Net lease real estate investment trusts (REITs) are very popular today, with industry bellwethers such as Realty Income (NYSE:O) and National Retail Properties (NYSE:NNN) trading near all-time highs. They aren't alone, either: A lot of net lease REITs are doing very well.
But, fundamentally speaking, that isn't new. What's changed is that investors are keying in on the strength of the net lease business model. Here's a prime example of just how important these types of REITs can be.
Net lease REITs offer a valuable lifeline
Troubled retailer Bed Bath & Beyond (NASDAQ:BBBY) has been trying to get sales heading higher in a tough retail market, but it hasn't been going very well. As a new CEO takes the helm, the home goods store has found a way to raise some cash to help fund its turnaround plans. The big move? Selling 2.1 million square feet of retail, distribution, and office space to Oak Street Real Estate Capital for around $250 million. But it isn't vacating the properties -- it will immediately begin renting them under long-term leases.
The deal is pretty close to a quintessential net lease transaction. A company wants to raise capital for some reason -- in this case to fund a turnaround effort, but often the goal is to help fund growth initiatives. It owns property that's vital to its operations but is simply weighing down its balance sheet. So it sells the properties to a company like Realty Income or National Retail Properties -- or, in this case, Oak Street Real Estate Capital -- and then instantly leases them back. That frees up cash and allows the seller to retain access to the vital properties. Normally, these transactions require the lessee to pay for most of the property expenses as well.
It's pretty clear why a company like Bed Bath & Beyond would like this deal, but why would a REIT want to get involved? For starters, these are fairly low-risk transactions, since the properties come with built-in tenants happy to sign long leases. With lessees handling most of a property's expenses, net lease REITs basically get to sit back and collect rent. And, perhaps more important, the REIT makes the difference between its cost of capital and the rent it charges. So it can lock in a solid return for 10 or 20 years if it picks good properties and good tenants. It's important to remember that lessees are usually happy to sell to net lease REITs, so this is usually a win/win relationship.
Where to look for net lease REITs
When it comes to retail stores like Bed Bath & Beyond finding alternate ways to manage properties, National Retail Properties is the leading name in net lease REITs. It has a portfolio of more than 3,000 properties across 48 states. All it does is buy retail assets using the net lease structure. It has been a good business, allowing the REIT to increase its dividend annually for 30 consecutive years. Annual dividend increases have averaged in the low to mid-single digits -- enough to keep up with, or slightly outpace, inflation -- so this is a slow and steady tortoise. But for investors seeking consistency, it's worth a deep dive.
With a slightly more diversified portfolio, Realty Income is the net lease REIT investors are probably most familiar with. It's an industry giant, with around 6,000 properties. Roughly 83% of its portfolio is tied to retail, with the remainder of rents spread among industrial (12%), office (4%), and "other," including large vineyards. Realty Income has increased its dividend for 27 years and counting, again at a low- to mid-single-digit pace. One of the key differences here is that Realty Income pays its dividend monthly, which is kind of like replacing a paycheck. If you like to go with category leaders, Realty Income is the name to watch.
Stepping further out on the diversification front, the REIT to dig in on is W.P. Carey (NYSE:WPC). Its portfolio of roughly 1,200 properties is spread across office (25% of rents), industrial (24%), warehouse (20%), retail (17%), self-storage (5%), and a very diversified "other" component (around 10%). But this REIT takes diversification to another level, with roughly a third of its rents coming from outside the United States, largely Europe. Carey is, very likely, the largest and most diversified net lease REIT that investors can add to their portfolios.
However, there's a grain of salt to be taken here. The REIT often strikes deals with companies that are below investment grade, so it takes a bit more risk than some of its peers. It also tries to be opportunistic, which can lead to buying properties that are out of favor for some reason. That said, with 23 years' worth of annual dividend increases under its belt -- again in the low to mid-single digits -- it's obviously doing something right.
A relative upstart in the space is Spirit Realty (NYSE:SRC), which recently spun off some assets to better focus its business on expanding its net lease portfolio. The record here is short and the spinoff complicates the picture -- there was a dividend cut involved -- but the goal is to be simple to understand and reliable from here on out. The spinoff materially reduced risk at Spirit, which investors recognized and have rewarded over the past year or so, as the stock has had a big rally. Roughly 80% of the portfolio of about 1,700 properties is targeted to be retail, with the rest spread across "other" areas. What's most attractive about Spirit, though, is its 5% yield, a function of its still-progressing turnaround effort.
That brings up an interesting issue. Net lease REITs are in favor today with investors because of the business model's many benefits. The stocks have been bid up, with Realty Income yielding just 3.7% and National Retail Properties 3.9%. This pair and Carey are trading within roughly 10% of their all-time highs. Spirit is still off its all-time high by about 20% as it works to earn back investor trust, which is a huge improvement, considering in 2017 it dropped 50% or so from its all-time high. So of this quartet, it's the turnaround candidate offering a still substantial yield. Carey's yield, however, is similar because of its willingness to deal with lower quality tenants and a heavier-than-peer use of leverage.
Keep an eye on net lease REITs
All of that said, these are just four names to start with. The net lease space is big and growing, with plenty of other companies to research. However, interestingly, the historically high prices that many of these REITs are experiencing today can be a huge plus for their businesses. REITs generally raise capital by selling stock and debt. A high stock price effectively reduces a REIT's cost of capital and improves its ability to buy properties profitably.
So while today's relatively high prices can make it hard for investors to initiate positions in bellwethers like Realty and National Retail, if valuation is a key consideration, it's actually a huge boon to their businesses. Carey and Spirit are offered up as compromises between yield, value, and opportunity. Still, if you're looking for a dividend-paying stock with an advantaged business model, net lease is a space you need to watch. Even if you don't buy any net lease REITs today, you'll probably want to have a few on your wish list for the next market sell-off.