Written by Sam Kovacs

An Unfortunate Plunge

As the year 2024 unveils its course, REITs have seemingly fallen out of favor after a triumphant rise in November and December.

Particularly, the realm of Triple Net Lease REITs has been hit hardest by this nosedive.

While the SPDR Select Real Estate Fund (XLRE) shows a 5% year-to-date descent, the larger triple net REITs have endured a greater plummet, with declines ranging from 8-14% in entities such as Realty Income, WP Carey, Agree Realty, and National Retail Properties.

One of our members asked:

Just seems all the Triple Nets have done the worst, Whether it be ADC, NNN, O. It’s interest rate related, but why the triple nets more than the others ?

And that is a brilliant question, and the basis of this article.

We’ll break down why it is that triple net lease REITs are falling more than the rest, why this spells opportunity, and highlight those which we believe are the top buys.

The Root Causes of the Plunge

Reason 1: Sensitivity to Higher Interest Rates

To start with, the first cause is associated with the sensitivity of these REITs to interest rate adjustments.

The 10-year U.S. Treasury yield has surged from 3.78% on December 27th to 4.18% today, showcasing a significant leap.

It is well known that REITs are negatively correlated to rates. Why?

1. Cost of capital: higher rates mean that the cost of debt that REITs pay goes up, which crunches profits as rents are usually not tied to interest rates.
2. Income yield comparisons: Investors often compare the yield from REITs to the yield of fixed-income securities. As interest rates rise, the yields on bonds increase, making them more attractive relative to REITs if the REITs do not increase their dividends at the same pace. Given that the yield on the 10Y has nearly doubled in the past two years, it is clear to everyone that dividends have not doubled for the vast majority of REITs.
3. Property Prices: As rates go up, the yield required (the cap rate) for property investors on buildings goes up to justify the higher cost of capital. Given that rents don’t increase in lockstep, property values go down.

This should be clear to everyone. But it applies to all REITs right? So why does it apply more to triple net REITs than others?

The “three nets” in a triple net lease refer to the three types of costs associated with property ownership and operation that the tenant agrees to pay, in addition to their base rent. These are:

1. Property Taxes: The tenant is responsible for paying the property taxes for the leased space. This ensures that the landlord is not liable for the tax obligations associated with the property.

2. Building Insurance: The tenant must also pay for the insurance on the leased property. This coverage typically includes property damage and liability insurance, protecting the tenant and landlord against various risks and damages.

3. Maintenance Costs: Maintenance and repair costs for the property’s common areas and the structural components are also the tenant’s responsibility. This includes routine upkeep and major repairs, ensuring the property remains in good condition throughout the lease term.

It is therefore a given that if you take out these costs, then the place that interest rates take in the cost structure is higher for a triple net like Realty Income than it is for Simon Property Group.

You can see this by comparing the ratio of the cost of interest to all these costs.

1x to 2x for Realty income vs 1.0x to 1.3x for SPG.

SPG is the prime example as it does not operate any form of net-leases. The financial statements extract above clearly shows items that you’ll never see on Realty Income’s income statement: tax expenses, maintenance, direct costs of the real estate.

Because of this, if rates go up, there’s more downside for Realty Income.

If rates go down, there’s more upside for Realty Income.

Of course since stock prices reflect future expectation, the mere expectation of rates going down later, or less, can be enough to send prices down if they had previously increased in anticipation of these declines.

This is Keynes “second level thinking”. In the stock market, first-level thinking is buying a stock because you think the company is good. Second-level thinking is buying a stock because you think other investors will realize it’s good and start buying it too, making its price go up.

Keynes suggested that successful investing requires this second-level thinking. You have to think about what others believe and how they’ll act, not just what you believe. It’s like playing chess and thinking several moves ahead, considering not just what you want to do but also what your opponent might do in response.

So this is the first reason explaining why

Reason 2: Longer Lease Terms Weight Heavily

A secondary factor contributing to the downfall of triple nets is the extensive durations of their leases.

This implies that fixed rents (or rents with set escalators) are negotiated for a long period of time.