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2 REITs Avoiding the Real Estate Plague

By Jordan Wathen - Sep 24, 2013 at 3:07PM

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How Realty Income Corp. and National Retail Properties are avoiding carnage in commercial real estate.

Source: Scott Hingst.

Knock, knock.

Who's there?

*Crickets chirping*

As much as 10.1% of all American retail store square footage is sitting unused, empty, and without a single tenant. This according to a source that would have incentive to inflate statistics: the National Association of Realtors.

It's a harrowing sign that the economy still has a long way to go to greet levels last seen before the financial crisis.

And it isn't just retail buildings that are feeling the pinch. The real estate industry trade group forecasts vacancies towering over 15% for office buildings, and 9% for industrial buildings for the remainder of 2013.

The "crisis" REITs haven't noticed
Even as real estate sits empty across the country, two of the biggest retail real estate investment trusts, Realty Income Corp. (O -0.16%) and National Retail Properties (NNN -0.52%), reached new all-time highs in 2013:

O data by YCharts.

Why does this disconnect exist?

For starters, interest rates plunged through May, when REITs were making new highs each day. As yields go down, the value of REITs -- more specifically, their cash flows -- goes up.

But there's more to it than that. Public REITs seem to own much better quality real estate than the national average. Realty Income Corp. and National Retail Properties last reported occupancy rates of 98.2% and 98.1%, respectively.

Not all real estate is created equal
Real estate isn't just a place to hang a sign. Location, traffic, and access to the property all have a significant impact on the value -- and rentability -- of a retail building.

Data from Jones Lang Lasalle reveals that vacancies in major markets vary greatly based on the type of retail real estate:

The further you venture into the data, the clearer it becomes that the shopping center is at the core of real estate weakness. Shopping centers make up more than a third of all retail property in the major markets.

The obviously strong performers are single-tenant properties, which have vacancy rates under 5% in major markets.

Guess what top retail REITs own?
Yep, that's right: Realty Income Corp. and National Retail Properties are most heavily invested in single-tenant, freestanding buildings -- the stuff with the lowest vacancy rates.

Standalone buildings have a natural advantage over other property types. They're generally not commoditized; they serve a specific purpose: fast food, car washes, gyms, convenience stores, and gas stations, just to name a few.

To put it simply, a stand-alone building tenant usually can't just pack up their bags and move to a new location at a moment's notice. Furthermore, a stand-alone tenant invests significantly in their location, and location is usually central to their top-line revenue. A car wash located in the middle of a corn field will go bankrupt quickly. But there are thousands of warehouses located in corn fields all around the country.

Real estate with a margin of safety
Of all types of commercial real estate, single-tenant freestanding properties have the largest margin of safety. They're typically leased on 10-20 year contracts, and properties are customized to fit a particular kind of business.

It shouldn't be a surprise that Realty Income and National Retail Properties are posting sub-2% vacancy rates when the rest of the market is showing nationwide vacancies above 10%. Their single-tenant portfolios fend off vacancies and provide dividend stability even in weak real estate markets.

Fool contributor Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Stocks Mentioned

National Retail Properties, Inc. Stock Quote
National Retail Properties, Inc.
$47.49 (-0.52%) $0.25
Realty Income Corporation Stock Quote
Realty Income Corporation
$73.58 (-0.16%) $0.12

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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