Net Lease REITs: The Ultimate Sleep Well At Night Business Model

Net Lease REITs: The Ultimate Sleep Well At Night Business Model

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This article was coproduced with Chris Volk, who took public and guided three successful net lease REITs over three decades, co-founding two of them. He’s currently a visiting professor at Cornell University and a frequent guest lecturer at other universities.

He’s the author of the recently released “The Value Equation: A Business Guide to Wealth Creation for Entrepreneurs, Leaders and Investors”, published by Wiley.



Since 1994, I have learned a thing or two about how net lease REITs perform over time and how they respond to market disruption.

In recent months, we have had plenty of disruption.

Since December 2021, the yield on the benchmark Ten-Year Treasury Note has nearly doubled, rising from 1.5% to occasionally pierce the 3% barrier. It now stands shy of 3% and Federal Reserve Chairman Jerome Powell has been vocal about rising interest rate expectations to tamp down inflation.

Given Powell’s exhortations on the shifting Federal Reserve emphasis from employment to inflation, a new concern has been looming: The potential of a recession. Former Treasury Secretary Larry Summers put an exclamation point on this concern in a recent interview, stating,

There’s never been a moment when we had inflation over 4% and unemployment below 4%, when we didn’t have a recession within the next two years.

Investors hate uncertainty. Since the beginning of this year, NETL, which is an exchange-traded fund comprised of net lease companies, is off about 17%.

So is the index of all equity REITs. REITs, and net lease REITs in particular, have predictably responded poorly to recent inflationary and recessionary sentiments.

The Market Today

On a weekly basis, I receive a bank report that illustrates REIT sectors by valuation multiples, dividend yields and other characteristics. Here’s a quick summary of that report as of the end of last week:

Of the 14 sectors reported, net lease companies have an average dividend yield of about twice that of the sectors at the bottom half of the list. Within the net lease sector, the 11 companies I follow looked like this as of May 20:


Chris Volk

With respect to 2022 growth expectations, there are some comments to be made. EPR Properties (EPR) was most impacted by the pandemic with its investments centered in “social gathering places.”

Hence its expected 2022 growth is coming on the heels of a poor comparative number. Some of the other companies may also have slightly elevated growth for 2022 to the extent that tenants were not fully performing for all of 2021.

And then some companies have elevated growth expectations arising from their smaller size.

Still, add the growth number to the dividend yield and the result is generally well above 10%. Growth expectations for 2023 and beyond will be more telling. I expect that growth in the area of 6% should be feasible for much of the net lease group, suggesting normalized average dividend yields in the area of 4%.


Chris Volk

The 10-Year Treasury Relationship

Since 1990, the average spread between REIT dividend yields and the yield on the Ten-Year Treasury Note has approximated 1.1%, but with a high standard deviation of about 1.1%.

Therefore, 95% of the time, the spread will be between -1.1% and 3.3%.

Today, for the FTSE Nareit All Equity REITs index, that spread approximates 45 basis points. However, for net lease REITs, the spread is closer to 220 basis points.

Assuming a stabilized 10-Year Treasury of 3.0% to 3.5%, moving net lease average yields to approximate 4% is hardly a stretch. Higher note yields would likely bring with them very elevated recessionary pressures, together with potentially material impacts on the US housing market, which already is feeling the heat of 30-year mortgage rates exceeding 5%.


Net Lease REITs May Not Be What You Think

A common investor refrain is that net lease REITs are more sensitive to interest rates, in light of their long lease terms which lock in modest escalations.

Anyone who knows me knows that I take issue with this.

Starting with the obvious, investors who invest in net lease companies are not investing in a basket of leases. They are investing in a stock. There are three big differences:

  • Net lease companies are generally modestly leveraged at around 40% or less at cost, with such leverage partially protecting investors from inflation and rising rates.

  • Net lease companies do not pay out all their cash in dividends. Net lease REIT dividend payments relative to 2022 AFFO guidance range from 68% to 81%, averaging around 73%. This provides for some return compounding and some guaranteed growth from cash flow reinvestment into new assets.

  • Net lease REITs are generally not sensitive to debt maturities that need to be refinanced at higher rates. In a period of low rates, companies opportunistically extended debt maturities and refinanced borrowings. Also, the combined total of free cash flow after dividends and annual asset sales often comes close to, and occasionally exceeds, debt maturities.

This means that net lease companies often don’t need to refinance maturing debt but can simply repay it from cash flow. Then, new borrowings taken on are used to invest in new assets, presumably with some elevated lease rates and even elevated lease escalations.

I once did an investor day presentation that illustrated the impact of rising interest rates. Over a long period of time, my observation was that net lease cap rate sensitivity to interest rates produced a coefficient of around .5.

That means that, for every point change in the 10-Year Treasury, our cap rates tended to move by half the amount. So, at 40% leverage, the investor result tended to be that expected rates of returns tend to stay within a tight absolute bandwidth.

It’s interesting to note that such also appears to be the behavior of the broad stock market and REITs in general since 1990.



REIT Data Limitations

Admittedly, one problem with the REIT data I am using is that it started in 1990, which approximates the time when REITs 2.0 started, resulting in substantial market growth.

In 1980, the last period in which there was double digit inflation, REITs were far too small to merit a decent comparison to the broader markets. During that decade, the S&P 500 Index blew through its 10% average return, delivering a 16.1% compound annual rate of return.

Returns were even more robust in the 1990s, at 18.5%. It bears mentioning that 1990s investors fared far less well in the Nasdaq. Still, since 1990, REITs have performed about on par with the S&P 500.



Since 1990, REITs have tended to show more volatility in turbulent times, as seen by the shifts in the performance curve in 2008 and 2020. In both cases, the corrections overshot the mark, with REITs rising afterwards.

I believe that this will happen in response to the current uncertainty and turbulence.

In fact, this illustration helps support my long-stated view that REITs are not necessarily sensitive to interest rates or economic growth. They are sensitive, perhaps overly so, to moves in interest rates and to market disruption and uncertainty.

Once rates stabilize and an economic outlook is more secure, REITs tend to rebound. Some recent REIT pressures might be attributed to the nature of the overall stock market.

On April 30, I attended for the first time the annual meeting of Berkshire Hathaway in Omaha. At that meeting Warren Buffett and Charlie Munger each took shots at what they referred to as the “casino-like” atmosphere of the stock market.

Ironically, Warren Buffett took advantage of this characteristic by purchasing 25% of the tradable stock in Occidental Petroleum (OXY) over a 10-day trading period.

Even though 40% of the company was held by index funds and a large shareholder, investors in the other 60% whirled the shares so fast that Berkshire was able to accumulate a 15% position.

Many of the people and algorithmic traders whirling the shares likely had any idea of what the company does, let alone its financial position. In leading public companies, especially over the past decade, I have found this to be increasingly true.

Dividend and Performance Reliability

Part of me finds it amusing that net lease REITs might trade off on recessionary concerns.

In 2009, prominent investor Bill Ackman made an ill-fated short bet on Realty Income (O). His thesis at the time was that the yield on the shares was too low relative to the weighted underlying credit quality of the portfolio tenants.

Ackman missed two key points.

The first of these was that the Realty Income portfolio did not represent any single tenant. It was highly diversified. And, to paraphrase Harry Markowitz, the economist who devised modern portfolio theory, diversification is a free lunch.

As such, diversification can transform a portfolio of non-rated tenants into an investment-grade stream of cash.

Secondly, the landlords are not investing in tenant businesses, just their real estate. Typically, there’s wide margin for performance error between the amount of cash a company throws off and the amount of rents owed.

That was my argument in 2009.

Since then, I have added another argument.

Of the 11 net lease companies I follow, nine endured the pandemic (the other two were listed during the pandemic but would have performed just fine).

The pandemic was far worse than any recession I have ever endured.

Really, there’s no solution for getting tenants to pay rents when they have no business. That’s irrespective of their credit quality, since no company can exist without sales.

But such is precisely what happened in 2020.

Of the eleven REITs I follow, nine endured the pandemic, and of the nine, only one (EPR) suspended dividends. That company had no choice, since it was beholden to “consumer gathering places.”


Chris Volk

With conservative dividend payout ratios, contract seniority on tenant capital stacks and universally conservative balance sheets, my view is that any future recession will be child’s play relative to the pandemic.

Is Now The Time?

In putting together my own investment portfolio, a sizable piece is devoted to dividend-paying stocks. The aim is not necessarily to beat or equal the S&P 500.

The aim is to have a pool of rising cash flow that covers a reasonable amount of my living costs so that I do not need to be dependent on capital gains, margin loans or market moves.

Historically, I have found it a challenge to find dividend yields approximating 5%. Keep in mind that most pension funds have actuarial return assumptions in the area of 7% (and often less), which means that a 5% dividend company only need to produce 2% annual growth.

Timing a market bottom is hard, but I know a good deal when I see it. Net lease REITs may head lower as volatility, economic concerns and a “casino market” reign. Meanwhile 5% is amazing and I’m a buyer.

Sector Metrics


iREIT on Alpha

Net Lease REIT Metrics


iREIT on Alpha

Thank you for the opportunity to be of service!