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Real Estate Investment Trusts (REITs) are one of the most dividend-rich segments of the financial market. Understanding the lease structure of commercial REITs can help you identify optimal investment opportunities to include in your portfolio.
Commercial REITs give investors exposure to income-producing real estate in the form of offices, apartment buildings, warehouses, shopping centers and hotels, among others. Commercial real estate leases are generally broken down into three basic categories, which are based on two rent calculation methods: net and gross.
A gross lease requires the tenant to pay one lump sum for a rental property from which the landlord deducts expenses. A net lease has a smaller rental rate but requires the tenant to pay for other expenses.
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Under a gross lease, the rent is all-inclusive, which means the landlord pays for all or most of the expenses associated with the property. This includes taxes, insurance, maintenance, utilities and janitorial services. A gross lease offers predictability for the tenant because they can forecast expenses without worrying about unexpected costs like maintenance. Under this arrangement, the landlord assumes all responsibility for maintaining the building.
In a net lease, the tenant is charged a lower base rent for the commercial space and is also on the hook for some or all of the associated costs. These costs often include real estate taxes, property insurance and common area maintenance items. Net leases are broken down into three sub-categories: single net lease, double net lease and triple net lease. Below is a breakdown of each.
To bridge the two calculation methods, there’s something called a modified gross lease. While similar to the gross lease in that the rent is requested up front in one lump sum, it can include any or all of the associated “nets,” such as property taxes, insurance and common area maintenance. For most buildings, utilities and janitorial services are excluded from the rent and covered by the tenant. The modified gross lease has proven to be more popular with tenants because it provides greater flexibility.
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For investors, REITs with a triple net lease structure are easier to predict in terms of dividend payment. This makes them more attractive for yield-seeking investors, especially those nearing retirement or looking for steady income growth. STORE Capital (STOR ) is one of the most notable triple net REIT providers. The company focuses primarily on fragmented subsectors of the leasing industry, including middle-market and larger companies that don’t have credit ratings. As of 2017, STORE’s leadership team had invested more than $12 billion across 8,000 properties.
REITs structured around single or double net leases also make good investments. For example, W.P. Carey (WPC ) is a global provider of net lease REITs focused on long-term, sale-leaseback and build-to-suit financing solutions.
Realty Income (O ) is a net lease REIT that offers diversification across tenants, industry and geography. By the end of 2017, Realty Income had a portfolio of nearly 250 commercial tenants across 47 industries. It has also proactively managed rollover, including a 99.5% recapture (i.e., re-leasing prior rent).
Although REITs offer tremendous dividend-earning potential, they are highly sensitive to economic cycles and real estate dynamics. Historically, they have underperformed the market during periods of rising interest rates. As we’ve seen during the Federal Reserve’s latest rate-tightening cycle, higher borrowing costs have already impacted the market negatively. Investors should also pay attention to upfront fees, which tend to be exorbitant for non-traded REITs that might require an upfront fee of between 9 and 15%.
Don’t forget to read this article to learn more about how a REIT is valued.
Net lease REITs with long-term leases can provide your portfolio with a sense of stability and transparency. As the previous discussion illustrated, the triple net lease structure offers the most predictability for investors looking for stable earnings over long durations.