REIT Ranking Overview
In our "REIT Rankings" series, we introduce readers to one of the 13 REIT sectors and the individual REITs that comprise these sectors, focusing only on the larger, internally managed REITs with proven track records of performance. (We avoid externally managed, non-traded, and otherwise exotic REITs)
We rank REITs within the sectors based on both common and unique valuation metrics, presenting investors with numerous options that fit their own investing style and risk/return objectives. We plan to update these rankings every quarter.
We encourage readers to follow our Seeking Alpha page (click "Follow" at the top) to continue to stay up to date on our REIT rankings, weekly recaps, and analysis on the REIT and broader real estate sector.
Net Lease Sector Overview
Net lease REITs comprise roughly 7% of the REIT Index (NYSEARCA:VNQ). Within our market value-weighted net lease index, we track the six largest REITs within the sector, which account for nearly $55 billion in market value and 16,000 total properties: National Retail (NYSE:NNN), Realty Income (NYSE:O), Spirit Realty (NYSE:SRC), Store Capital (NYSE:STOR), VEREIT (NYSE:VER), and W.P. Carey (NYSE:WPC).
Net lease REITs rent properties with long-term leases (10-25 years) to high credit-quality tenants, particularly in the retail and restaurant spaces. "Net lease" refers to the triple-net lease structure, whereby tenants pay all expenses related to property management: property taxes, insurance, and maintenance. Similar to a ground lease, triple-net leases result in a long term, relatively predicable income stream.
Average remaining durations of net lease REITs range from 10-15 years, and the majority of the leases have contractual rent bumps, often tied to the CPI index.
By the nature of the portfolio, compared to other REITs, net lease REITs are typically more like a financing company than an operating company. These companies hold the long-term, capital-intensive real estate assets that other companies prefer not to hold on their balance sheets.
As we'll see, net lease REITs are quintessential bond alternatives and thus highly sensitive to interest rates, and less sensitive to future economic growth. In many ways, these companies can be thought of as an inflation-hedged, long-term corporate bond that has additional elements relating to leverage and potential growth.
Below we show the size, geographical focus, and quality focus of the six net lease REITs. Note that the "quality focus" is based on the credit quality of the tenants. High quality tenants tend to be larger, more established companies with investment grade credit ratings.
Net lease REITs have outperformed the REIT index on a one-year, two-year and three-year basis. Much of this outperformance has come in the last six months as falling global bond yields have pushed investors into the sector in search of dependable bond-like income.
The green shaded regions highlight outperformance of the net lease index. Net lease REITs have outperformed the index by roughly 20% (2,000 basis points) over the prior six months.
Below is our REIT Heat map, showing annual performance in relation to other sectors. Net lease REITs have gained over 31% on a price-return basis and over 35% on a total return basis over the prior 52 weeks, beating all sectors besides tech, student housing, and industrial REITs.
We highlight the strength of intermediate-term Treasury notes, as well as investment grade bonds, which explain much of the sector's outperformance.
Valuation of the Net Lease Sector
On average, in comparison to the 12 other REIT sectors, net lease REITs appear either fairly valued or attractively valued depending on the specific metric.
Net lease REITs are the third "cheapest" sector based on current and forward AFFOx multiples. At 19x current and 18x forward AFFO, net lease REITs are trading at discounts to the sector average of roughly 23x and 22x, respectively.
When we factor in two-year growth potential, though, the sector appears less attractively valued. We use a modified PEG ratio, using the forward AFFO multiple divided by the expected 2-year growth rate which we call AFFOG. Based on AFFOG, net lease REITs are the most "expensive" sector.
Based on dividend yield, net lease REITs rank towards the top of REIT sectors, paying out an average of 4.45%, well above the VNQ distribution of roughly 3.3%.
Using our Beta calculations, which use the past three years of weekly return data, net lease REITs are among the most bond-like REIT sector, as they exhibit the second highest sensitivity to changes in interest rates and the least sensitivity to changes in the broader equity market.
For a more specific explanation of these calculations, we highlighted the dynamics of bond-like and equity-like REITs in our previous articles, "Are REITs Bond Substitutes" and "REITs Without Interest Rate Risk."
Net Lease REIT Absolute Performance
Not all net lease REIT investors have been happy over the prior three-year period. While investors in NNN, O and SRC have seen returns in excess of 50%, investors in VER and WPC have not participated in the gains until recently.
Net Lease REIT Performance Relative to Net Lease Index
We find it very useful to analyze how individual REITs perform relative to their peers. In this case, we measure performance relative to our net lease REIT index.
The longer-term outperformance of NNN and O become more clear, as does VEREIT's recent resurgence.
Net Lease REIT Valuation Rankings
Depending on an investor's preferred valuation metric, several names screen as "attractively valued" relative to their peers. Generally, in efficient markets, high multiples are a function of an expectation of stronger future operating performance, as well as the predictability and sustainability of future cash flows.
Some companies, particularly those with management teams that have a proven track record of Net Asset Value (NAV) growth, warrant a persistently high multiple, while other companies achieve a higher than warranted multiple through a shorter-term market inefficiency.
As described above, net lease REITs are some of the "cheapest" REITs based on AFFO multiples, but their lower-than-average expected growth results in AFFOG multiples that screen as extremely expensive. VEREIT and W.P. Carey may appear cheap based on AFFOx multiples, but the lack of future growth shows up in poor AFFOG metrics.
We view STOR and SRC as the most attractively valued net lease REITs.
NNN and O appear expensive for the "right reasons" (strong future operating performance).
VER and WPC are attractive in the sense that they trade less like bonds and more like equities, as we describe in more detail shortly.
As REITs (particularly net lease REITs) continuously raise equity capital to fuel acquisition-based growth, multiples have an added dimension, as higher multiples reflect a lower cost of equity capital. Cost of equity capital is a self-reinforcing feedback loop whereby companies with persistently higher multiples are more easily able to grow via acquisitions, essentially paying for new properties with cheap capital. Of course, REITs that trade at persistently low multiples are forced to raise capital at discounts to book value and NAV, which dilutes current shareholders. In other words: not a formula for sustainable value creation.
Sensitivities to Interest Rate and Economic Growth Factors
As we described earlier, on average, net lease REITs exhibit more sensitivity to interest rates and less sensitivity to economic growth than the average REIT. Realty Income, National Retail, and Spirit are among the most interest rate sensitive REITs we track.
Interestingly, though, VER and WPC stand out for their lack of strong interest rate sensitivity. WPC in particular trades far more like an equity-like REIT than a bond-like REIT, due in large part to its significant foreign exposure.
We highlighted in a previous article that investors can effectively hedge the interest rate sensitivity of their REIT portfolio by investing in international real estate. Click to read: "International Real Estate: REIT Investors Can Avoid 'Home Country Bias." We see this effect quite clearly in the case of WPC.
Dividend Yields
Finally, when it comes to dividend yields, net lease REITs show an interesting tiered pattern with NNN, O, and STOR exhibited a tight correlation in yield around 3.6%. SRC, VER, and WPC yield in excess of 5.25%.
Bottom Line
More than any other REIT sector, net lease REITs trade at the mercy of global interest rates. A true bond-substitute, we view these REITs are essentially a levered inflation-hedged 10-year corporate bond. Lower sovereign real bond yields and tightening credit spreads will send these REITs higher, and vice versa.
The credit quality of that bond depends on the underlying tenant-focus. Unlike a corporate bond, though, these REITs have shown an ability to grow NAV per share, particularly when cost of equity capital is cheap, as it is now for NNN and O in particular.
In this analysis, we hope to have introduced readers to the current market-based valuations of the net lease REIT sector and the names that comprise the sector.
Let us know in the comments if you would like us to expand on any part of the analysis. Again, we encourage readers to follow our Seeking Alpha page (click "Follow" at the top) to continue to stay up to date on our REIT rankings, weekly recaps, and analysis on the REIT and broader real estate sector.
This article was written by
Hoya Capital
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Alex Pettee is President and Director of Research and ETFs at Hoya Capital. Hoya manages institutional and individual portfolios of publicly traded real estate securities.
Alex leads the investing group Hoya Capital Income Builder. The service features a team of analysts focusing on real income-producing asset classes that offer the opportunity for reliable income, diversification, and inflation hedging. Learn More.
Analyst’s Disclosure: I am/we are long STOR. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
As an expert in real estate investment trusts (REITs), particularly in the net lease sector, my extensive knowledge and experience uniquely position me to provide valuable insights into the article titled "REIT Ranking Overview." With a proven track record of performance analysis and a deep understanding of the intricacies within the REIT market, I aim to elucidate the key concepts discussed in the article.
The article begins by introducing the REIT Rankings series, which focuses on larger, internally managed REITs with a history of proven performance. Excluded from the analysis are externally managed, non-traded, and exotic REITs. The rankings are based on various valuation metrics, catering to investors with diverse styles and risk/return objectives, with quarterly updates planned.
The specific focus of the article is on the Net Lease Sector, constituting approximately 7% of the REIT Index (NYSEARCA:VNQ). Within this sector, the six largest REITs are tracked based on market value, amounting to nearly $55 billion and encompassing 16,000 properties. These REITs include National Retail (NNN), Realty Income (O), Spirit Realty (SRC), Store Capital (STOR), VEREIT (VER), and W.P. Carey (WPC).
Net lease REITs rent properties with long-term leases (10-25 years) to high credit-quality tenants, mainly in the retail and restaurant sectors. The "net lease" structure involves tenants covering property management expenses like property taxes, insurance, and maintenance, resulting in a predictable income stream. The article emphasizes the quasi-financing nature of net lease REITs compared to other REITs, as they hold long-term, capital-intensive real estate assets.
The performance of net lease REITs is influenced by their sensitivity to interest rates and their relative independence from future economic growth. Notably, the article points out that net lease REITs have outperformed the broader REIT index over one, two, and three-year periods, with a recent surge attributed to falling global bond yields.
The REIT Heat Map illustrates the annual performance of net lease REITs compared to other sectors, showing significant gains over the prior 52 weeks. The valuation of the Net Lease Sector is discussed, highlighting metrics such as AFFO multiples, dividend yield, and sensitivity to interest rates. Net lease REITs are considered attractively valued based on certain metrics but less so when considering two-year growth potential.
The article delves into absolute and relative performance of individual net lease REITs, analyzing how they fare against their peers. The concept of valuation rankings is introduced, with considerations for an investor's preferred metric. STOR and SRC are identified as the most attractively valued net lease REITs, while others like NNN and O may appear expensive due to strong future operating performance.
Sensitivities to interest rates and economic growth factors are explored, emphasizing the bond-like nature of net lease REITs. The article concludes by highlighting the tiered pattern of dividend yields among net lease REITs and emphasizes their dependence on global interest rates.
In summary, the article provides a comprehensive overview of the net lease REIT sector, covering performance, valuation, and individual REIT analysis. It offers valuable insights for investors looking to navigate the real estate market, with a focus on net lease REITs as bond alternatives with unique characteristics.
