Here’s why net lease real estate could be a smart addition to your portfolio.
Net-lease real estate investment trust Store Capital (NYSE:STOR) recently announced that Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B), the conglomerate led by Warren Buffett, had made a substantial investment in its common stock. Here’s what you need to know about net-lease real estate, why Berkshire may have decided to invest in it, and some companies you can check out if you want to add net-lease real estate to your portfolio.
What is net-lease real estate, and why can it be an attractive investment?
Net-lease real estate is a category of real estate that typically includes freestanding, single-tenant properties. Retail and service businesses are common net-lease tenants, as are certain office, healthcare, and industrial properties, to name a few.
A “net lease” means the property’s tenant is responsible for some of the expenses associated with owning the property, typically taxes, insurance, and maintenance. Net-lease tenants are usually on long-term leases with annual rent “escalators.” This type of lease is attractive from an investor’s perspective because it minimizes tenant turnover, eliminates some of the variable costs of real estate ownership, and produces a steadily growing stream of income.
According to Store Capital, the market for single-tenant operational real estate (which is what the company’s name stands for, by the way) exceeds $2.6 trillion in market value.
Why did Berkshire choose to invest in Store Capital now?
To be clear, we don’t know exactly why Berkshire decided to invest in Store Capital, aside from a statement from Store Capital’s management saying that Berkshire had been following the company closely since 2014. This leads me to believe that Berkshire was looking for a buying opportunity, and with the weakness in the retail sector, it may have gotten one.
It’s no secret that many retailers are struggling. 2017 is shaping up to be the worst year for retail in recent history, with several high-profile bankruptcies and store-closing announcements. Department stores and brick-and-mortar apparel retailers have been hit particularly hard.
Most retailers that occupy net-lease buildings, especially those owned by Store Capital, have not been affected. However, that hasn’t stopped their stock prices from taking a beating. In Store Capital’s case, the combination of expected higher interest rates, a disappointing first-quarter earnings report, and general retail weakness has produced quite a price drop over the past year. Even after the “Buffett rally,” the stock is still down 18% since this time in 2016.
Store Capital and other top net-lease REITs to consider
Store Capital certainly has a lot going for it that could have been attractive to Berkshire, and that could make the company a smart investment for you. For example, a unique quality of Store Capital’s business model is that the company requires virtually all of its tenants to submit property-level financial statements. Also, more than two-thirds of the company’s portfolio is occupied by serviced-based businesses, which are naturally immune to e-commerce.
In addition to Store Capital, there are several other net-lease REITs that are trading at attractive prices thanks to the weakness in retail. My preferred ways of investing in net-lease retail and service-based real estate are Realty Income (NYSE:O) and National Retail Properties (NYSE:NNN), two excellent examples worth a look. These two leading net-lease REITs have dropped by 22% and 26%, respectively, from their 52-week highs.
Realty Income is the largest retail-focused net-lease REIT and, in full disclosure, is one of the largest holdings in my own portfolio. The company owns nearly 5,000 properties, about 80% of which are net-lease retail, with office and industrial properties making up the rest. While service-oriented retail does make up a significant portion of the portfolio, Realty Income also focuses heavily on non-discretionary businesses (think drug stores and gas stations), as well as discount-oriented retailers (such as dollar stores and warehouse clubs). The idea is that these businesses are not only e-commerce-resistant, but are recession-resistant as well.
National Retail Properties has roughly half as many properties as Realty Income and focuses on the same three property types (service-based, non-discretionary, and discount retail). The biggest difference between the two, other than size, is that National Retail Properties focuses exclusively on net-lease retail properties. I mentioned that Realty Income has substantial office and industrial holdings, and Store Capital has a fair amount of manufacturing-based tenants. The fact that National Retail is more of a pure-play on retail real estate could explain why its stock price has been more beaten-down than Realty Income’s.
Both companies have impressive histories of dividend growth and market-beating returns. Realty Income pays monthly dividends and has grown its payout at an average rate of 4.7% per year. National Retail Properties has been listed on the NYSE slightly longer, and its 27-year streak of dividend increases has earned it a spot in the S&P 500 Dividend Aristocrats index. Both stocks pay dividends of about 4.5% as of this writing and have handily beat the market over the past couple of decades.
The bottom line
The retail sector is definitely having its problems, but it’s a mistake to group all brick-and-mortar retail businesses into the same category. Many department stores and apparel retailers are struggling, but many service-based, discount-oriented, and non-discretionary forms of retail are not just doing fine, but are thriving.
Still, since the market seems to be punishing all companies involved with the retail sector, there may be some excellent opportunities for long-term investors to get into some of these net-lease REITs at a discount.
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