NETLease Corporate Real Estate ETF: The Pros And The Cons (NYSEARCA:NETL)

Investment Thesis

The NETLease Corporate Real Estate ETF (NETL) offers exposure to 23 real estate investment trusts with properties in various industries that all utilize net leases. These contracts, which typically sport long lease terms, stipulate that the tenant will pay for all or almost all property-level expenses. This makes them similar in some ways to asset-backed corporate bonds, except that they usually have built-in revenue (i.e. rent) escalations that are sometimes tied to inflation.

These long and contractually fixed leases become more valuable as interest rates fall. Since the US is likely to experience a “lower for longer” interest rate environment for the foreseeable future, net lease REITs look extraordinarily well positioned right now. Many of them still trade at discounts to fair value and offer high yields.

NETL currently offers a trailing twelve month yield of 4.7%, or a 5.0% yield based on the most recent distribution annualized.

In what follows, I’ll sketch out what I view as the pros and the cons of the ETF. In short, while I personally own it in my Roth IRA and believe it is worth owning for those who are looking specifically for an ETF, it is probably a better bet just to buy the individual stocks, all else being equal.

Portfolio Characteristics

The underlying index that the ETF tracks is called the “Fundamental Income Net Lease Real Estate Index.” It’s a modified market-cap weighted index that screens for REITs that are at least $200 million in market cap and primarily use net leases. At each quarterly rebalance, the portfolio is rearranged based on two weightings: tenant diversification and market capitalization. Companies with greater overall tenant diversification are awarded greater weight, and then the portfolio is weighted by market cap.

This focus on tenant diversification is why we find industrial REIT Monmouth Real Estate Investment Corporation (MNR), which has FedEx (FDX) as its largest tenant at around 55% of contractual rent, at the very bottom of the list with a mere 1.19% weighting. In contrast, we find some of the largest and most diversified net lease REITs topping the portfolio:

Source: NETL Holdings

Since the portfolio is so concentrated with only 23 holdings, the index takes steps to prevent further concentration in the largest REITs. At each rebalance, the top five holdings are capped at 8%, while every other holding is capped at 4%.

At the end of Q1 2020, NETL’s holdings had an average market cap of $4.8 billion, according to the Fact Sheet. Its 23 companies owned 24,461 properties with a weighted average remaining lease term of 14.8 years and 99.0% occupancy. Debt to enterprise value sat at 40.7%, which would equate to about a 41% loan-to-value in the private real estate world. Across all holdings’ portfolios, the largest tenant came in at a weighted 3.1% of NETL.

Though investors often think first of retail REITs like Realty Income (O), National Retail Properties (NNN), and STORE Capital (STOR) when it comes to net leases, industrial tenants are also heavy users of the contract structure. Industrial tenants make up the largest percentage of NETL’s weighted average tenant base, followed by retail and then hotel/gaming/leisure:

Source: Q1 Fact Sheet

Unsurprisingly, some of the largest and most populated states like Texas, New York, and Florida are high on the list of top states. Nevada probably makes the top ten list merely because of casinos owned by the likes of Vici Properties (OTC:VICI), Gaming and Leisure Properties (GLPI), and MGM Growth Properties (MGP).

As you can see from the two weighting panels above, NETL is fairly well diversified both geographically and by tenant industry, despite being focused solely on one type of lease contract.

The expense ratio is a rather high 0.6%, which means that for every $10,000 invested, one is charged $60 annually for the pleasure of owning NETL. That ratio is on the high side for a passive ETF, but on the other hand, it is a very specialized fund offering targeted exposure to a certain kind of REIT.

Pros And Cons

There are both pros and cons to owning NETL from my perspective. Let’s begin with the pros.

Positives:

1. Diversification

The index’s screening methodology is a logical way to give the largest, most diversified, financially strongest companies the highest weighting in the fund while including smaller and/or less diversified companies at lower weightings.

As we can see below, the non-top ten stocks run the gamut from warehouse/distribution properties to casinos & resorts to restaurants.

Source: NETL Holdings

Many REITs are already like the mutual funds of real estate, owning a variety of properties leased to a variety of tenants across a variety of industries and spread across the United States (and, for some, into Europe). One of the primary means of diversification offered by NETL, then, is exposure to multiple management teams. This necessarily means multiple balance sheets, dividend policies, and acquisition criteria.

2. Technology & E-Commerce Resistance

Net lease REITs spent the last decade shaping their portfolios to be resistant to online commerce companies like Amazon (AMZN). They reduced exposure to retailers with the most susceptibility to online competition and increased it in essential goods like pharmacies, general merchandise superstores, experience-based tenants, automotive services, restaurants, and warehouse/distribution/fulfillment centers.

In the face of a global pandemic, these moves were admittedly a form of “fighting the last war.” Owning technology-resistant real estate does not necessarily prepare one well for a pandemic; in fact, it mostly does the opposite. But while technology-resistant real estate might be vulnerable to a pandemic, it is uniquely prepared for a future of ever-more online commerce.

In this case, short-term vulnerability correlates to long-term strength.

Negatives:

1. Individual Stock-Based Quirks

There are a few quirks of the portfolio based on individual stock picks that probably wouldn’t exist in a portfolio that a value-oriented investor would make themselves.

Safehold (SAFE), for instance, is a ground lease REIT trading for an astonishing 38x expected 2020 FFO. Its yield is an ultra-low 1.16%. What’s more, it is not what one would consider a growth REIT. The most recent dividend raise was 4%, which followed the previous year’s 4% raise. SAFE may very well be what its name describes – a safe investment – and may be suitable for some investors. But its inclusion in the portfolio marginally drags down the ETF’s yield and diminishes one of its primary draws: high income.

Moreover, while Industrial Logistics Properties Trust (ILPT) certainly accomplishes the goal of high income and boasts a quality portfolio of Amazon fulfillment centers, it is externally managed by the RMR Group (RMR), which has demonstrated some of the negative and shareholder-unfriendly tendencies of external management through other REITs such as Office Properties Income Trust (OPI). OPI has lost 67% of its value over the last five years. Similarly, ILPT has lost 13.4% of its value since its January 2018 IPO.

Does it make sense on paper to include ILPT in NETL? Yes. Would investors include it in their own individually chosen portfolio of stocks? Most would not.

2. Omission of Healthcare REITs

Inexplicably, NETL completely omits the handful of healthcare REITs that primarily utilize net leases. These include National Health Investors (NHI), CareTrust REIT (CTRE), and LTC Properties (LTC) – all senior housing and skilled nursing REITs. The inclusion of these REITs would provide further diversification to NETL’s portfolio.

The index also excludes American Finance Trust (AFIN), which is about two-thirds net leased properties mixed with shopping centers. That decision may make sense, and I am certainly not complaining about the exclusion of the externally managed and highly leveraged REIT. But as AFIN transforms itself into a more fully single-tenant net lease REIT, it may eventually be included in the index and thus the ETF.

3. Relatively High Expense Ratio

As already covered, the 0.6% expense ratio is on the high side, though far from the highest for a specialized ETF. With less than two dozen holdings, this creates the temptation for the motivated retail investor simply to replicate NETL’s portfolio with only the companies one wishes to own while excluding the rest.

Conclusion

For the sake of simplicity, I only own ETFs in my Roth IRA. In my taxable brokerage account, I’ll own individual stocks. For someone in a similar situation, having restricted themselves to ETFs for whatever reason, NETL is a good option for exposure to net lease REITs.

At the same time, while well-constructed overall, NETL is by no means a perfect ETF, in my opinion. Its stock-picking methodology ends up including some stocks that I would rather avoid altogether, and it inexplicably excludes others that would seem good fits for the portfolio. On top of that, its expense ratio is rather high for an age of ever-lower investing fees.

There are things to like and things not to like about NETL. The purpose here was to present a rounded picture of the ETF. As for myself, I find it suitable for net lease exposure in my retirement account but I would much rather construct and manage a portfolio of net lease REITs on my own. For those who are not interested in managing a dozen or so individual net lease stocks and would prefer a one-stop solution, NETL gets the job done.

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Disclosure: I am/we are long NETL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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