NETL: Peak Inflation Is A Tailwind For Net Lease REITs (NYSEARCA:NETL)

tailwind for startup

baza178/iStock via Getty Images

Thesis: Net Lease REITs’ Time Is Here

What the commercial real estate industry classifies as “net lease” (wherein tenants are responsible for all or most maintenance, insurance, and taxes) has blossomed into an asset class of its own over the last few decades. Corporations have increasingly concluded that they would rather be renters of their real estate than owners of it.

And publicly traded real estate investment trusts (“REITs”) have proliferated to take advantage of this trend. In 2008, there were 11 public net lease REITs with $19 billion of gross assets. By the first quarter of 2022, there were 25 public net lease REITs with $203 billion of gross assets.

That’s where the NETLease Corporate Real Estate ETF (NYSEARCA:NETL) comes in. The ETF owns 23 net lease REITs with a combined enterprise value of $228 billion. The expense ratio sits at 0.6%, while the 30-day SEC yield is around 4.5%.

As an increasing chorus of voices predicts that inflation has peaked and a recession is oncoming, net lease REITs appear well-positioned to outperform. That is because they tend to perform better than the average REIT during the average recession, and also because cooling inflation will probably lead to falling interest rates.

For those wishing to gain exposure to all net lease REITs in one fell swoop, NETL makes a great option.

The Macroeconomic Case

A definitive peak and sustained decline in inflation (and thus probably also interest rates) would be highly beneficial for net lease REITs.

Net leases almost always feature long lease terms of 10-15 years (or more). And, depending on the tenant and property type, net leases typically have only 1-3% annual rent escalations, which obviously can’t keep up with high single-digit inflation. Real (inflation-adjusted) organic rent growth for net lease REITs is thus deeply negative right now, and management teams can’t do anything to increase organic rent growth if the tenant has many years of term remaining.

That is why net lease REITs severely underperform REITs with shorter lease terms that can be reset at the rapidly rising market rate quicker. Compare, for instance, the performance of NETL against the Nuveen Short-Term REIT ETF (NURE), which owns multifamily, self-storage, and hotel REITs:

Chart
NETL data by YCharts

From September 2021 through April 2022, as the US CPI kept climbing higher and higher with no end in sight, REITs with short-term leases greatly outperformed net lease REITs.

But over the course of this summer, more and more experts have begun to predict that inflation has (or will soon) peak and then begin to decline into the end of the year. Hence we find that net lease REITs have begun to outperform REITs with short-term leases:

Chart
NETL data by YCharts

What’s more, more and more experts have been warning of a likely oncoming recession. The historically reliable recession predictor of an inverted yield curve has already manifested for the 10-year / 2-year Treasury yield spread, and now the 10-year / 3-month spread is teetering just 7 basis point away from inversion.

Chart
10 Year-3 Month Treasury Yield Spread data by YCharts

Typically, when the 10-year Treasury rate goes lower than the 3-month Treasury rate, it is a very strong indication that a recession is coming in the next several months.

Why is this good news for net lease REITs? Because the archenemy of net lease REITs is the twin nemesis of high inflation and rising interest rates. Recessions have an excellent track record of causing inflation and interest rates to decline, at least temporarily.

Thus, as long as the recession doesn’t do too much damage to their tenants as to make them incapable of paying rent (as was widely the case during COVID-19), a garden variety recession could actually be a net benefit to net lease REITs.

NETL Overview

Here is some basic information about NETL’s portfolio as of the end of the second quarter of 2022:

  • Average price to FFO multiple: 13.5x
  • Total property count: 29,492
  • Occupancy: 99.1%
  • Weighted average remaining lease term: 14.7 years
  • Weighted average debt to enterprise value: 32%
  • Weighted average remaining debt term: 6.9 years
  • Weighted average interest rate: 3.4%

Though net lease is most often associated with single-tenant retail properties because it is what the longest running net lease REITs have specialized in, there are all kinds of tenant and property types that use net leases. By absolute dollar value, all forms of retail combine to account for a little over 1/3rd of net lease.

net lease tenant types

Fundamental Income

But if you combine the “industrial” and “freight and logistics” categories above, you’ll see that industrial makes up a little over 1/4th of the net lease sector.

NETL’s index does not weight holdings by market capitalization alone but rather by a few factors, including tenant diversification. That is why Realty Income (O), the biggest net lease REIT by far at a $46 billion market cap and $62 billion enterprise value, is only the second-largest holding. The top holding is casino landlord VICI Properties (VICI).

NETL holdings

Fundamental Income

Though NETL’s top holdings will shift over time as its various holdings perform differently and the fund rebalances, the current top 10 is a good representation of the variety that net lease REITs have to offer.

For instance, it includes Agree Realty (ADC), which overwhelmingly owns the largest, strongest, investment-grade retailers like Walmart (WMT), T.J. Maxx (TJX), and Kroger (KR). And it also includes STORE Capital (STOR), which owns a mix of retail, service-oriented, and industrial properties leased to private, middle-market tenants.

Likewise, among the top holdings are National Retail Properties (NNN), a longstanding REIT with an exclusive focus on retail and 33 consecutive years of dividend growth, as well as STAG Industrial (STAG), a newer REIT that focuses exclusively on industrial properties.

Though net lease REITs are frequently called “bond proxies” or “bond alternatives,” total returns have historically been far higher than they have for bonds.

From January 2008 through June 2022, NETL’s underlying index has generated annual total returns of 11.7%, which absolutely trounced the broader REIT index.

NETL backtested returns'

Fundamental Income

Now, this isn’t exactly a fair comparison, admittedly, because over half of the current net lease index was added over the last 12 years. Moreover, backtesting an index that was recently created against one that has been in existence during the entire test period isn’t exactly fair either.

Even so, it is interesting to note that, generally speaking, net lease REITs have outperformed over the last decade or so. Indeed, the four largest net lease REITs that have been around since January 2008 have each outperformed the broader real estate index (represented below by the Vanguard Real Estate ETF (VNQ)):

Chart
O Total Return Price data by YCharts

Here are two more net lease REITs that went public in the last 11 years:

Chart
STAG Total Return Price data by YCharts

And here are two more net lease REITs that IPO’d in the last five years:

Chart
VICI Total Return Price data by YCharts

Hopefully this flurry of charts shows that an above-average amount of net lease REITs outperform the broader real estate index. I’m not merely cherry-picking the winners.

Not all net lease REITs outperform, of course. But the point is that it is not uncommon to see them outperform.

Bottom Line

There are a few externally managed net lease REITs included in NETL’s portfolio that I would personally rather avoid. These include Global Net Lease (GNL) and Industrial Logistics Properties Trust (ILPT). As such, I choose not to own NETL in my taxable brokerage account, which acts as my primary active investment channel. But I do own NETL in my Roth IRA account, in which I only hold ETFs.

For investors interested in gaining exposure to net lease REITs but do not want to go through the trouble of picking which ones, NETL is a great, one-stop-shop way to accomplish that. If inflation actually has peaked and interest rates also begin to come down, NETL should perform extraordinarily well going forward.

Be the first to comment

Leave a Reply

Your email address will not be published.


*