease structure to some degree, these twelve retail-focused net lease REITs operate exclusively under this triple-net structure and are also referred to as the "free-standing retail" sector. 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 (FCPT on restaurants, GTY on gas stations), while other REITs own diversified portfolios of both retail and non-retail properties. While only eight of the twelve REITs in our coverage have investment-grade, long-term debt ratings from S&P, all twelve net lease REITs command investment-grade bond ratings from at least one of the three major credit rating agencies.

Despite mounting concerns of a “Retail Apocalypse 2.0” given the unexpected surge in store closings this year, net lease REITs have bucked the negative retail trends and continue to outperform. CoreSite Research has tracked more than 9,000 closings so far this year, already outpacing the full-year count for 2018, and estimates that up to 12,000 could announce closings by year-end. While nearly two-thirds of a net lease REIT’s revenue comes from retail-based tenants, it’s primarily the “right kind” of retail. Restaurants, convenience stores, fitness, and home improvement retailers are the top tenants across the industry, sectors facing less e-commerce competition. Amid the search for yield, however, we think that investors discount the retail-related risks in other critical net lease sectors, including pharmacies and movie theaters, with a higher risk of disintermediation, which we discuss in more detail below.

Compared to malls and shopping centers, net lease REITs typically own and lease smaller properties (generally single-tenant) under longer lease terms. 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 index or a fixed annual percentage. Because of this structure, property-level upside potential is generally retained by the tenant and net lease REITs are more sensitive to changes in interest rates and inflation. Below, we discuss the advantages and disadvantages inherent with these different retail models.

Recent Stock Performance and Valuation

Considering the critical importance of equity market valuations on net lease REIT operations and external growth potential, we begin our analysis with a review of recent stock performance and current valuations. As discussed in our recent Real Estate Earnings Recap, after three years of middling performance, the "Goldilocks" macroeconomic environment of lower interest rates and moderate domestic-led economic growth have rejuvenated not only net lease REITs but the entire real estate sector in 2019. The performance of the net lease REIT sector over the past half-decade has ultimately been driven by movements in the 10-year Treasury yield. The domestic-focused, defensively-oriented net lease sector has been revitalized this year by the plunge in global interest rates, as the 10-year yield has dipped more than 140 basis points since peaking last November.

The REIT Rejuvenation of 2019 has been a tide that has lifted (almost) all boats across the REIT sector. While the Hoya Capital Net Lease Index has jumped 28% so far this year, the other retail REIT sectors have not enjoyed the windfall from lower rates, as store closings have unexpectedly surged this year after some relative reprieve in 2018. Malls are the lone real estate sector in negative territory this year, dipping 9% so far this year and underperforming the best-performing sector (manufactured housing) by a staggering 65%. Specific to net lease REITs, stock performance this year has boosted equity valuations and re-opened accretive external growth opportunities that have fueled AFFO growth this year.

The 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. Quality is critical across the REIT sector, but that is especially the case in the net lease REIT sector. For several years, we have defined a top-tier of names within the sector as the Power 3, which includes Realty Income, National Retail Properties, and STORE Capital Corp. As we'll analyze in more detail shortly, these three REITs have accounted for the majority of the share price appreciation and AFFO growth of the sector over the past five years, while many of the small-cap names have persistently underperformed the broader index. This year, however, we've broader participation with strong gains from Essential Properties Realty Trust, Spirit Realty Capital, and VEREIT.

A rather unique phenomenon among publicly traded companies, equity market valuations can and do have a meaningful impact on the underlying business operations of these companies. Before the rally began around this time last year, net lease REITs were trading at the lowest valuations of the post-recession period, an issue we discussed in the article "Net Lease REITs Are Too Cheap, And That's A Problem." The macroeconomic regime has shifted dramatically and favorably over the last eighteen months. Since early last year, inflation expectations and interest rates have fallen dramatically, pulling investor capital back into the yield-sensitive segments of the equity markets and restoring the coveted NAV premium - perhaps the best reflection of the cost of equity capital. Net lease REITs now trade at an estimated 25-35% premium to Net Asset Value, allowing these REITs to get back to doing what they do best: external growth via accretive acquisitions.

Net Lease REIT Fundamental Performance

Led by the "Power 3" (O, NNN, STOR), third-quarter earnings were generally better than expected across the sector, as AFFO and dividend growth look poised to turn decidedly positive in 2020 after a challenging two years. Of the eight REITs in the sector that provide AFFO guidance, six names boosted full-year 2019 AFFO growth expectations and four names boosted full-year acquisition guidance. Again, however, the bifurcation in performance becomes very noticeable. The Power 3 REITs are expecting to grow AFFO to grow an average of 5.4% this year and are expected to account for more than 80% of the total net acquisition activity this year. Most of the rest of the sector is expecting to see low-single digit or negative AFFO growth this year, though we do expect the rest of the sector to see decidedly positive AFFO growth in 2020 given that the favorable cost of capital conditions enjoyed almost exclusively by the Power 3 over the last several years have now spread to the other names in the sector.

Property-level fundamentals remain steady despite the headwinds across the broader retail sector. Occupancy ticked higher by roughly 10 basis points from last quarter to end the period just shy of 99%. Pressured by the unexpected wave of store closures in 2019, however, the rest of the retail sector has seen an average 50 basis point dip in occupancy in 2Q19 from the same period last year. 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 Q2. 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.

As discussed, similar to the trends we've observed in the retail space, we continue to note the significant bifurcation in operating performance between the two tiers of the net lease REIT hierarchy. Over the last several years, three REITs have separated themselves from the pack, which we dub the Power 3: Realty Income, National Retail Properties, and STORE Capital Corp. Unlike some of the smaller-cap names and their mid-cap peers like VEREIT, Spirit Realty Capital, and W. P. Carey, the Power 3 have kept their hands clean of accounting issues, tenant bankruptcy problems, and non-traded REIT complications. This Power 3 tier has widened their relative spread in AFFO growth above the rest of the sector in recent years, but we expect that spread to tighten in 2020.

Capital Markets and Acquisition Activity

With external acquisitions being responsible for more than two-thirds of total AFFO growth over the past decade, the focus of investors remains on acquisition activity, which did not disappoint in 3Q19. Spurred by rejuvenated valuations, the external growth spigot has re-opened over the past twelve months. Net lease REITs acquired more than $1.3 billion in net assets last quarter, coming after 2Q19's similarly strong $2.0 billion in net purchases. Over the last twelve months, the sector has acquired more than $5.5 billion in net assets, representing roughly 8% of the sector's market value.

After several years of very modest equity capital raising, net lease REITs have been very active this year with secondary offerings and at-the-market (ATM) offerings, building up as much "dry powder" as possible while the capital raising window is open. On a quarter-over-quarter basis, net lease REITs have expanded their share count by roughly 2%. Overall, over the last year, the sector has expanded its share count by roughly 17%, boosted by W. P. Carey's share issuance to fund its acquisition of one of its managed funds, Corporate Property Associates 17.

Property-Level Fundamentals

While M&A activity is the bread and butter of the net lease sector, 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. After reaching the fastest rate of growth since 2012 in the middle of last year, retail sales growth has generally moderated over the past several months, but data has been relatively strong since early this summer, led by the e-commerce category. Holiday sales got off to a very strong start this year with reports of record sales growth during the Black Friday weekend.

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. 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.

While we're comfortable with the exposure to restaurants, auto parts, fitness, and home improvement, amid the search for yield, we do think that investors discount the retail-related risks in other critical net lease sectors, including pharmacies and movie theaters, with a higher risk of e-commerce-related disintermediation. Following a strong year at the box office in 2018, movie ticket sales are down 7.8% YTD, a group that we follow closely considering the clear headwinds from streaming services, which has helped to shave more than two-thirds of market value from AMC Entertainment (AMC) since 2017. On a similar note, CVS Health (CVS) and Walgreens (WBA) are each more than 30% below their highs from back in 2015 as pharmacies face disintermediation risk from online pharmacy sales.

Restaurants continue to be the standouts among the net lease retail categories, and while we are bullish on the long-term outlook for the quick-service restaurant business, we should note restaurateurs have lowered their expectations for near-term growth over the next six months on continued fears of slowing global economic growth affecting the US consumer. According to Restaurant.org, just 31% of survey respondents project higher same-store sales over the next six months, the lowest level in more than two years. The RPI - a monthly composite index that tracks the health of and outlook for the U.S. restaurant industry - stood at 101.1 in October 2019, one of the weakest readings of the post-recession period, a trend that net lease investors need to keep an eye on in 2020.

Net Lease REIT Dividend Yields

Relatively high dividend yields are the key investment feature of the net lease REIT sector. Net lease REITs pay an average dividend yield of 4.4%, a premium of roughly 1% over the broader REIT averages. Net lease REITs pay out roughly 80% of their available 2019 cash flow. On a market cap-weighted basis, the average REIT pays a yield of 3.4%. (Note, however, the median REIT in our coverage universe of roughly 150 REITs pays a yield of 4.3%, as REIT dividend yields tend to be lower for the larger-cap names.)

Within the sector, we see the yields and payouts of the twelve names. As with most sectors, the highest-quality names tend to pay the lowest yields, and vice-versa. The "Power Three," STORE Capital Corp., Realty Income, and National Retail Properties, along with Agree Realty and Essential Properties pay the lowest yields but have the largest buffer for future dividend increases and external growth. Global Net Lease, EPR, and VEREIT top the yield rankings, paying yields of 10.4%, 6.3%, and 5.6%, respectively.

Bull And Bear Thesis For Net Lease REITs

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 compared to private equity that has allowed REITs to efficiently and accretively grow through acquisitions as a result of their ample access to "cheap" equity capital in the public markets. Net lease REITs have outperformed the broader REIT index by more than 2% per year, on average, since the mid-1990s. Net lease REITs was the best-performing real estate sector in 2018 and is on pace to outperform the REIT index in four of the past five years.

At scale, net lease REITs are "insanely efficient," as Chris Volk of STORE Capital Corp. noted in the company's recent earnings call. Due to the triple-net structure with limited capital expenditure requirements and G&A overhead, net lease REITs command some of the highest operating margins across the real estate sector. With a restored NAV premium, net lease REITs are poised to be the external growth engines of the REIT sector in 2019, fueling growth through accretive share issuances. Below, we outline the five reasons why investors are bullish on the net lease REIT sector.

A case could certainly be made, however, that the outperformance of the net lease REIT sector over the past two decades is more a function of a favorable macroeconomic tailwind of ever-lower interest rates than anything else. The sector faced an existential crisis early last year as rising interest rates and higher inflation stymied external growth by eroding these REITs' cost of capital - the key driver of AFFO growth over the past several decades, as accretive acquisitions are responsible for roughly two-thirds of total growth during this time. Spruce Point Capital Management published a much-discussed bear thesis on Realty Income, noting this potential negative feedback loop. Additionally, with only about 50% of total lease escalators linked to CPI, rising inflation threatens to significantly outpace same-store internal growth if inflation rises above current expectations. Of course, investors also shouldn't forget about the retail exposure and potential for continued disintermediation in the more at-risk sectors. Below, we outline the five reasons why investors are bearish on the net lease REIT sector.

Bottom Line: Exploiting A Competitive Advantage

Net Lease REITs may be expensive, but perhaps that's a good thing. Utilizing "cheap" equity capital, Net Lease REITs have reasserted themselves as the external growth engines of the REIT sector. Access to the public equity markets to fuel accretive acquisitions has been the defining competitive advantage for these REITs, explaining much of the consistent outperformance over the last three decades.

3Q19 earnings were generally better than expected across the sector, as AFFO and dividend growth look poised to turn decidedly positive in 2020 after a challenging two years. 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.

While yield-focused investors tend to view the sector less favorably when valuations are extended (and dividends are lower), we believe that the total return potential of the sector is higher when the sector is trading with elevated equity valuations, as these REITs are able to grow AFFO and dividends via accretive external acquisitions. 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.

That said, with valuations at the top end of the post-recession range and with stock prices still highly sensitive to movements in interest rates, we think investors can wait for the seemingly predictable short-term, rate-driven pullback. As long as the rate environment stays in the "Goldilocks" zone, we think that net lease REITs are well-positioned for continued outperformance in 2020.

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