SEVN - Net Lease REITs: Avoiding The Winner's Curse

2023-03-22 11:00:00 ET

Summary

• Net Lease REITs - historically one of the most "rate-sensitive" property sectors - have surprisingly been the best-performing major property sector since early 2021 despite the significant rise in interest rates.
• Private market values have remained far "stickier" than comparable public market assets. Increases in these REITs' cost of capital has far-outpaced cap rate increases, resulting in record-low investment spreads.
• Despite the tighter investment spreads, the pace of acquisition activity for some REITs slowed only modestly in late 2022, a strategy that could prove costly if rates remain persistently elevated.
• Strong balance sheets and lack of variable rate debt exposure have positioned these REITs to be aggressors as over-levered private players seek an exit, but these REITs must wait until the price is right lest fall prey to the "winner's curse."
• We see the best value in REITs that focus on “middle-market” tenants and the middle-tier of cap rates where inflation-hedging lease structures and initial yields grant more breathing room for higher financing costs.

REIT Rankings: Net Lease

This is an abridged version of the full report and rankings published on Hoya Capital Income Builder Marketplace on March 20th.

One of the more "bond-like" and rate-sensitive REIT sectors, net lease REITs have surprisingly been among the best-performing property sectors over the past year despite the significant rise in benchmark interest rates and the narrowing of investment spreads. Within the Hoya Capital Net Lease Index , we track the eighteen net lease REITs and one ground lease REIT, which account for roughly $100 billion in market value. These net lease REITs generally own single-tenant properties leased to high credit-quality tenants under long-term leases, focused primarily on retail, restaurant, and industrial properties.

"Net lease" refers to the triple-net lease structure, whereby tenants pay all expenses related to property management: property taxes, insurance, and maintenance - a structure similar to a ground lease. As a result, net lease REITs tend to operate more like a financing company than a property manager, effectively capturing the spread between the acquisition capitalization rate ("cap rate") and their cost of capital. Net lease REIT investment characteristics are similar to corporate bonds due to the long-term nature of 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 (rent escalations) and accretive external growth (acquisitions). Lease terms average 10-15 years and typically include fixed-rate contractual rent escalations at 1-2% per year.

Triple net leases are used to varying degrees across the REIT universe - including the Casino and Healthcare REIT sectors - and 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 which make heavy use of the net lease structure that don't otherwise fall neatly into one of the other property sectors. Some net lease REITs focus their strategy on investment-grade tenants with near-zero credit risk, while others focus on "middle-market" or smaller tenants with higher potential credit risk levels. Currently, the most significant sources of credit risk are movie theaters (3% of rent), offices (5% of rent), and specialty retail (5% of rent).

With this bond-like lease structure, naturally, comes bond-like risks - notably a high sensitivity to inflation and interest rates. Inflation and rate sensitivity is driven by several interacting factors, including lease structure and term, external growth potential, tenant credit quality, and the cyclicality of the underlying property type. Investment Grade ("IG") tenants typically have minimal credit risk, but lease terms generally grant less potential upside or inflation protection to the property owner with fixed-rate or zero rent escalations. Only a handful of net lease REITs include explicit CPI linkages in their rent escalators – namely W.P. Carey , which has a sector-high 55% of its leases calculated using a CPI-based formula. Broadstone is the only other net lease REIT to report average escalations of at least 2% in 2022.

Balance sheet quality plays a critical role in the degree of risk - and the "cost of capital" more broadly - and the net lease REITs, which have operated with lower leverage and with less variable rate debt exposure should be able to maintain accretive investment spreads in a variety of macroeconomic environments - assuming that acquisition cap rates eventually "catch up" to the rise in the cost of capital. Strong balance sheets and lack of variable rate debt exposure has positioned these REITs to be aggressors as over-levered private players seek an exit, but these REITs can afford to wait until the price is right. We see the best value in REITs that focus on “middle-market” tenants and the middle-tier of cap rates where inflation-hedging lease structures and initial yields grant more breathing room for higher financing costs.

Can Net Lease REITs Avoid 'Winners Curse'?

Acquisition-fueled external growth has historically been the "bread and butter" of the net lease sector's strategy, explaining the vast majority of the sector's FFO ("Funds From Operations") growth over the last two decades. Despite narrower investment spreads resulting from the significant increase in benchmark interest rates over the past year, net lease REITs acquired nearly $14B in net assets in 2022, which was more than in any other year since 2013. Notably, while net lease REITs account for just 7% of the Equity REIT Index - they accounted for over a third of total REIT acquisitions over the past twelve months. The initial outlook for 2023 calls for another $10B in acquisitions this year, which would be the second-highest behind 2022.

The "business as usual" strategy worked just fine in 2022 - driving impressive FFO growth of nearly 10% for the year, which brought the sector-wide FFO to levels that were about 8% above pre-pandemic levels from full-year 2019. Seven of the nine REITs that provide full-year guidance reported full-year 2022 FFO that exceeded their prior outlook in Q4, but compressed investment spreads are expected to weigh on sector-wide FFO metrics this year, with guidance calling for average FFO growth of 0.1% for full-year 2023. Upside standouts of fourth-quarter earnings season included W.P. Carey ( WPC ), which forecasts that same-store rent growth will increase to around 4% as the effects of its CPI-linked escalators take full effect. Downside laggards included Gladstone Commercial ( GOOD ), which was one of two net lease REITs alongside Global Net Lease ( GNL ) that reported negative FFO for the year as weakness in its office portfolio offset strength in its industrial segment.

Curiously, private market real estate valuations of net lease properties have been far "stickier" than other comparable public market assets, underscoring our sense that net lease REIT investors, executives, and asset owners have seemingly never bought into the idea of a "new normal" of sustained higher interest rates. As noted in our Earnings Recap , the average acquisition cap rate increased just 40 basis points to 7.0% in Q4 compared with 6.6% a year earlier, during which time the benchmark 10-Year Treasury Yield increased over 200 basis points. Meanwhile, the benchmark BBB Corporate Bond Yield - a useful proxy to approximate a Net Lease REITs' long-term cost of capital - increased by over 240 basis points to just shy of 6%, which resulted in a record-low spread between acquisition cap rates and cost of capital in Q4.

For most REITs, the pace of acquisition activity slowed only modestly in late 2022 and early 2023, a strategy that could pay off if we do indeed see a "soft landing" and return to "lower for longer" - but could prove costly if rates remain persistently elevated. Cap rates have been especially "sticky" in the investment-grade segment. Agree Realty ( ADC ) reported an average acquisition cap rate in Q4 of 6.4% - only 30 basis points higher than last year. Despite this compressed investment spread, ADC reported its fastest pace of acquisition activity ever in 2022 and expects to acquire another $1B in assets this year. There were some indications that cap rates were beginning to "catch up" with the increase in interest rates late in 2022 and into early 2023. Realty Income ( O ) - the largest net lease REIT - reported a 70 basis point increase in acquisition cap rates, but commented that spreads have gapped wider in recent months to levels that are "about 100 basis points" since June.

Cap rates on "Middle Market" net lease properties appear to have adjusted slightly more quickly, underscored by a 100 basis point increase in acquisition cap rates reported by Spirit Realty ( SRC ), a 80 basis point increase reported by W.P. Carey ( WPC ), and a 70 basis point increase reported by Broadstone ( BNL ). Some net lease REITs, including Spirit and Broadstone, have clearly pivoted their external growth strategy in response to the compressed investment spreads. SRC commented that it plans to "prove out what we've been doing the last few years... and at that point, we can look at potentially increasing volume with a more effective cost of capital." Broadstone has also taken a more conservative approach to external growth with guidance for 2023 which calls for 70% lower acquisition volume this year compared to 2022.

Net Lease REIT Stock Performance

Net lease REITs were slammed early in the pandemic - plunging more than 50% at their lows in March 2020 - but began to rebound in mid-2020 and have delivered notable outperformance over the REIT Index in recent quarters despite concerns over rising rates and inflation. The Hoya Capital Net Lease Index - a market-cap weighted index of these 18 REITs - was lower by just 7.5% in 2022 - the top-performing property sector last year - significantly outperforming the 24.6% decline from the broad-based Vanguard Real Estate ETF ( VNQ ) and the 15.9% decline from the S&P 500 ETF ( SPY ). The outperformance has continued into 2023 as the Net Lease Index is lower by 1.0%, slightly outpacing the 1.2% decline on the broader REIT Index.

The relatively muted performance of the market-cap-weighted net lease index over the past few years, however, does mask some of the bifurcations in the performance between sub-segments of the sector. Notably, many of the smaller-cap REITs that outperformed in 2021 were laggards in 2022, characteristic of a "flight to balance sheet quality" within the sector. The best-performing net lease REITs of 2022 included Getty Realty (GTY), Agree Realty , and W.P. Carey. Laggards last year included Safehold (SAFE) - the lone REIT focused specifically on ground leases - which dipped more than 60% in 2022 - and One Liberty Properties (OLP) - which declined more than 30%. Notable laggards this year include Gladstone Commercial - which in January became the only net lease REIT in the past two years to reduce its dividend.

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 toward the top of the REIT sector. Net lease REITs now pay an average dividend yield of 5.4%, a premium of 140 basis points over the broader market-cap-weighted REIT average of 4.0%. Net lease REITs pay out roughly 75% 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.

Two net lease REITs have raised their dividend this year - Realty Income and W.P. Carey . Within the sector, we note the dividend yields and historical dividend growth of each of the eighteen 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 , Four Corners (FCPT) , STORE Capital, Agree Realty , and Realty Income . Nine net lease REITs are currently paying a dividend yield above 6%, led on the upside by externally-managed Necessity Retail (RTL) and Global Net Lease which each command a dividend yield above 12%.

Equity market valuations can and do have a meaningful impact on the underlying business operations of these companies, a rather unique and sometimes counterintuitive phenomenon for these REITs. Since 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 valuation scenarios, highlighting our view that the total return potential of the sector is maximized when the sector trades at slightly elevated valuations.

Net Lease REIT Credit Risk

At the outset of the pandemic, investors were painfully reminded of the potential credit risk faced by net lease REITs amid a wave of economic lockdowns and uncollected rents - a focus that has been renewed given the lingering recession concerns. While the triple-net lease structure has provided a strong degree of protection for most segments, some tenants in several heavily disrupted categories including movie theaters, offices, and some specialty retail segments (such as Party City and Bed Bath Beyond) still face an uncertain future. We discuss several of these key categories below.

For restaurants, the largest net lease category, we note that the National Restaurant Association's Restaurant Performance Index ("RPI") has also shown a rebound in recent months after a decline throughout 2022. The RPI stood at 102.8 in January, up 0.9% from December and the strongest monthly increase in 15 months. A majority of restaurant operators said their same-store sales and customer traffic levels were higher than January 2022 readings, which was a month that saw business conditions negatively impacted by the omicron variant. A majority of operators also have a positive outlook for six months, which boosted the Expectations Index to its highest level in 10 months.

The recovery is significantly less certain for movie theaters, which represent roughly 5% of overall net lease NOI - but are the primary property type for EPR Properties . Box Office Mojo data shows that box office revenue plunged 80% in 2020 and has remained about 25% below 2019 levels in early 2023. A handful of other net lease REITs have between 1.5-5% of their rents coming from movie theater tenants, but these REITs have not seen a material uptick in missed rents from these theater tenants despite the apparent distress.

Takeaway: Avoiding The 'Winners Curse'

Despite the tighter investment spreads, the pace of acquisition activity for some REITs slowed only modestly in late 2022, a strategy that could prove costly if rates remain persistently elevated. Strong balance sheets and lack of variable rate debt exposure have positioned these REITs to be aggressors as over-levered private players seek an exit, but these REITs must wait until the price is right lest fall prey to the "winners curse." We currently see the best value in the "middle-class" of the net lease sector - those focused on middle-market tenants and the middle-tier of cap rates, which typically benefit from lease structures that provide better inflation protection compared to the typical fixed rate lease escalations found in leases to investment-grade tenants, and from slightly higher cap rates that provide some buffer to protect investment spreads in a potential "higher for longer" interest rate environment.

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