NETL - Epic REIT Rally 3.0 (The Most Important Thing)

2023-08-21 07:00:00 ET

Summary

• REITs have experienced a selloff, creating attractive valuations and high dividend yields in the net lease REIT sector.
• The key to unlocking value in REITs is selecting stocks that demonstrate growth potential.
• Net lease REITs with the most favorable cost of capital include Agree Realty, Four Corners Property Trust, Realty Income, NETSTREIT, Essential Properties Realty Trust, and VICI Properties.

This is the third and final article in my Epic REIT Rally series.

In case you missed series one and two , let me provide a few highlights:

“Recent share price weakness in this sector has driven valuations on many of my favorite REITs down to levels where we’re seeing very attractive margins of safety…

I believe that the poor sentiment surrounding REITs today will allow investors to have their cake and eat it too when it comes to both passive income and strong capital appreciation over the coming years.”

The REIT selloff I’m talking about can be viewed below:

Vanguard Real Estate ETF ( VNQ ), one of the REIT benchmarks we use at iREIT® on Alpha is down over 24% in the last 12 months, compared with the S&P 500 ( SPY ) that’s just about even (actually -1.5%).

The net lease REIT sector has underperformed both VNQ and SPY.

As shown below Fundamental Income NETLease Corporate Real Estate ETF ( NETL ), that consists of net lease and industrial REITs, has dropped by over 26% in the last 12 months.

I recently wrote on NETL and I explained that this ETF “ derives at least 85% of earnings or revenues from real estate operations in the net lease real estate sector .”

There’s little doubt that net lease REIT dividend yields have become attractive, with an average dividend yield (for the sector) of 6.8%.

However, I decided to focus on growth in this final “ Epic REIT Rally ” series because I believe that so many readers are getting mesmerized with yield alone.

In other words, they’re trying to pick REITs that yield 5% or higher, without any due diligence regarding future growth prospects.

The popular view in the REIT sector is that owning a high yielding stock is that way to generate profits, however, that’s wrong.

The key to unlocking value is to select stocks that grow, and that’s especially true in the net lease REIT sector.

Slow-growing REITs present fewer interesting opportunities and many are challenged because of their cost of capital (keep reading for examples).

REITs create value for their shareholders by investing cash now to generate more cash in the future. The amount of value they create is the difference between cash inflows and the cost of the investments made.

So, in this final series ( Epic REIT Rally ) I would like to provide a closer look at the net lease REIT sector to identify the best REITs to select for this upcoming Epic REIT Rally .

WACC-a-Mole

Weighted Average Cost of Capital, or WACC, is a critical metric for determining value creation and for evaluating strategic decisions.

It’s defined as the rate you compare with the return on invested capital (‘ROIC’) to determine if the REIT is creating value.

In real estate, we refer to the capitalization rate – more commonly shortened to “cap rate” which is the REIT’s expected rate of return from a piece or pieces of property. Here’s how we’ve been defining it:

Net Operating Income ÷ Current Market Value of the Asset = Capitalization Rate

Most practitioners use the weighted average cost of equity capital and the cost of debt capital to arrive at a blended WACC. If you can achieve lower volatility than peers’, the cost of capital will be slightly lower.

Cap Rate - Cost of Capital = Spread/Profit

To put the WACC model to work, I created the chart below.

WACC Equity is the reverse of P/AFFO (or AFFO/P) x % Equity in the capital stack.

WACC Debt is the 10-year debt cost x % Debt in the capital stack.

WACC = WACC Equity + WACC Debt

As you can see, I prepared this WACC model that includes equity cost (2023 AFFO/sh divided by current price) and debt cost (using assumptions for these net lease REITs). The far-right column is the WACC from highest WACC to lowest.

So, to put this model to work, consider the fact that the Net Lease REIT, Global Net Lease ( GNL ) must acquire properties at cap rates over 11.6% to be accretive.

EPR Properties ( EPR ), with a WACC of 10.4%, must seek to acquire or invest in properties with cap rates over 10.4%.

Obviously, these two REITs are going to struggle under conventional financing sources which is why GNL did not see “any acquisition activity since the Boots deal back in 1Q, I think that was maybe $75 million.”

GNL has been focused on the Necessity Retail ( The Necessity Retail REIT, Inc. (RTL) Stock Price Today, Quote & News ) merger which one activist (Orange Capital) calls “value destructive”. The activist said,

"The proposed internalization terms under the merger are certainly an outrageous enrichment of AR Global at the expense of GNL shareholders.”

EPR said on the Q2-23 earnings call that it was maintaining investment spending of $200 million to $300 million in 2023. The company said that “cap rates continue to be in the 8% range” which means that the company must rely on recycling assets (dispositions).

The Winners

The Net Lease REITs with the most favorable cost of capital includes Agree Realty ( ADC ), Four Corners Property Trust ( FCPT ), Realty Income ( O ), NETSTREIT ( NTST ), Essential Properties Realty Trust ( EPRT ), and VICI Properties ( VICI).

A year ago, these REITs were acquiring properties at cap rates in the 6% range and today that number has grown to 7% and higher. On the Q2-23 earnings call , Joey Agree, CEO of Agree Realty said,

“Cap rates continue to move in our favor as demonstrated by our second quarter results. The acquired properties had a weighted average cap rate of 6.8% a 10-basis point expansion relative to the first quarter and 60 basis points higher than full year 2022.”

Even during the last sixty days, the WACC scores have increased by 10 to 20 basis points, which means in order to generate healthy profit margins (of 100 bps or higher) these REITs must target cap rates of 7% or higher.

Realty Income’s CEO, Sumit Roy explained on the Q2-23 earnings call,,

“..our second quarter initial cash lease yield of 6.9% represents a 120 basis-point increase compared to the second quarter of 2022 and resulted in a realized investment spread of approximately 133 basis points when calculating our WACC on a leverage-neutral basis using the cost of equity and debt raised in the quarter.”

Again, cap rates are adjusting with the cost of capital, and Realty Income must seek out cap rates of 7% or higher.

At the end of Q2-23 Realty Income had closed on over $4.7 billion and the company opted to bump its YE guidance to over $7 billion (from $6 billion).

VICI Properties, another consolidator we really like, is expected to grow AFFO per share by 10% in 2023, one of the highest growth rates across REIT sector.

Instead of buying a Net Lease REIT ETF that owns “the good, the bad, and the ugly” we suggest that you consider the following eight net lease REITs that score well based on (1) a low payout ratio and (2) solid growth forecast (based on analyst estimates as shown below).

In other words, we believe the following net lease REITs could provide investors with a safe yield (average of 5.5%). They have the lowest payout ratios with good growth forecasted (by analysts).

All of these net lease REITs are trading at a discount and iREIT® on Alpha’s consolidated total return forecast for these names is 20% annualized .

What this means is that we believe these REITs will continue to generate internal and external growth (albeit modest) and deliver safe and reliable dividend income.

Get on the Net Lease REIT Train

Net Lease REITs have sold off harder than most property sectors, and we believe they will bounce back (sooner than later), as the end of a rate-hike cycle is when we expect liftoff.

Importantly, the net lease sector has catalyst that’s often overlooked, as Sumit Roy pointed out on Realty Income’s latest Q2-23 earnings call,

“Because of this cost of capital convergence and because of the many benefits sale-leaseback financing provides, including the elimination of maturity risk, we believe there is a more compelling case to be made than ever for corporates to look to sale-leaseback financing to replace maturing debt .

As the attractiveness of sale-leaseback financing accelerates for corporates with looming debt maturities and elevated debt costs, we believe our growth opportunities will continue to expand on a sustainable basis.”

We’ve identified our favorite net lease REITs backed by empirical evidence that supports the notion that growth and ROIC are the key drivers of shareholder value.

Although accelerating interest rates have created a dynamic that slows growth (margins aren’t as wide), the net lease REITs are still able to generate sustainable organic growth.

As Sumit Roy points out “there’s a more compelling case to be made than ever for corporates to look to sale-leaseback financing to replace maturing debt.”

The “corporate” playing field that Roy is speaking about is massive and at some point, we believe that the net lease sector could become the largest property sector in the REIT universe, and of course, it takes new shares to fuel the fire.

Remember, when it comes to net lease REITs, cost of capital will determine what separates the best from the rest!

“The safest and most potentially profitable thing is to buy something when no one likes it. Given time, its popularity, and thus its price, can only go one way: up.” ? Howard Marks

Happy SWAN Investing!

Note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.

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