As investors look for opportunities in the equity market, many are considering the real estate sector that leases corporate properties to single tenants and an exchange traded fund strategy to access total return strategies that target sustainable income and predictable growth.
In the recent webcast, Smart Late Cycle Strategies for 2020, Christopher Volk, President, Chief Executive Officer and Director, STORE Capital, pointed out that real estate investment trusts are a great long-term source of returns for a diversified portfolio. Publicly listed equity REITs exhibited some of the best average annual net return over the two-decade long period ended 2017, outperforming broad asset categories like U.S. small-cap, U.S. large-cap and non-U.S. equities, among others.
Furthermore, the sector provided a great source of diversification in a traditional stock and bond mix. REITs showed a -0.03 correlation to U.S. long bonds and a 0.53 correlation to U.S. large caps.
“REIT and unlisted real estate returns had relatively low correlations with bonds and listed equity returns. These relatively low correlations reflect the potential diversification benefits associated with the real estate asset class, whether REITs or unlisted real estate,” Volk said.
Joshua Brown, CEO and Co-Founder, Ritholz Wealth Management, also underscored the improved risk-adjusted returns that REITs provided over the long-term.
“Outside of fixed income, REITs had the highest Sharpe ratio measuring 0.44, reflecting their historically high returns and just above average volatility,” Brown said.
While investors may dive into the REITs space, not all of the companies in the sector are the same. Volk highlighted a unique business model among so-called net lease REITs, which makes up 8.6% of the $1.1 trillion total equity REIT market. Net Lease REITs focus on properties leased to individual companies. They generally lease properties on longer lease terms. More importantly, the tenant is responsible for most if not all operating expenses, property taxes and insurance costs.
Volk explained that Net Lease REITs are real estate investment trusts which own portfolios of properties primarily leased to single tenants under long-term, net leases where the tenant is responsible for most operating expenses, property taxes, and insurance. These properties include convenience stores, drug stores, restaurants, grocery stores, distribution centers, corporate headquarters, health clubs and movie theatres.
“The primary difference between the Net Lease real estate sector and other real estate sectors is that REITs in the Net Lease sector are defined and grouped by a business model centered around a lease type rather than a property type such as industrial, office, or retail,” Volk added.
Alexi Panagiotakopoulos, Co-Founder and Partner, Fundamental Income, also argued that owning properties net leased to single tenants requires minimal management and fewer risks to consider, compared to multi-tenant REITs. Traditional landlords of a REIT with multiple tenants will have to consider operating expenses, property management, rent roll, lease maturities, alternative space and local supply/demand. Single tenant net lease will need to consider tenant credit quality, the importance of the property to the tenant and alternative spaces available.
Consequently, “minimal landlord responsibilities results in higher margins and more consistent cash flows” for single tenant net leases, Panagiotakopoulos said.
Panagiotakopoulos highlighted the composition of returns generated by net lease REITs. Like other REITs, existing portfolios aim to generate equity cash flow to pay consistent dividends. They also incorporate rent growth where leases typically have contractual rent escalators of >1%, which helps limit the drag from inflation. Companies also retain an average of approximately 20% of equity cash flow primarily to reinvest in new properties. Additionally, net lease REITs trading at equity yields less than the equity yields they are able to invest at can raise new equity capital that is accretive to existing shareholders.
As a way to gain exposure to real estate companies that generate income from net leases primarily in commercial property, investors can look to the Fundamental Income Net Lease Real Estate ETF (NYSEArca: NETL), which tries to reflect the performance of the Fundamental Income Net Lease Real Estate Index.
“The Fundamental Income Net Lease Real Estate Index was built around a fundamental and repeatable business model that has performed for a long period,” Panagiotakopoulos said.
NETL includes exposure to net lease REITs like Realty Income, W.P. Carey, VICI Properties, VEREIT, Gaming & Leisure Properties, National Retail Properties, STORE Capital, EPR Properties, Spirit Realty and STAG Industrial.
Additionally, Brown argued that the Fundamental Income Net Lease Real Estate ETF may be appropriate for total return strategies, investors seeking income and real estate exposure. The combination of current income with identifiable sources of growth may make Net Lease REITs appropriate for investors seeking a Total Return Strategy. With an income stream based on contractual lease obligations that must be distributed to shareholders, Net Lease REITs may be appropriate for investors seeking income. Lastly, Net Lease REITs may be appropriate for investors seeking targeted exposure to the real estate sector.
Financial advisors who are interested in learning more about real estate investment trusts can watch the webcast here on demand.