Slow and steady wins the race is an often-repeated maxim. While not the right way to invest for everyone, buying reliable, boring companies is a good way for most investors to achieve long-term success. Real estate investment trusts (REITs) were pretty much tailor-made to be tortoises, which is why some consider them bond alternatives. That's particularly true of the net lease sector, in which tenants bear most of the operating expenses of occupying a property. But there's a key difference between a bond and a REIT. With inflation on the rise, it's going to be increasingly important to watch this industry metric.
The problem with a bond
In a diversified portfolio, bonds are generally meant to provide safety and stability. This is because they are basically a contract between the seller and buyer that guarantees -- as best you can in finance -- the seller will return the cash when the bond matures and make regular interest payments until that point. The payments, normally, are preset.
So, if you hold to maturity and the company you have lent money to is financially strong, you will have a steady stream of income and get your money back to invest again when the bond comes due. That income stream and return of principle provide stability when stocks are gyrating.
The problem is inflation, or the tendency for things to cost more over time. Thus, the buying power of the interest payments, which are usually set at a static level, is reduced over time. So, too, is the value of the bond since you'll get it back in the future when the dollars you invested won't be worth as much.
REITs allow investors to collect material dividend income from an operating company that can grow in size. So, REITs avoid the negative inflationary impact of a bond while still providing material levels of income. But not all REITs are created equal. Some, notably net lease REITs, tend to have long leases with rent rates that may not change over the term of the lease. That means inflation can become a problem here, too.
The bad news and the good
For example, Four Corners Property Trust (FCPT 0.73%), which was spun off from Darden Restaurants (DRI 0.08%) and largely owns a portfolio of restaurant properties, has a contract with its former parent calling for an annual rent escalation of 1.5%. Darden accounts for roughly 60% of Four Corners' rents. While 1.5% annual rate bumps are better than the zero increase a bond investor would get, with inflation running at 7.8% or so, this REIT's rent roll isn't keeping up with rising costs. Right now, it looks like Darden got a pretty sweet deal.
The scary thing is that some high-quality tenants, such as pharmacies, can actually get leases with no rent bumps at all in them. Rents like this account for around 4% of the pie at W.P. Carey (WPC -1.10%). Fixed rent hikes like the ones that Four Corners afforded its former parent make up 37% of W.P. Carey's rents. But the rest of its rents, 59%, are tied to inflation in some manner. That means that most of the properties that W.P. Carey owns will see rent increases that rise along with inflation this year and in the future.
There are caps and floors that protect both W.P. Carey and its tenants from massive inflation swings like the one that's transpiring today. However, this net lease REIT has a leg up on peers that have more static leases and/or a larger percentage of leases with no escalations at all built into them.
As you might expect, REITs like W.P. Carey are happy to talk about and highlight the inflation-linked rent escalators it has, while those without such linked increases tend to avoid the conversation. But it is an issue that you need to look out for, given that net lease REITs are often conservatively managed dividend payers.
Indeed, the risk inflation poses is often seen as a negative in the net lease sector, but if you know to look at the breakdown of rent escalators, you'll be able to pick out the best-positioned names as Wall Street faces down the threat of soaring inflation. Simply put, net lease REITs will muddle through this period, but some net lease REITs will do better in an inflationary environment than others.