A Treasure Hunt For Absolute Return Potential: Real Estate Net Lease Business Models That Deliver
Long only, growth at reasonable price, corporate contributor, REITs
Net lease companies have historically outperformed and now have their own ETF and index.
Net lease outperformance has been largely a function of potent, predictable business models that are generally simple to dissect.
Net lease business models offer the potential for a modest range of long-term absolute return delivery through a variety of economic and valuation climates.
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On March 22, a net lease REIT ETF was launched by Exchange Traded Concepts, LLC based on the Fundamental Income Net Lease Real Estate Index (NNNLSCTR). The ETF is called NETLease Corporate Real Estate ETF (NYSEARCA:NETL). For those readers who do not know what a net lease REIT is, it is a company that holds real estate that is leased to tenants, generally on a long-term basis and with no landlord requirements to maintain the asset, or to pay property taxes and insurance on the asset.
As I often describe this relationship, tenants have generally elected to have a landlord, rather than a banker. I took an interest in the listing of this ETF for two reasons. First, the ETF and index were started by two individuals who had worked with me at STORE Capital (STOR). Second, this ETF represents the first time, to my knowledge, that a REIT category has been created based upon comparative business model similarities and not based on references to physical property characteristics.
Represented in this ETF are 24 companies having a combined equity capitalization of $103 billion, with property types that cover the waterfront, from gaming and leisure to industrial to chain restaurants. STORE Capital is one of the companies in the index.
The Net Lease Real Estate Index was created because net lease REITs, as a group, have outperformed just about every comparable benchmark for a long time. More than this, net lease companies have the high potential of delivering consistent and less volatile returns over time. I will demonstrate this later.
Part of the reason for their outperformance is that net lease companies are often misunderstood, which means that they have generally lower valuation multiples than do mainstream REITs. Personally, I would say that some of this misunderstanding rests in their underlying real estate valuation estimates. Historically, REIT-dedicated investors have tended to favor investments having valuations not falling far from underlying property, or net asset, values.
Similarly, REIT dedicated investors tend to prefer a portfolio of high quality assets. In real estate terms, high quality tends to mean that the assets are much sought after by real estate investors and so tend to trade at the lowest lease yields, or cap rates. Net lease companies, by contrast, do not always pursue such low yielding assets and they tend to generally trade at a premium to their net asset value.
This characteristic has enabled added cash flow growth through ongoing acquisition strategies. Realty Income (NYSE:O), the nations largest net lease company, went public in late 1994 and since then has raised nearly $11 billion through the end of 2018 from new share issuances to fund growth, which has diluted, but delivered accretive results to, its existing shareholders. Approximately 10% of this cumulative equity issuance amount was raised in 2018 alone.
Another area of net lease misunderstanding may relate to overall REIT disclosure. Net lease companies are generally willing to disclose adjusted funds from operations, or AFFO, whereas many mainstream REITs are not. AFFO is not an SEC or NAREIT sanctioned term, but is widely used and considered an approximate proxy for recurring shareholder cash flow.
Basically, you simply take net income, back out gains and losses on real estate sales, depreciation and amortization, straight-lined rental income and non-cash interest and employee compensation. There can be more items in the adjustment, but, for net lease REITs, these are the main universal ones. Missing in these adjustments, which would impact much of the REIT world, are recurring capital expenditures, such as tenant allowances.
This is an issue for many REITs, where there is no universally agreed upon manner to disclose this number. If youre not a net lease REIT, it can be a big deal. If you are a net lease REIT, such expenditures are far less and often inconsequential. This means that investors can understand more about the free cash flow from net lease companies than they can easily glean from the investor presentations of many other real estate investment and management companies.
Lacking such disclosure, REITs are often compared using relative FFO multiples, which ignores recurring capital expenditures and even non-cash straight-lined rents. Needless to say, comparing net lease AFFO or FFO multiples to overall REIT FFO multiples is an exercise in futility. Same with funded debt/EBITDA comparisons. So, while a number of net lease REITs have similar FFO multiples to their office, multi-family, retail and industrial counterparts, the actual cash flow multiples can be materially different.
I personally believe that business models contribute the most to shareholder returns. If you are a value investor, as I am, trying to understand the business models of companies is important. Since net lease REITs are basically monoline companies, understanding their business is generally not all that difficult.
For example, I find understanding banks to be hard. This is even more so with diversified companies like Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) or Amazon (NASDAQ:AMZN). But net lease companies are a comparative piece of cake. To prove the point, I will do something unusual for a CEO to do in Seeking Alpha and lay out the math behind the net lease business model that has allowed our leadership team to perform well through three public companies over the past 25 years.
To start, there are just eight key mathematical drivers of net lease shareholder returns that are within the control of management:
: This is an obvious one. All things equal, higher lease rates are better. This should be a cash yield number, so back out any straight-lined rents or tenant reimbursements.
: This includes general and administrative costs, less non-cash compensation
, plus property level costs, less tenant reimbursed costs as a percent of assets. I often find that research analysts tend to focus on general and administrative costs, leaving out non-reimbursed property management costs. But, of course, costs are costs and not all net lease REITs are created equal. Some will have leases that mandate certain landlord costs and others will simply have more vacant properties that require costs.
: This is the amount of borrowings and preferred stock as a percentage of total assets at cost. Simply take gross assets and add back accumulated depreciation and accumulated lease intangible amortization. From the vantage point of a shareholder, preferred stock is always debt. But since REITs are not taxable entities, REIT preferreds are more efficient forms of debt than are those of taxable companies. Absolutely stay away from useless leverage ratios like debt:enterprise value, which are often used in the REIT world. When evaluating comparative business models, borrowings and preferred stock as a percent of gross assets is the single most valuable ratio.
: Most net lease REITs are investment-grade companies and can borrow anywhere from a spread of 110 basis points to 200 basis points over the 10-Year Treasury on an unsecured basis. At STORE, we also have a secured conduit that is a highly efficient source of borrowings. Occasionally, net lease companies will also make use of unsecured bank term notes, which can be another highly efficient form of leverage
: Net lease REITs tend to have regularly scheduled tenant lease escalations, which is especially attractive given the long-term nature of the leases. Obviously, more is more. Not all companies disclose their average contractual tenant escalations, but most will show annual same store rents changes, which will be close.
: This variable encompasses lost revenues on resolved and unresolved underperforming assets plus any revenue lost on lease renewals, all as a percent of assets. Periodic tenant underperformance is a constant part of the net lease business. Most net lease REITs post constant occupancy rates not far from 100% (the total occupancy of the NETL ETF is 98.8%), but there will always be portfolio disruption and occupancy rates can mask underperforming asset turnover. To this percent of assets drag, we also include incremental or lost revenues from recycled cash from sold properties. In 2018, STORE sold over $250 million in real estate at a 7.1% yield and reinvested the proceeds at a 7.9% yield. For a full year, this would enable about 0.5% of added revenue growth. On average, our growth rate from recycled cash since 2011 has been about 0.1% a year. Between 2011 and the end of 2018, our average annual lost revenue drag as a percent of assets has averaged 0.4% annually. Actually, the way we annually disclose this amount includes related property management costs, which would mean that our average pure lost revenue drag would be slightly less. The impact of this drag is to lessen our effective tenant annual lease escalations. In STOREs case, the annual lease escalations, net of the lease escalation drag, has historically approximated 1.4% on average.
: This is the portion of our AFFO that we pay out in dividends. More importantly, the payout ratio reflects the amount of cash we can retain and reinvest into new assets to generate added shareholder AFFO growth. REITs have less ability than other companies to reinvest cash and compound shareholder returns, since they are required to distribute 90% of taxable income in the form of dividends. The depreciation shield they have offers them some ability to do this. At STORE, our payout ratio in the fourth quarter of 2018 was below 70% of AFFO, which gives us some ability to compound investor returns through cash flow reinvestment. The amount of our retained free cash flow approximated $120 million for 2018.
: This is the amount of new real estate we expect to invest in, net of property sales. The first dollars of the acquisitions will be funded with our free retained cash flow and incremental borrowings based on leverage targets. The resultant AFFO growth from these investments is part of our internally-generated (or simply internal) growth. Thereafter, acquisitions can be funded through new equity issuances and new proportional borrowings. Assuming net lease companies are trading at AFFO multiples that exceed their investment AFFO multiples at cost, then this added external growth is accretive to existing shareholders and is another important tool to deliver returns.
Using the eight shareholder return drivers, one can start to compute a few key performance indicators.
Investment AFFO Multiple. An investment AFFO Multiple is basically just an inverted AFFO yield. And an AFFO yield is basically just a current pre-tax equity cash yield. You can compute current pre-tax equity cash yields using the V-Formula, which is a simple computation I devised in 1999:
If you want to read up more on the V-Formula, you can start with my initial published article, which can be foundhere. By the way, for non-real estate businesses, the Lease Yield would be replaced by a Sales/Investment ratio. Using the V-Formula to compute the Investment AFFO Multiple for a REIT is simple:
Having high current equity returns is a starting point for shareholder value creation and also provides a margin of safety for having accretive external growth should traded AFFO multiples erode. It is important to keep in mind that the Investment AFFO Multiple excludes the dilution impact on existing shareholders by new ones. For instance, were we to increase our shares outstanding by 5% in a year, then our Investment AFFO Multiple, adjusted for dilution would increase as follows:
Investment Multiple Efficiency. Comparing the Investment AFFO multiple to our current traded AFFO multiple will give us a measure of external growth efficiency. We compute our current traded AFFO multiples by looking to our reported most recent quarter AFFO per share and comparing that to the share price of our stock as of the date of the press release. As of our most recent earnings date on Feb. 21, 2019, we were trading at a current AFFO multiple of 16.9X. Our forward multiple based on 2019 guidance would be lower than this, but I believe that business model comparisons are better done just looking to the actual current numbers, versus forward guidance estimates. With that said, Investment Multiple Efficiency is easy to look at as follows:
Investment AFFO Multiple Current Traded AFFO Multiple
Investment Multiple Efficiency will be a function of both the Investment AFFO Multiple and the Current Traded AFFO Multiple. REIT leadership naturally exerts more control over the former than the latter.
Operating Margin. The better the profit margin, the higher the shareholder returns. Here is the formula for marginal new investment profit margins:
(Going-In Lease Yield – (Cash Costs Average Assets at Cost))Going-In Lease Yield
The profit margins of the eight-company net lease peer group we use are high, ranging from 93.7% to 87.6%, which is a positive statement about the profitability of net lease companies.
Investment Spread. The wider the spread between the Going-In Lease Yield and the cost of borrowings, the better. Computing this is simply:
Going-In Lease Yield – Incremental Blended Borrowing Rate
External Growth Investments. You can estimate the amount of Acquisition Guidance investments that have to be funded with newly issued equity and borrowings through the next formula. STORE can fund close to $250 million in 2019 net new real estate investments absent new equity issuances. When evaluating net lease companies, you can estimate the amount of real estate investments that depend on new equity issuance by multiplying Acquisition Guidance by the following:
(1-(((1-AFFO Payout Ratio) x V-Formula) ((Acquisition Guidance x Going-In Lease Yield x Operating Margin) NOI Run Rate))) x Acquisition Guidance
External Growth Dilution. You can estimate the amount of new shareholder dilution needed to drive external growth through the below formula.
(1 Current Traded AFFO Multiple) (1 Investment AFFO Multiple) x % of NOI Growth from External Growth
External growth dilution efficiency basically mirrors Investment Multiple Efficiency. So, to estimate NOI growth from external growth, just take the percentage of External Growth Dilution and divide it by the simple or diluted Investment Multiple Efficiency quotient.
Estimating expected returns of any REIT is simple: Just add the dividend yield to the expected internal and external growth rate per share. Having looked at the eight fundamental drivers and then used those drivers to compute added Key Performance Indicators, you can now compute internal and external growth expectations and draw a few comparisons.
Internal Growth Rate: The Internal Growth formulas are fairly basic and look as follows:
Tenant Rent Increases: ((Lease Escalations – Lease Escalation Drag) x Operating Margin) (1 – Leverage %)
Reinvested Cash Flows:(1 – AFFO Payout Ratio) x V-Formula
External Growth Rate: Estimating external growth is far more complex. I have a formula for this as well2for die-hard formula geeks. Basically, though, it reflects a four-step waterfall of cash priorities as follows:
Step 1: Compute the whole AFFO amount to be divided between existing and new shareholders:
Beginning Run Rate AFFO + Internal Growth + External Growth = Total AFFO
Step 2: Multiply Total AFFO by the percentage of existing shareholders at year-end:
Total AFFO x (1-External Growth Dilution) = Total Existing Shareholder AFFO
Step 3: Subtract from this amount what existing shareholders would have had with no external growth:
Total Existing Shareholder AFFO – Beginning Run Rate AFFO – Internal Growth AFFO = External Growth AFFO
Step 4: Compute the External Growth Rate for existing shareholders:
External Growth AFFO Beginning Run Rate AFFO = External Growth Rate
The power of the eight mathematical drivers, added computed Key Performance Indicators and internal and external growth rate computations is that you can actually take large net lease companies and lay out their business models on a single line of a spreadsheet. We do this at STORE with a growing peer group that today includes seven other companies. Here is how we ranked in Q4 2018:
There are three critical observations that Id like to make before you do. The first is that all the relative financial statement variables are based on assets, from lease rate to lease escalators to operating costs to leverage. Creating comparative business models requires such consistency. Leverage is often viewed as a multiple of EBITDA and operating costs are likewise often spoken of in terms of their relation to sales, or net operating income (NOI) in REIT terms. For side-to-side business model comparisons of net lease companies, nothing beats using asset relativity.
The second observation is that the comparative model presumes that all the internal and external growth occurs at the start of each year. If youre going to make a one-line corporate model, you have to make some simplifying assumptions. With that said, such simplification can work in the net lease space.
The reason is that, presuming a company acquires the same amount of assets each year at the same time and at similar lease rates and that lease escalations also occur at the same time, then each year will have the same approximate growth, with some of that growth coming from assets acquired the prior year where they were only partially impactful.
The third observation is that there are quantitative variables not accounted for in constructing this side-by-side net lease company evaluation approach. A key item of interest would be interest rate sensitivity, which is driven by asset yields, borrowing costs, borrowing maturities and annual free cash flows that include asset sales proceeds. And, while the model has imbedded a Lease Escalation Drag variable, analysts are likely to want to stress different companies for asset non-performance in different ways. Likewise, portfolio investment diversity, including tenant and industry concentrations, may impact the amount of Lease Escalation Drag sensitivity.
The final observation is that our simplified model is purely quantitative. Investors will always have qualitative views that they emphasize, especially with respect to corporate leadership.
You should be. We have run through a lot of math, but part of the beauty of net lease companies is that you can actually do this. Perhaps you are a generalist investor and cannot think of anything more boring than a net lease company. You should reconsider.
If you are also a value investor, the ability to look to side-by-side business model comparisons might pique your interest. It bears note that the dividend yield of the NETL ETF approximates 5.5%. The dividend yield of STORE as of our Q4 2018 earnings release date was approximately 4.1%, or more than double the 1.9% yield of the S&P 500. In addition, our internal growth rate, which you can work out for yourself with the preceding framework, pencils out to just over 5%.
By contrast, long-run earnings growth for the S&P 500 is unlikely to outpace overall economic growth. Inclusive of inflation, S&P 500 earnings growth would be hard-pressed to exceed 5%, resulting in a 7% approximate rate of return absent multiple swings. Adding STOREs internal growth to our dividend yield results in a comparable total rate of return in excess of 9%. And we have not even gotten to our external growth potential.
Between the beginning of 2015 and the end of 2018, STORE delivered four consecutive years of double-digit rates of return with an AFFO multiple that changed little as of each year-end. That we could deliver this should not be much of a surprise given our business model fundamentals. What might interest you more is that, all else equal, our traded AFFO multiple contraction will result in elevated dividend yields, but no alteration of internal growth. External growth will be impacted, but the absolute overall predicted rate of return is similar. Raise the AFFO multiple we trade at and our dividend yield will decline, internal growth will be the same and our external growth contribution will rise. Again, absolute shareholder returns are similar. The most important mathematical contribution to this comparative return stability is a solid internal growth profile.
I can think of few sectors where there can be a promise of similar absolute rates of return through varying valuation climates.
1A number of analysts do not add back non-cash employee compensation costs when computing AFFO. For the purposes of this comparative corporate analysis, I do. While employee share grants and do present an economic cost to shareholders, the cash cost will be limited to the dividends paid on such shares, which is far less consequential. Moreover, to the extent cash dividends are paid on restricted shares, this amount will not be included in the non-cash compensation AFFO add-back.
2External Growth Rate reflects AFFO growth for existing shareholders as a result of new investments funded through new share issuances and is computed as follows:
(((NOI Run Rate x Operating Profit Margin – NOI Run Rate Acquisition Cap Rate x Leverage % x Borrowing Interest Rate + (NOI Run Rate x Operating Profit Margin – NOI Run Rate Acquisition Cap Rate x Leverage % x Borrowing Interest Rate) x Internal Growth from Tenant Rent Increases + (Acquisition Guidance – External Growth Acquisitions) x Acquisition Cap Rate x Operating Profit Margin -(Acquisition Guidance – External Growth Acquisitions) x Leverage % x Borrowing Interest Rate + (External Growth Acquisitions x Acquisition Cap Rate x Operating Profit Margin – External Growth Acquisitions x Leverage % x Borrowing Interest Rate)) x (1 – External Growth Share Dilution) – (NOI Run Rate x Operating Profit Margin – NOI Run Rate Acquisition Cap Rate x Leverage % x Borrowing Interest Rate) – ((Acquisition Guidance – External Growth Acquisitions) x Acquisition Cap Rate x Operating Profit Margin – (Acquisition Guidance – External Growth Acquisitions) x Leverage % x Borrowing Interest Rate)- ((NOI Run Rate x Operating Profit Margin – NOI Run Rate Acquisition Cap Rate x Leverage % x Borrowing Interest Rate) x Internal Growth from Tenant Rent Increases)) (NOI Run Rate x Operating Profit Margin – NOI Run Rate Acquisition Cap Rate x Leverage % x Borrowing Interest Rate))
Disclosure:I am/we are long STOR, NETL, EXCHANGE TRADED CONCEPTS.
Additional disclosure:I am the CEO of STORE Capital.