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Almost all signs point to a recession in the United States coming probably sometime in 2023. And that's great news for net lease real estate investment trusts ("REITs").
Let me explain why.
First, I continue to believe a recession is coming, despite how long it's taking to arrive. It's impossible to predict exactly when it will begin, how severe it will be, or how capital markets will respond. But the fundamental economic factors that actually determine recessions continues to show a recessionary trend.
Consider the Conference Board's "Leading Economic Index" of forward-looking indicators like manufacturing, housing, and credit metrics as well as unemployment. This index has a solid track record of forecasting recessions when sinking below a certain level, and the index has indeed sunk meaningfully below that level.
The Conference Board
While the labor market continues to be tight, manufacturing output is in moderately negative territory and home sales have collapsed to near their lowest level in the last two decades as home-buying affordability is near its lowest level in recorded history.
VICI March Presentation Chartr
A significant share of the US economy is based on home sales, from homebuilders to banks to appliance makers, furniture manufacturers, and home improvement stores. As such, a sharp decline in the housing market signals a downturn in the broader economy to come.
And then, of course, there's the inverted yield curve, which has a long history of predicting oncoming recessions with accuracy.
VICI March Presentation
Both the 10-year / 2-year and the 10-year / 3-month Treasury yield spreads are more deeply negative today than at nearly any time since the early 1980s.
In fact, there's a case to be made based on the personal savings rate that the US economy may already be in recession.
For most recessions, the personal savings rate trends down for months prior to the recession, and then when the recession begins, the savings rate reverses course and trends upward as households shift from a spending mindset to a saving mindset.
That's what happened in the Great Recession of 2008-2009...
VICI March Presentation
...as well as the post-tech-bubble recession of the early 2000s...
VICI March Presentation
...as well as the two recessions in the high inflation years of the early 1980s:
VICI March Presentation
The same pattern appears to be playing out in 2022-2023:
VICI March Presentation
On the one hand, it is somewhat healthy to see the savings rate rebound, because it had sunk to a multi-decade low amid surging inflation in 2022. On the other hand, a higher savings rate necessarily means that Americans are shifting from spending (current consumption) to saving (future consumption).
Since around 2/3rds of US GDP derives from consumption, a larger share of paychecks going to savings rather than spending is another indication that GDP growth will fall and a recession is likely coming (or already here).
Why is this positive for net lease REITs? Because:
With that said, let's take a brief tour of my five favorite net lease REITs right now.
ADC is a retail-focused single-tenant net lease REIT that invests in the largest and strongest (mostly investment grade) retailers in the nation, including names like Walmart (WMT), Dollar General (DG), and Tractor Supply Company (TSCO). The portfolio is highly recession-resistant, as tenants almost uniformly provide essential goods and services that are needed in good economies and bad.
ADC March Presentation
So, the assets side of ADC is very strong. What about the liabilities side?
To complement its asset quality, ADC sports peer-leading balance sheet strength, headlined by its low debt to enterprise value of 23% and net debt to EBITDA of 4.4x. Moreover, given ADC's weighted average interest rate on debt of about 3.5%, it's comforting to know that the REIT has only a negligible amount of debt maturing until 2028.
ADC March Presentation
Despite ADC's undeniable quality and consistent growth, I can hear the commenters cracking their knuckles in preparation to type out a question like this: "Why would I buy a REIT yielding barely over 4% when I could buy a 6-month Treasury bond for over 5%?"
I'll tell you why.
The same logic holds for all other REITs. One should not buy a REIT for the yield alone. One needs to consider yield and growth. Between ADC's ~4% yield and ~6% growth rate, the REIT's total return potential of ~10% is roughly double that of the 6-month Treasury yield.
Those familiar with ARE might be surprised to see it listed among net lease REITs. After all, the REIT owns and develops life science properties, which are sometimes categorized in the "office" sector and other times categorized as "healthcare." But the truth is that "net lease" refers to a set of lease terms, not to a type of property.
ARE Q4 2022 Presentation
ARE's Class A research & development facilities are leased to the world's leading biotech and pharmaceutical companies on a triple-net basis. And these high-quality, specialized buildings are located in the nation's top research clusters like Boston, San Francisco, and the "Research Triangle" in North Carolina.
ARE Q4 2022 Presentation
I highlighted the asset and balance sheet quality of ARE in my recent article "Best Time In Years To Buy Quality REITs - Top Picks In 5 Sectors," so here I will instead highlight the inherent inflation protection of the portfolio.
Not only does ARE benefit from inflation in the way all real estate does by appreciating in value along with other prices, but ARE's assets are protected from inflation through:
Led by founder Joel Marcus, ARE is among the highest quality REITs out there and is now cheaper in terms of its AFFO multiple than it was at the depths of the COVID-19 selloff in early 2020.
While ADC heavily emphasizes goods-based retailers, EPRT is a net lease REIT that emphasizes service-oriented and experiential retail properties. The REIT's top four tenant industries are:
VICI March Presentation
After the take-private of STORE Capital last year, EPRT has taken up the mantle of the premier REIT specializing in sale-leaseback financing for private, middle-market companies. Since tenants have less negotiating power, these leases feature landlord-friendly lease terms like above-average cap rates, higher annual rent escalations, long initial terms of 15-20 years, master leases covering multiple properties, and unit-level financial reporting that allows the landlord to keep an eye on rent coverage levels.
These attractive lease terms, especially higher cash cap rates, more than offset the additional risk of populating the portfolio with private, non-investment grade tenants.
What's more, with a low net debt to EBITDA of 4.6x, no debt maturities in 2023, and over $200 million in liquidity recently raised through a forward equity deal at a 6.5% AFFO yield, EPRT still has plenty of dry powder with which to invest this year as other buyers pull back.
The king (or shall I say emperor) of Las Vegas still reigns supreme in REITdom. Last year was a transformative year for the casino landlord as it obtained an investment grade credit rating, completed ~$23 billion in acquisitions including the take-private of MGM Growth Properties, and joined the S&P 500.
VICI March Presentation
Today, 85% of VICI's rent derives from three tenants: Caesars Entertainment (CZR), MGM Resorts (MGM), and the Venetian, which is operated by Las Vegas Sands (LVS). Nearly half of rent comes from Las Vegas, while slightly over half comes from regional gaming hotspots around the country like Atlantic City and Lake Tahoe.
One striking aspect of VICI's leases is the incredibly inflation protection through CPI-based rent escalations that will progressively kick in over time. In 2023, about 50% of leases have CPI-based escalators, but that will rise to 85% by 2033 and 96% by 2035.
VICI March Presentation
Moreover, thanks to triple-net leases, VICI is able to operate with ultimate efficiency, as its general & administrative costs account for a mere ~2% of total revenue.
VICI's net debt to EBITDA of 5.7x may not be low, but it is by no means alarmingly high either. And fortunately, the REIT has zero debt maturities for the remainder of 2023, and only 6.8% of total debt matures in 2024. Not to mention the fact that 100% of debt is fixed-rate.
After a relatively low year of AFFO per share growth of 6% in 2022 (due to the massive equity and debt issuance in preparation for the MGM Growth Properties acquisition), VICI now expects growth of 9-10% in 2023.
WPC is a diversified, cross-continental net lease giant that has traditionally had a lot of moving parts. Last year, however, the REIT acquired its final managed real estate fund (CPA:18), simplifying the story for WPC by making it a pure-play landlord.
WPC's nearly 1,500 properties across the US and Europe are increasingly weighted toward industrial/warehouse property types. Slightly less than 1/3rd of WPC's 392-member tenant base is investment grade-rated, as the REIT targets sale-leasebacks with companies that have credit ratings just below investment grade status.
WPC February Presentation
And like VICI, WPC enjoys peer-leading inflation protection through CPI-based rent escalations making up 55% of rental revenue, with most of those being uncapped CPI rent bumps.
WPC February Presentation
What's more, with ample liquidity totaling over $2 billion, management attests that WPC goes into 2023 with a larger investment pipeline than at any time in recent history. Guidance for this year assumes total investment volume of $1.75 billion to $2.25 billion, a significant step up from the $1.4 billion closed in 2022.
WPC does have some refinancing to do with debt maturing both this year and next year, but with ample capacity on the credit revolver, the REIT can afford to be opportunistic about finding long-term financing.
With interest rates shooting higher, things look dire for net lease REITs as their stock prices fall. But the fundamentals of their real estate businesses have not eroded. Financing has become more expensive, and interest expenses will gradually rise as debt matures and needs to be refinanced. But that isn't the end of the world for well-capitalized REITs with strong assets and growing revenue streams.
A likely recession this year (bad news on its own) will probably benefit net lease REITs on net by dragging down inflation and interest rates, thereby allowing them to refinance maturing loans and raise new capital at attractive prices.
But even if interest rates remain high all year, net lease REITs will still be able to grow (albeit at a slower pace) through a combination of retained cash, property dispositions, and well-time equity issuance.
So, in short, the worst-case scenario for net lease REITs isn't that bad, and in the best-case scenario, their stock prices look an incredible bargain.
