Net lease REITs piece together Covid strategy

What do a Target in Phoenix, a Wegmans in Chapel Hill, North Carolina, and a Marshalls-Homegoods store in California’s Napa Valley have in common?

They’re among the 26 tenants occupying 91 properties across the U.S. that net lease REIT Agree Realty Corp. acquired in the third quarter. The $458 million worth of purchases set a quarterly record for the half-century-old real estate investment trust.

At a time when the pandemic continues to throttle many real estate markets and the retail sector, Agree Realty surpassed 2019’s full-year acquisition volume by 37 percent in the first nine months. But the Michigan-based firm has not been alone in its recent buying spree.

Among publicly-traded real estate companies, net lease REITs have been some of the most active buyers of property in recent months. The strategy is focused on single-tenant asset purchases, and in addition to some big box retailers, much of the space involves smaller properties. Those are leased to dollar stores, car washes, fast-food restaurants and groceries, mainly in suburban markets.

While shopping mall REITs have been hit hard by the pandemic, net lease REITs have benefited from the fact that most of their retail properties were deemed “essential” and located outside of the early outbreak hotspots.

Getting busy

After a slight pause in the market during the initial coronavirus surge, “product velocity took off,” said Realty Income president and CEO Sumit Roy, during the Nov. 3 earnings call. The giant of the net lease REIT sector with a market capitalization of more than $21 billion, Realty Income soon “started getting really busy, getting inbound [inquiries] and seeing transactions that we wanted to pursue,” Roy said.

The net lease sector has rebounded more quickly “and more vibrantly than just about any other asset class,” said Haendel St. Juste, a REIT analyst at Mizuho Securities USA. Noting that several net lease REITs have raised their acquisition guidance for 2020, he added, “there’s a ‘back on offense’ feeling we’re getting from a lot of these REITs.”

In Q3, $11.7 billion of net-lease investment accounted for 18.4 percent of all commercial real estate investment activity in the U.S. That was well above the five-year average of 11.8 percent, according to CBRE. REITs in particular saw their activity skyrocket, increasing 176 percent quarter-over-quarter to $1.9 billion. The third-quarter figure still represents a drop of more than 50 percent year-over-year, but is outperforming the overall market, which fell by 60 percent, and the hotel sector which fell by 84 percent, according to CBRE.

Triple-net effect

The basic characteristic that sets net lease REITs apart is their lease structure. Most commonly, this takes the form of a triple-net lease in which the tenant assumes responsibility for real estate taxes, maintenance and insurance.

“In a typical landlord-tenant relationship, the landlord takes on all those costs and they charge a higher rent for it,” St. Juste said. With the net-lease model, “you get a lower average base rent and less rent bumps, but you get longer leases and generally greater stability over a longer-term lease.”

The stable, long-term nature of net leases means that REITs in the sector rely on acquisitions to fuel growth. And the highly liquid nature of the market — relatively small properties across the U.S. — combined with favorable costs of capital, means that these companies have had plenty of room to grow before the pandemic and in recent months.

The potential market for net lease REITs is massive, at least in theory.

The net lease sector has rebounded more quickly and more vibrantly than just about any other asset class. — Haendel St. Juste, Mizuho Securities USA analyst

Another major player, Phoenix-based Vereit, estimates the single-tenant net lease universe to be worth about $1.5 trillion.

In a retail landscape that has been in flux for years, net lease REITs have pursued different strategies in their efforts to build resilient portfolios. Some, like Agree Realty, focus heavily on investment-grade tenants that present a lower risk of default. The company — which buys properties like an O’Reilly Auto Parts for about $1 million up to a Wegmans food market for about $35 million — also makes a point of avoiding tenants backed by private equity, which it views as particularly vulnerable.

Store Capital, a REIT that focuses more on creating custom net lease contracts and less on investment-grade tenants, values the real estate in its target market at more than $3 trillion in total.

Store Capital president and CEO Christopher Volk

Short for “Single Tenant Operational Real Estate,” Store Capital argues the market for properties with investment-grade tenants is inefficient, overpriced and full of less sophisticated private players.

“There is a veritable conga line of family offices and high-net-worth individuals willing to invest in real estate occupied by such companies,” Store Capital president and CEO Christopher Volk wrote in Seeking Alpha in August.

Instead, Store Capital’s model is to use custom lease terms to “create net lease contracts better than the underlying credit of the tenants themselves,” he wrote.

In the broader net lease space, a preference for investment-grade tenants has become even more pronounced since the start of the pandemic, increasing competition and driving up pricing in a narrower segment of the market.

“As Covid-19 continues to impact the real estate market, net lease investors are limiting the type of properties they are willing to acquire,” Boulder Group senior vice president John Feeney wrote in a recent research report. “Consequently, sellers of high-quality net lease properties priced assets to a level not previously seen as they look to take advantage of investors’ more conservative acquisition criteria.”

On the sidelines

While many of the leading net lease REITs are all-in on acquisitions in the current environment, some are still taking a wait-and-see approach.

“There wasn’t anything that was being marketed recently that we felt like was something that we really wanted to pursue,” said National Retail Properties president and CEO Julian Whitehurst during the REIT’s November third-quarter call.

“We don’t think we’re going to look back three years from now and say that we should have really bought much, much more in the second half of 2020,” he added. “So we just think it’s a little more prudent to go a little slower at the moment.”

National Retail Properties president and CEO Julian Whitehurst

REITs are hardly the only players in the space; investment clubs and institutional funds also regularly make use of the net lease structure. That includes RFR Realty, whose $350 million sale-leaseback with Morgan Stanley for the office tower at 522 Fifth Avenue in Manhattan was one of the largest net lease deals in the past quarter, according to CBRE. REITs in niche sectors like gaming also typically rely on net leases.

“It’s a pretty wide swathe of properties, and not everybody’s competing for the same things,” St. Juste said. “A local investor might end up buying a couple of Wawas, a couple of Chick-fil-As,” he said. By contrast, a REIT like Realty Income might opt for a portfolio of corporate sale-leasebacks with 7-11, “a bigger deal that the smaller groups just don’t have the capital for.”

Rent collections, asset classes

Following a drop in the second quarter, net lease REITs have generally been able to bring their rent collections back above 90 percent, after providing rent deferrals to tenants in need.

The most obvious exception is movie theaters, which represents 3.9 percent of Store Capital’s rent exposure and 5.4 percent for another net lease REIT, Spirit Realty Capital.

The continued shutdown of theaters in key markets like New York City and Los Angeles has prompted studios to hold back content, with most major releases now pushed to the spring.

In some cases, theater owners are already considering alternate uses for their properties, such as conversion into mixed-used multifamily or distribution centers.

“Whereas nearly every sector saw a drop in volume between the first and second quarter, certain sectors that have experienced minimal disruption in their day-to-day business are now seeing significant rebounds in investment volume,” Avison Young researchers wrote in their Q3 report on the net lease market. Those include the kinds of properties net lease REITs have targeted: pharmacies, dollar stores and fast-food chains.

With the months-long pickup in activity, St. Juste noted there was still enough room in the net lease REIT space for new entrants like Netstreit and Broadstone, which both closed their initial public offerings in September.

At the same time, operating in a world of big and small properties scattered across America’s suburbs comes with its own challenges — and net lease REITs believe they have an advantage here.

“It’s a very, very fragmented business, very much a relationship business,” Netstreit CEO Mark Manheimer said on an Oct. 30 earnings call, after going public. He pointed to a complex deal it recently put together for a Wal-Mart Supercenter and Sam’s Club in Tupelo, Mississippi.

That would have been a difficult deal for a private buyer “if they’re not in the business, you know, each and every day like we are,” he said. Because the market is so fragmented, he continued, the company will “be able to execute our business plan in the future.”