How To Win In Net Lease Investments
Over the past decade, net lease real estate has secured one of the top positions among the major asset classes. Demand for net lease real estate is high for a number of reasons. With the increased popularity of the sector, however, comes a blurring of the line of what constitutes a high-quality net lease asset or investment strategy within the sector. Investors need to be cognizant that not all net lease real estate is created equal. Those who understand what to look for in the net lease market and understand what makes a net lease asset or strategy truly high quality are those who will be better positioned to take advantage of the asset class over the next decade.
So here, in question-and-answer form, are some strategic insights to maximizing investments in net lease assets.
What Is Behind the Increased Demand for Net Lease Real Estate?
We have seen a significant shift in the overall investment market and the traditional portfolio allocation models of institutional and individual investors. Forecasts of modest growth and extremely low interest rates have many investors questioning whether bonds and equities can deliver the returns they have in the past. As a result, a significant number of investors are moving from traditional stocks and bonds to alternative asset classes that can provide competitive total returns including stable income and equity-like upside. Real estate, particularly net lease real estate, is one of the assets classes into which they are moving. Many investors have realized that this asset class, if executed correctly, can offer a compelling mix of yield, equity-like upside and inflation protection superior to fixed income or equity investments on a risk-adjusted basis.
Why Is This the Case?
Investors have seen yields in this asset class that, in many cases, have been well above the yields currently available from fixed-income or equities. Investors are attracted to the stability of the asset class as a result of the underlying long-term contractual rent, especially when the rent is derived from high-quality assets and guaranteed by corporations with investment-grade credit ratings. Given the uncertainty in the markets and the forecasts for modest growth over the next several years, investors are also attracted to the high current income and role it plays as a percentage of total return, as well as its role as a wealth-preservation tool, especially if the economy remains weak. Equally important is the ability of the asset class, if approached correctly, to appreciate in value in both strong and weak markets.
Investors who want to maximize the yield and upside potential while retaining the risk protections associated with net lease will need to understand the sector or align themselves with a manager who does. The net lease label is broad, and the strategies employed within this sector by public REITs, private REITs, private equity managers, and others third-party investors are varied. If not approached correctly, an investor may achieve only some or a fraction of the potential benefits of investing in net lease. Not all net lease real estate or investment strategies are created equal.
What Are the Essential Components of an Effective Net Lease Strategy?
An investment manager needs to structure a transaction correctly or buy an asset “right” from the beginning to create a foundation from which to build. To do this, there are a number of components with which the investor or their manager should be familiar. Lease type, lease duration, asset quality, credit profile, tenant industry outlook and pricing are all critical in determining if an asset is being structured or bought correctly. In addition, the investment horizon is important in shaping the overall strategy. Maximizing each component is important. Many of those who operate in this space utilize a strategy that leaves out certain components which can be detrimental to a strategy or investment and open the manager and investor up to risks that they might not otherwise face.
Why Are All Net Lease Strategies Not Created Equal?
Even though a lease or investment strategy might be characterized as net lease, you may not be getting what you think you are getting. There are different types of net leases, the terms of which vary and have an impact on the owner’s responsibilities and future capital requirements. Additionally, some managers and strategies focus on assets that have lease terms that are shorter than others, which removes some of the benefit of the guaranteed lease stream and opens the owner up to near-term releasing risk and capital exposure. Asset quality and age, as well as location, have a significant impact on the desirability of the asset from both an investor and tenant’s perspective. The outlook for the tenant’s business sector and their corporation credit, or lack thereof, are other important factors in structuring or buying right.
What Is So Important About Investment Horizons?
Investment horizons, whether long- or short-term, need to be considered before an investment is made. With that said, it is important to view all investment as a potential long-term hold, even if your horizon is short. If you are a short-term investor, the investor to whom you sell is probably going to be a long-term holder. If the fundamentals for a long-term hold are not there, an investor or their manager is going to have an issue when they try to sell the asset.
Lease term, in addition to the factors previously mentioned, also has a significant impact on investment horizon. Generally, leases with less than 10 years remaining are more exposed to near-term re-leasing risk. While the underlying quality of the real estate is always of utmost importance, with less than 10 years of remaining lease term, the real estate component of the investment now starts carrying more weight than the underlying credit of the tenant or lease structure. Lease terms in the 12-to-15 year range or longer seem to make sense for both long-and short-term horizons. Long-term investors have 12 to 15 years of guaranteed cash flow, which is often escalating. Short-term investors can hold the asset for a few years and have term remaining on the lease so they can exit prior to the 10-year window. Many who operate in the net lease space are focused on shorter lease-term assets and accept considerable re-leasing risk. For example, a number of the major public net lease REITs have significant lease revenue maturing within the next 10 years. These lease maturities range from 88% to 32% of the underlying REIT’s portfolios.
Why Is Credit Rating a Major Consideration?
One of the competitive advantages of net lease is that it sits between corporate bonds and pure real estate in the investment continuum while taking advantage of the best of what both investments offer. Credit quality is as important in the net lease sector as it is in the bond sector; the credit provides assurance to investors regarding the quality of future cash flows. This quality of cash flows has additional implications for the underlying real estate, including its future capital requirements, occupancy, prospects for growth and ultimate return on investment. In addition to the significant rollover I mentioned earlier, the portfolios of a number of managers and REITs, both public and private, are backed by tenants without investment-grade credit ratings. This, obviously, increases the risk that the tenant might go out of business before the expiration of the lease. If the tenant is not around to honor the commitment, an investor loses a big portion of what they were counting on when they underwrote the property. In today’s uncertain market, tenants that carry investment-grade credit ratings are generally going to be able to weather a poor to modest economic environment better than tenants that do not carry an investment-grade credit rating. As we enter a growing market, investment-grade tenants are also better positioned to capitalize on the trend and expand their business, which is beneficial to the underlying investor.
So Where Should an Investor or Manager Invest Within the Net Lease Market?
Investors need to align themselves with a knowledgeable manager with an investment strategy that focuses on high-quality net lease assets that can offer: yields that are competitive or better than fixed-income alternatives; stability of income through long-term contractual rent guaranteed by investment-grade credits; equity-like appreciation; diversification benefits; and inflation protection. Investors who align themselves with managers employing this investment strategy have the ability to experience very attractive investment outcomes over the next decade.
Shelby Pruett is chairman and CEO of Equity Global Management in Chicago. He may be reached at firstname.lastname@example.org. Views expressed here are the author’s own.