ValueWalk’s Q&A session with Chris Burbach, Co-Founder and Partner at Fundamental Income, the Sponsor/Index Provider to the NETLease Corporate Real Estate ETF (NYSE:NETL). In this interview Chris discusses his background, defines net lease REITs and how they differ from other real estate properties, multiple sources of cash flow growth with NETL, the impact of Fed policy on NETL, how economic opportunity zones work, nationwide trends relating to real estate, and looking beyond the superficial qualities of an investment.
Can you tell us about your background?
Prior to starting Fundamental Income with my partner, I was an executive with two Net Lease REITs, Spirit Realty (NYSE: SRC) and STORE Capital (NYSE: STOR). At STORE, I led the underwriting of $12 billion in net lease investments including $7.5 billion in closed transactions. I also served as Chairman of the Investment Committee and jointly led the capital markets activities of the company. I played a similar role at Spirit prior to joining STORE.
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Can you explain what net lease REITs are?
Net Lease REITs are real estate firms that invest in primarily free-standing commercial properties leased to operating companies on long term leases, often ranging between 10 and 20 years. Net Lease is a moniker commonly used in real estate to refer to real estate leased to one company, or a single tenant, using a type of legal document called a “net lease”, the most common of which is a “triple-net lease”. The name also alludes to what makes investing in the sector so compelling. A net lease is a type of lease agreement made between the property owner and the tenant wherein the tenant is responsible for paying both the rent and typically all the property expenses (taxes, insurance and maintenance) one may incur under traditional ownership. As a result, investors have a high level of certainty as to what cash flow they may expect from their investment.
How do net lease REITs differ from other real estate properties?
The primary difference between the Net Lease real estate sector and other real estate sectors is that REITs in the Net Lease sector are defined by the type of business model used as opposed to a property type such as industrial, office, or retail. Properties leased to single tenants responsible for paying the rent and the property expenses results in high margins and consistent cash flow. Net leases tend to have long initial lease terms of 10-20 years with the weighted average remaining term across the sector of 11.5 years. Traditional types of commercial real estate are multi-tenant properties such as office buildings, shopping malls, hotels or apartments that require much more for investors to consider, such as shorter lease terms, unknown future expenses, frictional costs of marketing and leasing space, and managing and maintaining the property.
The result is lower margins and less certain future returns. Net Lease REITs in our index have gross profit margins of roughly 90% and normalized EBITDA margins of roughly 80%, which on a relative basis, is nearly 30% higher than any other REIT sector in the industry. Net Lease REITs are property type agnostic and work closely with corporations to provide a more efficient cost of capital, replacing debt and equity otherwise used by the company to finance the property.
Can you explain the concept behind the NETLease Corporate Real Estate ETF and its index?
NETL aims to focus on the results and avoid all the behavioral biases that exist with investors historically being enamored with the most popular property types or the biggest cities. Nearly all real estate ETFs are broad-based and market cap weighted. REIT mutual funds tend to follow a similar approach slightly overweighting certain sectors or companies just enough to justify their higher fees, but the results net of fees haven’t been materially different for investors. This market cap weighted approach has led to overconcentration in segments of the market that happen to be the largest.
Unfortunately for investors, bigger doesn’t necessarily mean better when it comes to REITs and the largest companies and sectors trade at significantly higher equity multiples and lower dividend yields without projected cash flow growth to adequately compensate investors for these higher multiples. Net Lease REITs, which represent approximately 11% of the market, have largely been left behind as of result of funds flows into traditional market cap weighted products despite historically outperforming the broader market. Investors looking for more exposure to the sector were left to pick individual stocks which presents its own challenges.
We decided to create the Fundamental Income Net Lease Real Estate Index (NETLXT) with NASDAQ to define and track the performance of the publicly traded Net Lease real estate sector. We wanted to be different, so we created a modified market cap weighting, with concentration constraints that aim to protect investors from idiosyncratic missteps. The top 5 holdings are capped at 8%, and the remainder capped at 4%.
In addition, on a quarterly basis, individual REIT holdings are tested for rent/revenue concentrations—if any REIT is over 50% concentrated to one company/tenant, then that REIT is capped at a 3.5% weighting individually and those REITs are capped at 12.5% cumulatively. As a result, over 87.5% of the index, or more, is focused on more diversified REITs. The investment thesis aims to provide a strategic tilt to value over growth, small over large holdings, while rebalancing quarterly on a rules-based, passive basis that caps tenants/holding concentration.
After solidifying the index, we partnered with Exchange Traded Concepts to launch the NETLease Corporate Real Estate ETF (NYSE Arca: NETL) to give investors direct, diversified access to a value-oriented segment of the market that still trades at an equity multiple more than three times lower than the broader REIT market despite offering a higher dividend yield and similar equity cash flow growth. In addition to offering an innovative way to play real estate, we are also offering investors broad based exposure to American business, focused on long term contractual cash flows and corporate credit that alternatively could only be access in thinly priced corporate bonds.
Is NETL a play on USA real estate or is it more than that?
NETL is much more than that - there are more than 23,000 properties owned by the 23 companies in the portfolio; it is an asset and contractual cash flow backed play on the US economy similar to investing in corporate credit fixed income products but unlike fixed income, Net Lease REITs offer multiple sources of cash flow growth. In addition, in traditional corporate credit, investors are primarily secured by cash flow of a company, whereas in Net Lease, investors already own an asset, so even if a corporation defaults, investors have a direct avenue to attempt to recover their principal. Net Lease REITs are paid rent by operating businesses that have signed long-term contracts to use the real estate they use to generate revenue and profits or produce and distribute their product to the end customer.
These lease agreements generally require rent to increase during the term of the lease, so unlike a loan to a company where the best you can hope for is collecting the interest and getting paid back, the cash flow is growing. Net Lease REITs also can grow cash flow for its’ shareholders through acquisitions using recurring cash flow not paid out in dividends and raising capital to make accretive investments.
The tenants behind these leases operate across a variety of industries. Net Lease is the warehouse that processes your online orders, the gym where you work out, the drug store where you pick up your prescriptions and receive flu shots, your favorite movie theater or late-night restaurant to name a few. When you invest in NETL, you are investing in the backbone of American business.
Is any industry more impacted by rates than real estate? How much does Fed policy impact NETL?
Banks and finance companies are fundamentally more impacted by interest rates considering changes in interest rates directly impact the value of their portfolio, the interest they can charge on new loans and for non-bank lenders their cost of capital. As income-oriented investments, real estate often gets grouped into the same bucket and trades in the opposite direction of interest rates. But unlike these industries, real estate offers an inflation hedge through rent growth and in some cases other ways to grow cash flow so it is more insulated from interest rate movements.
NETL is no more impacted by changes in interest rates than any other type of equity. Historically, the trading levels of Net Lease REITs have been more impacted by expected changes in long-term rates, namely the 10-year US Treasury, than by Fed policy. Because Net Lease REITs have longer lease terms and trade at a higher dividend yield than the rest of the REIT market, investors often make the mistake of thinking they are more interest rate sensitive and overlook the growth these companies offer as well. The reality is that these REITs have equity cash flow locked in with average debt terms of 6 years and can offset some of the negative impact from rising rates with new investments at higher yields.
In addition, investors are still investing in the equity of a public company that is professionally managed by experienced executives that are actively looking to minimize their firms’ exposure to rates and macroeconomic headwinds. You are not investing in one group of fixed rate leases and then simply buying and holding, you are investing in the equity of a dynamic group of companies who are endlessly looking to grow, diversify and create value.
Are you involved with economic opportunity zones (EOZs)?
No. Net lease investments generally don’t qualify under the IRS guidelines due to the passive nature of net lease investments.
Can you explain how EOZs work?
The Opportunity Zone program was passed as part of the Tax Cuts and Jobs Act of 2017 to encourage economic development and job creation in distressed communities and incentivizes investors to invest capital gains from the sale of assets into Qualified Opportunity Funds (QOF). These funds then invest in government-designated Opportunity Zones. QOFs can invest in an Opportunity Zone business as long as at least 50% of gross income is derived from that business’ activities in the Opportunity Zone which effectively means that new development or major renovation of existing buildings would qualify but not existing properties.
Investors receive the following tax benefits: 1) they defer tax liability from capital gains until Dec. 31, 2026; 2) they receive up to a 15 percent step-up in basis equal to the deferred gain which is effectively a 15 percent discount off of the original tax liability; and 3) they don’t have to pay taxes on any gains in the QOF if they hold that investment for at least 10 years.
Why are EOZs gaining popularity and what should those investing there know?
Deferring a tax liability for a number of years has obvious benefits along with potentially tax-free appreciation on the new investment. Numerous real estate investment firms have jumped on the opportunity (no pun intended) and are raising capital in QOFs to invest in QOZs often before the assets they will ultimately invest in have been identified. Regardless of the obvious marginal tax benefits, investors should look closely at the merits of a QOF investment on a stand-alone basis in terms of yield, expected returns and fees charged by the management company. Any tax benefit can be more than offset by a fundamentally bad investment.
Are EOZs having any impact on real estate prices?
The biggest winners from the passage of the Opportunity Zone program have been original property owners in designated Opportunity Zones that QOFs will buy the properties from to develop or redevelop. The value of land and properties that can be redeveloped located in designated Opportunity Zones have increased as the many QOFs compete for properties to invest in which is ultimately at the expense of the value a QOF investor should expect to realize.
Are you identifying any nationwide trends relating to real estate?
The seismic shift in the retail landscape driven by the emergence of e-commerce has been well documented. Traditional retail real estate is going through an expensive reinvention process. Likewise, the distribution infrastructure required to support this shift has led to massive growth in the development of industrial properties for the likes of Amazon, FedEx and retailers building out their own distribution networks. What has been lost on most investors is the significant growth in service-oriented businesses which largely are operated in freestanding buildings. Net Lease REITs invest in both logistics and service-oriented properties which is one of the factors that has led to Net Lease REITs being one of the fastest growing segments of the REIT market.
What do you think of recent proposals to cap interest rates?
The needs of capital in the market have changed dramatically. Retired individuals, life insurance companies or pension funds with rising obligations need income from their investments more and more. Given the demographic shift happening in the US, Europe and Asia, the amount of capital searching for income-oriented investments has become insatiable and that trend is only becoming more pronounced. I don’t see how interest rates increase in that type of environment. I am more worried about interest rates being too low and the impact that environment will have when that trend inevitably reverses however long that may be in the future.
If you could craft one piece of legislation on the matter what would it be?
The market does a better job of price discovery than any sort of legislation aimed at controlling price levels when the market is balanced competitively, information is readily available to all participants and is free from government intervention. Legislation designed to protect those qualities would be more helpful.
Any final thoughts?
Following the crowd typically ends with marginal results in the long run for an investor. Investors should always look beyond the superficial qualities of an investment particularly when it comes to real estate. Investing in the prettiest building doesn’t mean you will make the most money. Buying a popular broad-based REIT ETF will leave you overexposed to the highest priced sectors and companies without the expectation of a higher return. Tax incentives create price distortions in the markets they target leaving questions around whether tax-incentivized investors will be marginally better off. Net Lease REITs offer investors a compelling alternative that removes a number of these uncertainties and gives investors an identifiable path to a total return built around an above average dividend yield and multiple sources of cash flow growth.