Net lease is generally considered a conservative niche in the real estate investment trust (REIT) sector. However, every company is different, a fact highlighted by the disparate performance of industry heavyweights National Retail Properties (NYSE: NNN) and W.P. Carey (NYSE: WPC). Here's why one of these net lease REITs faltered during the coronavirus pandemic and the other didn't.
A simple model
Net lease is a term used to describe properties where the lessee is responsible for most of the operating costs of the property they occupy. That leaves the landlord to, simplistically speaking, just collect rent. Often these types of deals are created via sale-leaseback transactions in which the seller is looking to raise cash (for growth, debt reduction, or some other purpose) but doesn't actually want to lose access to a vital property. It's a win/win in most cases, since the buyer of that property instantly gets a tenant happy to sign a long-term lease, usually with built-in rent escalations.
Net lease properties span the gamut from retail assets to casinos and a whole lot in between. Many real estate investment trusts specialize in one type of net lease property, including National Retail Properties. This REIT only buys single-tenant retail properties in the United States. Its portfolio contains around 3,100 buildings across various retail niches, including convenience stores (around 18% of rents), full-service restaurants (11%), auto service (10%), fast food (9%), family entertainment (7%), health and fitness (5%), and theaters (5%). The rest of the sectors to which it has exposure round down below 5%.
To be fair, the REIT's approach has been very successful over time, leading to 31 consecutive years worth of annual dividend increases, which puts National Retail in the vaunted Dividend Aristocrat space. And there's no particular reason to believe its business model is broken. However, the coronavirus pandemic did expose a material weakness: In April of 2020, the landlord only collected around 50% of the rent it was due.
A quick look at National Retail's top tenant categories is all you need to see why that might be, given the economic shutdowns used to slow the spread of the illness. Add social distancing into the mix, and the situation looked even more dire in the early days of the pandemic. Companies were worried, and so were investors, given that National Retail's portfolio appeared to be faltering badly.
Nearly a year later, the REIT's collections are creeping back toward 100%, hitting 94% in October, and it looks like the hit was temporary. But the potential for further disruption is still there, given the REIT's laser-like focus on retail assets.
Spreading its bets
This is where a comparison to W.P. Carey comes in. This net lease REIT has an equally impressive dividend record, with a hike every single year since its IPO in 1998. Its streak is up to 24 years -- and counting. But it goes about building its portfolio in a vastly different manner.
W.P. Carey's portfolio breakdown spans across the industrial (24% of rents), warehouse (23%), office (23%), retail (17%), and self-storage (5%) sectors, with a broad "other" category making up the difference. Roughly 36% of its rent roll is located outside the United States, largely in Europe.
Diversification is a big part of the story here, and the results it achieved during the pandemic are telling. In April 2020, when National Retail was having trouble getting paid, W.P. Carey collected 97% of the rent it was owed. At its worst, in May, collections dropped to 96%. In December W.P. Carey collected 99% of its rents. Basically, it was as if nothing had happened.
This helps explain why industry bellwether Realty Income (NYSE: O) is increasingly following W.P. Carey's approach. For example, "retail" is in the company's name and makes up 85% of its rent roll, but it also has exposure to industrial (10% of rents) and office (3%) assets. A couple of years ago, it also started to invest in the United Kingdom, which now makes up around 4% of rents. Realty Income isn't exactly changing its stripes, but it is adding more diversification to the mix slowly over time -- which means it's becoming more and more like W.P. Carey.
It's over... right?
It would be easy for investors to look at National Retail's quick recovery on the rent collection front and dismiss the diversification issue. But that's too simple a view. When times are tough, investors look for reassurance, and a collection rate of around 50% during the pandemic is not at all reassuring. In fact, it could easily be seen as a reason to sell. W.P. Carey's high collection rate throughout the pandemic, meanwhile, would have led to a far calmer emotional state, since its business performed well even in the face of adversity. For conservative dividend investors, that should make a big difference.