Unless you are completely out of touch, you know that your older clients are starving for yield. In fact, retirees who rely on their REIT fixed income investments for “simple” things, such as housing and food, are particularly yield-hungry. With yields on traditional fixed income investments so low, investors must either accept more risk to achieve higher yields or seek out non-traditional investments to provide steady income.
Historically, investors would have turned to CDs, money market funds and bonds. In this low-yield environment, however, investors are finding REITs attractive, especially net lease REITs. They’re attracted to the sector’s stable asset base and steady dividends, which are usually paid monthly.
“The credit crunch really taught investors a big lesson about risk, and investors today are much more risk-averse and more yield-oriented,” says Tom Lewis, chairman and CEO of Realty Income Corp., an Escondido, Calif.-based REIT that invests in net lease properties and brands itself as The Monthly Dividend Company (NYSE: O). “In fact,” says Lewis, “I’d say they’re starving for yield. For retired people who are trying to replace their salaries, this yield environment is excruciating.”
Long-Term Leases = Less Risk
Net lease REITs derive their name from a type of lease that is common for office, industrial and retail properties—the triple net lease, also known as an NNN lease. Simply put, an NNN lease requires the tenant to pay for all expenses related to the property, including rent, maintenance, and property taxes.
In addition, most net leases are long term—typically 20 years or longer. And, in the commercial real estate sector, where risk is associated with lease terms, net leases are usually viewed as low-risk.
Assets with long-term leases are considered less risky than those with short-term leases because owners don’t have to worry about finding new tenants on a regular basis. Hotels, for example, have the shortest lease term—basically leasing rooms on a daily basis—and are the most vulnerable to economic conditions. At the other end of the spectrum are net leases, which are typically structured with incremental rent increases, usually to keep pace with inflation.
Net lease owners/investors give up big rental increases to lock in steady income. In fact, many investors consider long-term net lease properties to be fixed income investments because of the steady cash flow they provide.
Historically, net leases have been more common with freestanding retail properties. Walgreens, for example, is one of the most prolific net lease tenants, along with banks such as Chase and Bank of America.
As a result, most net lease REITs are heavily invested in retail properties and have been categorized as single-tenant net lease REITs. What’s interesting, however, is that many REITs in other categories—industrial and healthcare, for example—own properties that are secured by triple net leases. The difference, however, is that their portfolios also include properties with other types of leases and shorter lease terms.
A couple of companies have entered the publicly-traded, single-tenant net lease space—both Spirit Realty and American Realty Capital Trust had IPOs this year. Today, SNL Financial counts eight REITs in the net lease category and a market cap of $13.5 billion. In addition, there are a handful of non-traded REITs that specialize in net lease properties.
Year-to-date, publicly-traded, single-tenant net lease REITs have posted a total return of 32.33 percent, according to SNL Financial. The sector has outperformed SNL’s all-equity REIT index, as well as the S&P 500 and the Russell 3000. It posted an average dividend yield of 4.785 percent as of mid-October.
Demographics have a lot to do with the popularity of net lease REITs today, Lewis contends. Baby boomers are entering retirement, and with them, demand for income-producing investments has increased drastically.
In the 1990s and even into the early 2000s, baby boomers were in their peak earning years and accumulating money for retirement. Only a small segment of the population was looking for income.
“Today, it’s a very different picture,” Lewis says. “There are 76 million baby boomers, and 10,000 people are turning 65 every day. Thirty-five percent of the population is now over 55 years old, and this segment owns 62 percent of all brokerage assets. They’re moving into a phase of their life when they need income, and this yield environment is excruciating for retired people who are trying to replace their salaries.”
Lewis points out that the increased interest in steady income-producing investments has been evident in the volume of traffic to Realty Income’s website. “Last month, we had about 5,500 people come to our website from doing a web search for the keywords ‘dividend growth’ and ‘monthly income’, and every month the number has increased,” Lewis says. “We have always attracted retired investors, and as the baby boomers enter retirement in large numbers, we’re all that more attractive. It’s funny because 15 years ago when baby boomers were in their peak earnings years, there wasn’t anything we could do to get their attention.”
That’s clearly not the case today: The company’s stock currently is trading at about $40—a substantial increase from its 52-week low of $31.85.
The quality of a net lease is determined by three primary elements: 1) the tenant’s ability to pay the rent; 2) the importance of the real estate to the tenant; and 3) the quality of the property and the ability to lease it to another tenant.
Net lease owners/investors are particularly interested in the creditworthiness of the tenant. Like bonds, net leases are secured by a company’s credit or balance sheet, and companies that are ranked as investment grade by ratings agencies such as Standard & Poor’s are the most attractive net lease tenants.
“We certainly characterize net leases as a bond-like investment because the quality of the lease payment is the same as unsecured bonds,” says Kevin Shields, chairman & CEO of Griffin Capital Corp. and an advisor for Griffin Capital Net Lease REIT. “You’re getting a nice yield premium on the same credit quality relative to having bought the bonds.”
Shields points to Griffin Capital Net Lease REIT’s recent acquisitions—the company purchased assets leased on long-term net leases by AT&T, Westinghouse Electric, GE and Travelers Insurance. “If you look at the last five assets we acquired, our average lease yield on those assets is 8.4 percent,” he says. “If you were to buy a comparable maturities bond, the weighted average interest rate is 5.2 percent, representing a 320 basis point spread between the lease rate and the bond rate for the same credit.”
Realty Income, for example, made the decision to move up the credit curve and work with investment-grade tenants. Although the REIT previously invested exclusively in retail, it now is pursuing opportunities in industrial, manufacturing, distribution and agricultural assets.
Since implementing its new strategy, Realty Income has purchased about $1.2 billion in non-retail assets, about $1 billion with investment-grade tenants. The REIT completed its first investment-grade transaction with global adult beverage firm Diageo, paying $300 million for wineries/vineyards in California’s Napa Valley and leasing it back to Diageo for 20 years. Diageo, which makes Guinness as well as other well-known beverages, enjoys investment-grade credit scores.
However, the creditworthiness of the tenant only goes so far, and that’s why net lease owners/investors are also interested in the real estate itself.
“If you own an asset that is considered ‘mission-critical’— the tenant needs that property to run its business—there’s a higher likelihood the lease will be renewed,” Shields says. “And if worse comes to worse and the tenant chooses not to renew, a high-quality asset can be leased to another tenant.”