Has Net Lease Become Too Safe?
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While most of the experts consulted for this article vehemently deny that net lease has become too safe—several even asked to have the question repeated to be sure they were hearing it correctly—Sidney Domb, president of United Trust Fund in Miami, has a different take on the matter. His thoughts are that net lease could indeed be too safe and not provide enough yield for investors—that is, if their leases are set up incorrectly.
“We started doing this in 1972, so we’ve been in this for 40 years,” Domb tells Real Estate Forum. “When we started, the concept was that we didn’t want to have any staff outside fixing anything, so let’s not buy anything unless there’s nothing we have to do but collect a check. We sat down with an attorney—one we’ve been using for 28 years—and made up a bond net lease that said the tenant does everything. Even in the event of a condemnation, the tenant has to make an offer to purchase the property.”
Domb says his firm is meticulous when setting up its net leases. “When we’re doing a sale-leaseback, we tell the company, ‘We’re going to give you money and take the title, and then, for all intents and purposes, it’s like we got on a ship and went to China. The only time you’ll hear from us is if the rent doesn’t come in.’ Make it clear in the lease that the tenant is paying for everything. If you’re going to buy an existing deal, you can’t change the lease—it’s already in place—so you should get a bigger return.”
Too safe? Too boring? “The reality of it is, people tend to think that when something’s good for too long, then it has to get bad,” says Nicholas Schorsch, chairman and chief executive of American Realty Capital in New York City. “That’s just not the case with net lease. In real estate, the fundamentals are incredible. The cost of capital, the cost of debt, has never been lower. The Feds will keep interest rates low and keep pumping money into the system, and real estate really hasn’t compressed yet.”
Schorsch says his firm has bought millions of dollars of net-leased assets in the past four to seven months, and these have averaged cap rates in the mid- to high-7s, all essentially investment grade. “It’s almost like it was in 2006, but now the cost of debt is 2.5%—it was a lot higher in ’06. We’re seeing a dramatically better spread than before, and the market couldn’t get better. There’s nothing that could happen to make it better than it is today.”
Eventually this will change though, Schorsch says, so investors should hold onto their assets until the next compression and then sell. “You’ve got spreads that are almost 4% between the cost of debt and the average cap rate. When will the next compression hit? We thought it would have happened already, but it will happen when the economy gets better and unemployment starts to drop—then it will be a great time to start selling. Real estate is cyclical, and we just happen to be in the buying part of the cycle.”
Paul McDowell, CEO of New York City-based REIT CapLease, says he’s not sure he would qualify the sector as being “too safe. It is a safe sector. The cash flows produce good long-term income. Our dividend yield is 3.8% as of February. We have a premium yield only to the REIT universe, but when you look at the risk-free rate, you have to look at where the 10-year Treasury is, and that’s at about 1.92%. So here you have safe cash flows that produce quite a high yield.”
Of course, the dividend yield is not the only component to value for CapLease, McDowell points out. “You’re hoping for total return, and that’s based on REIT dividend and how much you hope the shares will rise in the course of a given year. The two together produce your total return percentage. The knockoff on net lease assets for years has been fixed cash flows, so portfolios have bond-like characteristics. When the REIT atmosphere is too frothy, you can’t raise rents as tenants move out because you have long-term leases. But that said, long-term cash flows look very attractive. REITs have had strong returns in the past 12 months. People look for safety in earnings, and they find that in net-lease REITs.”
According to Jonathan Hipp, founding president and CEO of Calkain Cos. of Reston, VA, investors seeking a higher yield without a doubt need to look at a different sector. “But if you look at other vehicles, yes, net lease is a good investment. Lack of product is more of an issue than lack of capital.”
Retailers that are particularly active within the net lease sector include gas stations and discount chain stores like Dollar General or Family Dollar. “They’re bringing product to the market, as are the banks, but not a lot of big boxes are being delivered” in the net lease space, says Hipp. “That doesn’t mean there’s nothing being built, but compared to the past, it’s very low.”
As a sector, net lease is very much driven by the economy, he explains. “The housing market is just now starting to kind of feel like it’s picking up—not across the whole country, but definitely in the Northeast and parts of the Southeast, housing is gaining some traction and gaining legs. As people begin to feel their houses are starting to appreciate in value, and they’re not underwater, it helps consumer confidence. And markets are driven by consumer confidence.”
Gregg Seibert, SVP of investments for Scottsdale-based Spirit Realty Capital, says that triple-net investing is safe and has experienced some cap rate compression due in part to lower yields on alternative financial products such as bonds, stocks and money-market funds. In fact, net lease has become an attractive alternative for a lot of investors. “The current dividend on our stock is approximately 6.4%, so compared to a lot of other liquid investments, the yield is considered high,” says Seibert.
Like other industry experts, Seibert says net lease has a very good track record. “I’ve been in the business for 17 or 18 years, and as far as shareholders of triple-net REITs are concerned, it has pretty much been a success story, with the exception of the blip from the financial crisis in 2008-2009,” he relates. “It’s been a strong sector, and although the yields are still low on a historical basis, it’s still attractive to investors. The yield alternative on REITs is higher than on money-market accounts or bonds. Most would say the yield is still attractive, on a risk-adjusted basis.”
Clearly, asset values are higher today than in the past, and there are only so many dollar stores in the country, says Gordon DuGan, CEO of Gramercy Capital in New York City. “My own view is that net lease is more of a real estate business than a credit business. Twenty-five years ago, when I first started out, it was a credit business with a strong retail component. Now, it’s primarily real estate with a strong credit component.”
DuGan says net-lease companies are trading well because they have performed extremely well throughout the downturn. “Bill Ackman, who is a brilliant investor, put out a piece on why Realty Income was short a few years ago, and Realty Income has just continued to prove him wrong in that case. When the net-lease strategy is done well, it’s a very attractive risk-return business.”
Knowing your tenant is crucial to success, Domb says. “The other night, I had dinner with a couple, and the wife says, ‘We’re buying a Burger King.’ I say to her, ‘You’re not buying it from Burger King—it’s a franchise.’ Three days later, the husband tells me they found out the owner is a franchisee, and he’s not buying it. If he had not met me for dinner, he would have bought a Burger King from a franchisee.”
At the end of the day, the key to a tenant’s solvency in net lease is the financial statement, Domb stipulates. Tenants may tell you what their EBITDA is, but you need something you can show the IRS at the end of the year that says how much profit they make.
Hipp points out that one of the first things an investor should look at when considering net lease is the underlying real estate: Are there good underlying fundamentals? Is the real estate in a good, growing location or area? Then, attach that to strong credit—will the tenant live out the term of the lease and pay the rent? Then attach that to a tenant that’s a leader in its market. “If you’re in the banking industry, you clearly want to be with somebody with good credit who’s expanding, like TD Bank, or if you’re in the dollar-store sector, go with Dollar General or Family Dollar. If you get everything on your wish list, it’s a good investment, but you’re probably paying the most aggressive cap rate because that’s what everybody else wants to buy. ”
While Hipp isn’t saying for sure that cap rates have bottomed out, “I’m not sure how much lower they can go. If we aren’t at the bottom, we’re very close to it.”
The fact that we’re close to bottom on cap rates could mean that developers will be feeling some pressure, since this could bring more sellers to the net-lease market. “Over the past 18 months, if you were a seller and waited, it was a smart decision,” says Hipp. “But now sellers could take a penalty if they wait, so as prices move up, they may feel they’d better sell now before cap rates get any higher. If there were 10 Walgreens on the market and 50 buyers, and suddenly you have 40 Walgreens on the market, there’s some price pressure. The developers who could hold out because of lack of product will suddenly feel more pressure.”
Seibert says it’s hard to give advice that would apply to all categories of net-lease investors since they differ so much in investment amounts and what they seek. “If you have a modest amount of money to spend, your best bet would probably be to purchase a liquid, public NNN REIT if you wanted exposure to the sector. You get yield, diversity of owning a small piece of a much larger portfolio and have the results of almost instant liquidity. The triple-net REIT sector has shown a strong history of raising its dividends, so increased income is usually possible over time.”
Short of a financial crisis or some other unforeseen event or dramatic rise in interest rates, all other industry metrics seem to be positive now, Seibert adds. “A lot of the available retail, office and industrial vacant space available after the financial crisis has been absorbed, and companies are starting to become active in new development again.”
Hipp says properties in tertiary markets that are not credit rated may offer better yields, and it’s tempting to go there since there’s such a low supply of net-lease properties in general. Yet Schorsch recommends looking mostly at newer assets that have a longer life and will be occupied for longer periods. “Stay away from tertiary markets, and stay in primary markets where there’s much better occupancy.”
McDowell and DuGan agree that not all net-lease companies are the same, and it behooves the potential investor to examine the different investment strategies and values relevant to total net-asset value of net-lease firms. “Some are more valued in the market and have values that can’t go up, and others are less valued and have values that can go up,” says McDowell. “When you look at the public net-lease sector, you have to look at it company by company and look at the strategies they produce and where their companies are trading, rather than just net asset value.”
DuGan recommends looking past the net-lease label and examining the firm’s management team—look for one that has managed a business through cycles—as well as how acquisitive that firm is today. “What type of assets are they buying?”
He also recommends looking at things like dividend coverage, lease rollovers and asset quality and basis. “There’s better value in industrial and office net-lease assets as single-tenant retail assets have seen cap rates fall faster and further than other net-lease asset types. So Gramercy is focused on single-tenant industrial and office assets, and that is where we have a ton of experience.”