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Sending the global markets in a tizzy, the Fed recently announced its plans to gradually phase out the $85-billion-monthly-bond purchase program by 2014 for the revival of the economy. Although the announcement indicated an overall improvement in the U.S. financial system and slammed the need for any additional stimulus, it unruffled the dynamics of several industries, the primary among them being net-leased REITs (real estate investment trusts).
This came as a shocking news to some, as the continued adherence to zero-interest policy by the Fed had helped the U.S. housing market stage a recovery from the downturn by attracting new buyers and allowing existing house owners to refinance the mortgages at a low rate. The low interest rates might have also propelled some investors to consider REITs that offer comparatively high yields.
Will the Fed’s sudden decision to catapult the stimulus put a hole in the housing recovery? Or will this add to the debate put forth in our earlier observation, REITs Breakthrough: Real or Bubble? Let's follow the arguments.
A Niche Identity
Net-leased REITs own free-standing buildings that are typically leased on a long-term basis (usually 15 to 20 years) to credit-worthy tenants who generally have the wherewithal to withstand the volatility in the market. In addition to rents, these tenants pay a part of the property expenses that would otherwise be borne by the owners.
Healthcare REITs in particular leass their facilities under "triple-net" master lease agreements, in which the tenant pays all taxes, insurance and maintenance for the properties, in addition to rent. This insulates healthcare REITs like Ventas Inc. (VTR - Analyst Report) and HCP Inc. (HCP - Analyst Report) from short-term market swings that might adversely affect the operations of a particular facility, providing a steady revenue stream with dependable cash flows.
During our challenging macroeconomic period, net-leased property owners like McDonald's Corp. (MCD - Analyst Report), Wal-Mart Stores Inc. (WMT - Analyst Report) and Walgreen Co. (WAG - Analyst Report) are unlikely to terminate the lease agreements due to their sound balance sheets and focus on recession-proof items. Even if the leases were terminated under extraordinary situations, strategic infill locations and intrinsic value of a tangible asset would make it easier to re-lease these facilities. Consequently, net-leased REITs operated at the prime of the market, generating a healthy yield in the form of dividends.
The Shift in Balance
REITs are largely dependent on the capital markets for their inorganic and organic growth as the U.S. law requires them to distribute 90% of their annual taxable income in the form of dividends to shareholders. As interest rates kept extremely low, REITs have managed to raise capital to pay off debt, owing to a large inflow of funds as institutional investors allocated more ‘dry powder’ to the industry, making them an increasingly attractive investment proposition.
Importantly, during the downturn, REITs were able to acquire properties from highly-leveraged investors at deeply discounted prices. This also enabled them to add premium high-return assets to their portfolios and thereby provide attractive risk-adjusted returns to the investors.
With a healthy dividend yield in the range of 4.4% to 6.4%, these net-leased REITs experienced a spurt in stock prices from early 2012 to mid-May 2013. According to a Wall Street report, the stock prices of the five largest net-leased REITs surged by an astounding 57% - 103% during this period, compared to a 42.5% rise in the Dow Jones All-REIT Equity Index as calculated on a total return basis. However, as the market started receiving feelers about a possible change in interest rates, these stocks fell by 11% to 18.5%.
Most of the investors gained a high ROI by putting their money in net-leased REITs as they leveraged their low cost of capital due to minimal interest rates and returned significant cash to shareholders in the form of dividends or share repurchases. However, with fears of rising interest rates, investors tend to leave capital-sensitive net-leased REITs and park their money instead on other avenues that promise comparatively higher yields.
The Road Ahead
Is this the end of the road for net-leased REITs like National Retail Properties, Inc. (NNN - Snapshot Report) and Realty Income Corp. (O - Snapshot Report), or are they standing at the cross-roads? To find out, let us first take the example of National Retail, which has earned the unique reputation of being one of only four publicly traded REITs and 104 publicly traded companies in America to have increased dividends for 23 or more consecutive years. The average annual total return to shareholders has clocked an impressive 13.3% over the past 20 years.
On the other hand, Realty Income, which owns 3,500 properties across the U.S., has paid 516 consecutive common stock monthly dividends throughout its 44-year operating history and increased the dividend 72 times since its listing in 1994.
Realty Income has generated a 7.4% average annual dividend return since 1995 through year-end 2012, with a 142.1% dividend growth since 1994 as of May 30, 2013. The stock had a 4.8% yield based on $45.35 stock price and $2.175 annualized dividend per share as on March 31, 2013 vis-à-vis a 10-year Treasury yield of 1.87% on that date.
All these factors signify the inherent strength of net-leased REITs. Probably due to this, experts opine that the beleaguered stocks are down but not out yet. In addition, they still believe that REITs' shares are trading a premium to their net-asset values and they can issue new shares at favorable prices to buy properties and boost yields in the future. Only time will tell whether such investor confidence is justifiable or not.