Earning Excess Returns in Real Estate

One such opportunity arises from the dual nature of the real estate market. Real estate is actively bought and sold in two parallel markets--the private market (for trading individual properties directly) and the public market for REIT shares. When private markets value properties more highly than the public markets, REITs can earn excess returns simply by selling properties to private investors. Alternately, when public real estate is priced too high--through lofty REIT share prices--REITs can add value to shareholders by issuing shares to the public and using the proceeds to snap up private properties. Few individual investors, though, can play this game. Besides, the dueling markets typically adjust to new price information in just a year or two, erasing any arbitrage opportunities. A more intriguing and persistent mispricing, though, arises when the real estate market intersects with corporate debt through the commercial net lease property market.

What Is a Commercial Net Lease?
A lease is a contract between a property owner (the landlord) and a user (the tenant). Leases generally come in three flavors: gross, hybrid, and net. A gross lease requires the landlord to pay all property operating expenses, which include utilities, maintenance, property taxes, and insurance. In a hybrid lease, the landlord typically pays fixed expenses, such as property taxes and insurance, while the tenant picks up the tab for variable expenses such as utilities. Finally, the net lease makes the tenant responsible for not just the rent, but also all or almost all operating expenses. The strong version of the net lease, the triple net lease, in effect gives full control of the property to the tenant, making the landlord a mere coupon clipper. The most sought-after triple net leases will typically have a single tenant (such as a freestanding drugstore or auto-parts retailer) with investment-grade credit ratings on a long-term lease. The lure of hassle-free property ownership is not the only attraction for investors, though. Many are also taking advantage of a gift from Uncle Sam: the IRS 1031 tax code.  

Net Leases and Taxes
1031 may not rhyme with anything, but it is music to the ears of some property owners. In a 1031 exchange, a property owner can swap one property for another (of a “like kind”), and defer capital gains on the transaction until the property is eventually sold. Landlords can switch from long-held, management-intensive buildings to hassle-free, single-tenant properties without paying taxes on realized gains. Corporations are using this favorable tax code to monetize, or cash out, of their real estate while maintaining full control of the property through a net lease/sale-leaseback transaction. In such a transaction, a company sells its real estate to an investor (such as a REIT specializing in net lease properties), then immediately signs a long-term lease with the new landlord on a triple net lease basis. The company gets cash that it could use to expand or pay down debt, and the investor gets a predictable cash flow stream. And, corporations are willing to pay a premium over their corporate borrowing rate for this privilege, giving rise to an arbitrage opportunity that has been exploited by commercial net lease property investors. 

The Economics of Commercial Net Leases
In commercial net leases, the investment yields (the return an investor expects from renting out the property) are primarily based on the credit of the tenant. Other factors such as location and rental trends in the tenant’s markets are important, but relatively minor. Yet, investment yields have historically been higher than yields on comparatively rated unsecured corporate bonds. In a typical transaction, a company with a BBB credit rating may enter into a net lease/sale-leaseback transaction that yields 8% to the investor. But, the same company would pay about 5.75% in interest for unsecured corporate debt based on its BBB rating.

For many companies, the ability to monetize their real estate assets is worth the price. A cash-strapped retailer that owns its own stores may use a net lease/sale-leaseback to cash out, reinvesting the proceeds in its core, and generally higher-return, retail business. Additionally, such transactions receive favorable accounting treatment: A net lease/sale-leaseback effectively treats a big portion of a company’s assets--its real estate--as an off-balance-sheet item. Almost magically, a company can show higher returns on its invested capital.

The Case for Investing in Net Lease Property REITs
Investors can take advantage of the numerous 1031 exchanges to swap a high-maintenance property for a hassle-free, single-tenant net leased property. However, this would still leave the landlord vulnerable to the fortunes of the single tenant; a bankruptcy could negatively affect the investor's cash flow. A better option is to swap a property for shares in a public REIT, such as  Realty Income ,  Getty Realty Trust, , or  iStar Financial, , that specialize in triple net leased properties. Through yet another goody from Uncle Sam, the 1031-721 tax code, property owners can swap into a replacement property and exchange it for units in a partnership controlled by the REIT; these units enjoy the same dividend as the common shares and can later be converted into and traded just like shares.

Net leased property REITs are a cross between a real estate and finance company; they effectively provide funds to corporations using their real estate as collateral. Such REITs are typically specialists in both real estate and corporate credit analysis. Publicly quoted commercial net lease REITs typically own geographically diversified properties leased to multiple tenants, reducing the impact of any single tenant on the company’s cash flows. For example, a share of Realty Income yields 6% and is a claim on the rental stream of more than 1,500 properties in 48 states and 30 different retail sectors.

A high dividend is not the only attraction for investing in net lease REITs, however. The REIT can also generate capital gains by issuing additional shares at a premium over its book value. For instance, in fiscal 2004, Realty income earned about $1.20 per share on its nearly $10 book value per share; this yields an average return on equity of almost 12%.  However, the company’s shares currently trade at more than 2 times book value--the average price/book value in the past five years has been about 2 times. Realty Income could double its equity by issuing new shares at this higher price, boosting both book value and earnings per share by more than one third. Not surprisingly, Realty Income shareholders have enjoyed 4% capital gains annually--in addition to 3% dividend per share growth--in the past five years, despite the fact that the company pays out all its earnings as dividends.

Earn Excess Returns
By enabling a corporation monetize its real estate, commercial net leased REITs exploit a unique, and so far persistent, arbitrage opportunity. Companies are happy to pay up for the privilege of cash and favorable accounting. Investors can earn 5.75% on a BBB-rated company’s unsecured debt. Or a 6% dividend yield, growing at 3% annually, with a 4% capital gains sweetener from a REIT that owns a collection of properties leased to BBB-rated tenants on long-term, triple net leases. And all this, at comparatively similar risk to the investor.