Not all net-lease REITs are created equal

Wide Moat Research has repeatedly preached about the importance of portfolio diversification over the years. And you’ve no doubt heard similar statements elsewhere:

You know the spiel. But have you stopped to consider that the same might be true about the companies themselves?

Think about it: Businesses that get their revenue from multiple sources will probably (though not definitely) be stronger than those that are heavily reliant on just a few. If one of their customers falters or outright fails, they can rely on all the others to keep them afloat.

Plus, they tend to generate more reliable earnings that support stronger credit ratings… which gives them better and cheaper access to financing… which opens up more attractive growth opportunities.

In short, they’re safer bets.

That’s why investors usually (though not always) demand higher returns from less-diversified businesses. They want to be properly compensated for the greater risk involved.

We’re seeing that reality play out (though not completely) in today’s net-lease real estate investment trust (REIT) scene. Normally considered to be conservative investments with long lease contracts, predictable rent streams, and contractual escalators, they’re nonetheless split into two distinct categories right now:

The diversification “haves” and “have nots.”

We all know REIT shares in general have struggled for years thanks to higher-for-longer interest rates. But there’s additional weight on “have not” net-lease REITs.

Them and, for some reason, the most diversified net-lease REIT of all time.

The gold standard for diversification within the net-lease REIT sector remains Realty Income (O). There’s no doubt about it.

The company owns more than 15,000 properties across all 50 states, as well as Europe. And its top three tenants – Dollar General, 7-Eleven, and Walgreens – account for just 9.6% of its annual base rent (ABR).

Agree Realty (ADC), though smaller, has also built a notably diversified portfolio. Walmart, Tractor Supply, and Dollar General, its top three tenants, collectively bring in only 6.6% of ABR. And the same number applies to Essential Properties Realty Trust (EPRT) concerning its own top three tenants, EquipmentShare, Whistle Express Car Wash, and Chicken N Pickle.

Even newbie net-leaser FrontView REIT (FVR) maintains relatively balanced tenant exposure. Dollar Tree, Fast Pace Health, and Verizon account for approximately 8.5% of ABR at this time, which isn’t bad at all.

In the “have nots” corner, meanwhile, is VICI Properties (VICI) – yes, the same one I keep touting. I do like this REIT. A lot, in fact.

However, it’s hard not to see how undiversified it is.

VICI owns some of the world’s most iconic gaming real estate. This includes Caesars Palace in Las Vegas, Nevada, and its sister casino in Atlantic City, New Jersey, along with Vegas’ MGM Grand and Venetian.

Those are enormously valuable properties. Make no mistake of it. However, it also matters that those top three tenants bring in a whopping 79% of total revenue: 38% from Caesars, 32% from MGM, and 9% from The Venetian.

This heavy Sin City presence is an overall boon, but it’s also very economically sensitive. So there are great years for VICI’s tenants… and there are distinct down years.

And there have been a lot of down years this decade thanks to the Covid-19 fallout.

As I wrote about two months ago, Caesars specifically has been struggling from slowing foot traffic – to the point where it could be taken private by billionaire investor Tilman Fertitta. And while I do believe VICI will come out ahead in the end, its stock is still suffering in the interim.

Because, again, diversification matters.

To me, this fact shows even more clearly in Four Corners Property Trust (FCPT). Olive Garden represents 31.5% of its ABR and LongHorn Steakhouse another 9%, with both owned by Darden Restaurants. Chili’s, its third-largest tenant, brings in 6.6%.

That’s a high concentration in and of itself, to say nothing about how restaurants have been struggling for years.

So have movie theaters, which puts EPR Properties (EPR) in a bad spot as well. TopGolf is its biggest tenant, followed by AMC and Regal. Together, they amount to 39.3% of the REIT’s revenue.

Investors (those who haven’t given up on REITs altogether, that is) are voting with their dollars in all six cases. And the contrast between the two net-lease categories is stark.

We’ll start with the least diversified net-lease REITs: VICI Properties, Four Corners Property Trust, and EPR Properties. Collectively, they’re trading at an average price-to-AFFO (adjusted funds from operations) multiple of about 12.3x compared with a historical average valuation that’s closer to 15.2x.

That’s roughly a 24% discount to their normal levels.

As for our four more diversified net-lease examples, they’re trading at an average multiple of approximately 15.3x. Whereas their historical average valuation is closer to 16.6x – so only about an 8% discount here.

Part of that is because of the aforementioned stigma against REITs. But it’s also because Realty Income is dragging down the group, trading at approximately 14.3x AFFO instead of 17x.

Agree Realty, for its part, sits at around 17x; Essential Properties near 16x; and FrontView at about 13.9x.

I find Realty Income’s valuation disconnect odd considering its status as the world’s most diversified net-lease REIT. This company boasts:

Its scale, its cost of capital, its diversification: They’re all virtually unmatched.

Yet the market continues to value the company at a meaningful discount to its historical norms.

Considering how healthy it is overall (believe me. I’ve checked more than once), my best guess is that Realty’s sheer size is working against it for the time being. The markets are wary about REITs’ ability to thrive in the face of high interest rates.

By that faulty logic, the more REIT there is to go around, the bigger the reason to worry.

That’s their loss regardless. I expect that as soon as interest rates start really dropping again, Realty Income’s stock will shoot right up.

It’s hard to keep a good, well-diversified REIT down… and even more difficult when that REIT is outright great.

Happy SWAN investing!

Brad Thomas
Editor, The Wide Moat Daily