Table of Contents
Co-produced with CashFlow Capitalist for High Yield Landlord
I’ve seen the process play out multiple times.
A net leased commercial real estate property is offered for sale at a cap rate of 6%. Years earlier, the seller had acquired it for a 7% cap rate. A potential buyer, knowing that he (or she) can borrow money at 4.5%, wants at least a two-point spread between cost of debt and the cap rate. So the potential buyer offers a sum that equates to a 6.5% cap rate for the property. The seller refuses to go down on the price by that much. The deal falls through.
And then the Federal Reserve lowers their ultra-short-term Fed Funds rate. Banks’ cost of deposits falls, so they are able to (and competition forces them to) offer a lower interest rate to the potential CRE buyer. The buyer goes back to the seller and says, “I’ll pay a 6% cap rate for the property now.” So now the market value of the property (with its specific lease characteristics) is a 6% cap rate rather than the 7% cap rate that it was when the seller originally bought it.
This happened just recently at the family office I work for. Last year, we made an offer for a grocery store property in a small town listed at a 6.75% cap rate. The offer was for 7.25%. We could borrow money (via mortgage) for 4.75%, and due to the somewhat elevated risk of owning real estate in a very small market, we wanted at least a two-and-a-half-point spread between cost of debt and the cap rate. The seller didn’t entertain the offer. But this year, the property was put back on the market for the same cap rate. Now we can borrow money for 3.5%-3.75%, so we offered a 7% cap rate. The seller is entertaining it.
A 2.25-point spread from last year’s interest rate environment has turned into a 3+ spread today. A fall in interest rates suddenly made the property tens if not hundreds of thousands of dollars more valuable, and it widened the crucial profitability spread for net lease landlords.
Net leased real estate properties are often compared to long-term corporate bonds. Since net leases stipulate that the landlord has little to no property-level obligations (such as building maintenance, taxes, or insurance), this comparison is an apt one. At least it’s during bull markets / economic expansions. As Ryan Lorey of the CCIM Institute put it in June 2017, “research shows triple-net transactions have traded in a fairly tight range of 350 to 540 basis points above the 10-year Treasury during the last several years.”
What’s more, like corporate bonds, net leased commercial real estate (“CRE”) properties are bid up when interest rates drop because their long contractual rent (most or all of which translates into net operating income) streams become more valuable.
But these leases are even better than corporate bonds. Why? Because:
- The property is a hard asset with intrinsic value,
- leases frequently include regular rent escalations (sometimes inflation-linked),
- cap rates are typically higher than the corporate tenants’ bond yields, and
- leverage can be added to the property to juice higher returns.
Thus, all else being equal, when interest rates fall, net leased properties gradually appreciate in value as buyers bid up prices (and cap rates down), and buyers get to enjoy a period (typically a few years) of a wider spread between cost of debt and cap rates.
And this phenomenon isn’t exclusive to private real estate companies. A very similar process happens with net lease REITs.
In what follows, I explain why the biggest threat to net leased CRE (and net lease REITs), like long duration bonds, is a sustained uptrend in inflation. I also explain why meaningful and sustained inflation is unlikely — and what would cause it. Lastly, I sketch out the macroeconomic recipe for lower interest rates.
In short, though various market prognosticators regularly predict a new bout of inflation — and, in turn, higher interest rates — just around the corner, the macroeconomic environment points to the opposite. That’s a very bullish setup for net lease REITs.
Inflation and Deflation
The most common definition of inflation is basically what happens when the prices of the same set of various goods and services across the economy rise over time and thus the currency used as a medium of exchange for those goods and services correspondingly drops in value. Deflation is just the flip side of inflation: Prices of goods and services falling and rendering currency more valuable.
Inflation, here, is typically caused by bottlenecks in which supply cannot keep up with demand, or by simple scarcity of resources. Growing economies, it’s widely thought, generally result in some measure of inflation. Meanwhile, deflation can be caused by either increased efficiency in the delivery of those goods and services (allowing sellers to lower their prices in order to capture greater market share) or by a drop in demand (due, for instance, to a recession) that forces sellers to lower prices in order to generate sales.
One might think that with all of the debt-funded fiscal relief measures that the federal government has engaged in this year, the supply of money in circulation in the economy will spike, leading to inflation. But as I explained in “Why Massive Federal Spending Probably Won’t Lead To Inflation,” demand destruction has actually outpaced the growth in the money supply. Through mid May, U.S. personal income lost due to COVID-19 came to $1.3 trillion, by one estimate, compared to $1.21 trillion that had been disbursed or committed via fiscal relief packages. As high unemployment persists, the amount of lost personal income due to the pandemic will continue to mount, which means that fiscal stimulus is only filling that hole rather than adding new (i.e. incremental) consumer demand.
And it isn’t even filling it completely. Much of the stimulus money is being saved. Some is going into the stock market. A lot is being used to pay off debt, which is basically paying for previous spending.
What’s more, the mechanism by which this newly-created money enters the economy prevents most of it from getting into the pockets of average consumers. That’s because the process of quantitative easing (“QE”) simply swaps certain assets like Treasuries and mortgage-backed securities on bank balance sheets for cash, which can be used to shore up reserves and loan loss provisions. And by reducing the amount of safe-yielding assets on the market, the Fed makes more valuable higher risk and higher yielding assets, thus ensuring that most of the QE money remains in the financial system rather than going into the consumer economy.
Why exactly is inflation a threat to net leased CRE? For the same reason that net leased properties are often considered “bond proxies.” The aforementioned long contractual lease terms stipulate fixed rental revenue for the landlord. If inflation rises faster than any contractual rent escalations in the lease, then the value of that net lease income stream gradually falls over time.
The same holds true for long-duration bonds, and it’s why longer dated bonds fall in price (and rise in yield) when the threat of inflation rises.
But, unless some massive new federal spending relief program or a universal basic income is introduced, a spike or uptrend in inflation is not likely for the foreseeable future. That’s one reason why the Fed feels comfortable projecting near-zero interest rates out to at least 2022.
The Macro Recipe For Lower Rates: Debt, Demographics, and Technology
There are at least three major economic forces pushing the value of dollars up rather than down, even as the supply of those dollars in circulation is rising at a rapid clip. In other words, these three forces are deflationary rather than inflationary.
The three forces are:
- Large debt burdens,
- aging demographics, and
- price-lowering technologies and business models.
Let’s start with the large debt burdens. It’s often assumed that a high amount of government debt issuance is inflationary because new dollars are being pushed into the economy faster than the supply of new goods and services. But that isn’t necessarily the case. In fact, in advanced countries with aging demographics and already large debt burdens, continuing to pile on more and more debt tends to be deflationary because it forces ever larger portions of future revenue streams to be diverted to debt service rather than spending or productive activity.
That is, more debt in an already overindebted society slows the velocity of money (the rate of turnover of a given unit of currency over a given period of time). That’s especially true if the objects of debt-funded spending are unproductive — e.g. government transfer payments, consumer debt, or stock buybacks. While these add dollars into the economy in the short run, they hinder economic growth in the long run because they do not invest in anything productive. “Productive” here refers to anything that produces a revenue stream capable of repaying the principal and interest on the debt.
That’s another reason why the massive fiscal relief spending during the coronavirus pandemic will likely not produce sustained inflation. As explained in a recent article by Eric Basmajian:
If government transfer payments stop, total income growth will decline sharply, leading to a drop in consumption, overall economic growth, and, thus, lower interest rates.
If we continue to increase debt and use the proceeds unproductively, we will decrease the marginal revenue product of debt, weaken the long-run trend rate of growth in the economy and again drag interest rates down toward the zero-bound, albeit on a slower path than the first scenario.
A moderate amount of debt can be sustained without much hindrance to the economy, especially since low to moderate debt tends to correlate with productive spending. But the higher the debt load, the greater the drag on economic growth and the ability for market actors to raise prices. This is why we’ve seen ever lower GDP growth as debt burdens have grown larger and larger in every advanced economy in the world.
Source: Hoisington Investment Management Company
Here’s Eric Basmajian again:
Together, a cumulative debt to GDP ratio that exceeds 250%-275% of GDP is virtually guaranteed to have negative impacts on economic growth, shifting debt clearly from helpful to harmful.
In the United States, total debt to GDP crossed the 275% threshold right around the year 2000.
Source: Hoisington Investment Management Company
It hovered around 360% just prior to COVID-19 and has spiked up even higher since then. Since 2000, when this rough threshold of total debt was crossed, “core GDP” (real personal consumption plus private domestic investment) gapped significantly lower. From 1960 to 2000, annual core GDP growth averaged 3.9%. From 2000 through the end of 2019, it dropped to 1.9% per year.
It’s incredibly difficult for inflation to take off in a circumstance like this.
What about the demographics point? This factor is widely discussed and well known, so I’ll just briefly quote a previous article of mine:
For cultural and economic reasons, along with advances in contraceptive technology, the birth rate has declined significantly in advanced economies. Moreover, the large Baby Boomer generation is either in or approaching retirement, and the United States is currently governed at the federal level by an immigration restrictionist administration that seeks to curtail immigration. Even setting anti-immigration policies aside, immigration into the US has slowed in the last few decades.
These three factors (declining birth rate, aging population, and slowing immigration) are the formula for very low population growth. Lower population growth naturally results in less consumer spending than higher population growth. Less spending > less demand > less inflation.
I’ll also mention that, according to BLS data, consumer spending tends to peak between age 45 and 54 and taper off thereafter. More money is spent on healthcare for the above-54 population, but less money is spent on everything else. In an aging country, this is deflationary.
Lastly, we have the preponderance of price-lowering technology and business models. Technology and the various forms of artificial intelligence that already are in use have been systematically lowering prices (and labor hours/wages) across virtually all sectors and industries for decades. This is partially due to the outsourcing of manufacturing to lower-wage countries, but it’s also due in large part to the advancement of automation. Modern factories just need fewer workers than they used to.
What’s more, business models that allow consumers to price compare across numerous sellers, such as Amazon‘s (AMZN) marketplace, naturally lead to lower prices as it is the only way for many sellers to compete. This is especially true when Amazon offers its own low-cost versions of products.
Many grocery stores such as Walmart (WMT) and Kroger (KR) are doing practically the same thing as Amazon by offering their own private label products alongside others on their shelves. Like Amazon, this business model makes stores both the marketplace and the seller. Third-party brands and sellers find it more difficult to raise prices — sometimes even to maintain prices — with such fierce competition.
Again, this is deflationary.
The main segments of the economy that are seeing rising prices (inflation) are those with:
- some sort of artificial restriction of supply or competition,
- high or at least steady demand, and
- a lack of replacement products or services.
Examples include housing in some markets with strict regulations and entrenched NIMBYism (“not in my backyard”), healthcare that’s dominated by price-insensitive insurers and government programs, and higher education with its unrestricted supply of favorable government loans. Aside from these (and perhaps a few other) special cases, the predominant tilt of the economy continues to be toward disinflation or deflation.
Enter Net Lease REITs
Traditionally, the best long-term investment for such an environment has been long duration Treasuries. Since the middle of 2007, for instance, the Vanguard Extended Duration Treasury ETF (EDV) that owns 20-30 year T-bonds has actually outperformed the S&P 500 (SPY) — even after stocks phenomenal bull run in the 2010s.
But there’s some reason to doubt that long-term Treasuries will be able to continue the same stellar performance over the next 13 years. They may continue to act as a good hedge against stock market volatility over short periods, but I doubt they will continue to outperform over the long term. There’s simply less room for rates to fall today than there was in 2007.
What about long-term corporate bonds? Over the past 10 years, long-term corporates have performed very similarly to long-term Treasuries, which means that yields have compressed significantly:
The problem with corporate bonds is the risk being assumed, perhaps without even knowing it. In order to capture that 3.5% yield, one must buy a fund that’s roughly half BBB bonds — the lowest rung on the credit rating ladder above junk. If there’s a moderately high amount of downgrades, then those funds may need to sell the bonds at a loss, which also would leave the fund with a greater percentage of lower-yielding bonds.
From my perspective, more attractive risk-adjusted returns can be found in the bond proxy of net leased real estate.
Personally, one of my largest holdings is Realty Income (O), the gold standard of net lease REITs that has raised its dividend for 36 years straight and generated over 15% annual returns since its IPO. The only problem with Realty Income today is that everyone seems to know about it. It’s one of the most popular REITs out there, trading at over 19x FFO and a 4.4% dividend yield.
source
In contrast, look at Spirit Realty Capital (SRC), a REIT with a checkered past but that spun off and sold its lower quality assets specifically in order to become a smaller, cheaper Realty Income. The two REITs share many of the same top tenants and have similar balance sheet metrics, but SRC currently trades at 11.7x FFO and offers a dividend yield nearly 7%. While there may be more risk with SRC than O, there certainly isn’t that much more risk.
Today, there exists exceptional opportunities among smaller and lesser-known net lease REITs because the fact that interest rates went to 0% has not yet been filtered into their valuations due to the short-term chaos. SRC could double in the recovery and still offer a high yield spread relative to treasuries.
I’m betting heavily on this recovery as I currently hold sizable positions in six different net lease REITs that represent nearly 25% of my entire Portfolio.
Closing Note
To sum it all up, I believe that net lease REITs are set up for another extremely bullish environment in the low-rates, low-inflation years ahead. The recent drop in interest rates will be a boon to these companies once the economy normalizes and rent collections return to near-100%. I’m buying more shares on every slight dip and share all those investments with members of High Yield Landlord in real time.
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Disclosure: I am/we are long O; SRC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.