Animal Spirits Podcast - Talk Your Book: Investing in Corporate Real Estate

Episode Date: May 22, 2020

On today's show we talk about all things related to corporate real estate in the United States. How has it been affected by COVID-19, what does the future look like, and what does it all mean for investors.   Find complete shownotes on our blogs... Ben Carlson’s A Wealth of Common Sense Michael Batnick’s The Irrelevant Investor Like us on Facebook And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation. Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's Animal Spirits is brought to you by Fundamental Income, sponsored to the net lease corporate real estate ETF, ticker NETL. We've been receiving a lot of questions about the future of corporate real estate, so this was a perfect time to bring back Alexei Paniadikopoulos, co-founder, and CIO of Fundamental Income. On today's show, we discuss what just happened in the corporate real estate market, what the future might look like, and how the triple netley structure can be advantageous to investors in these companies. I hope you enjoy this conversation and have a very happy Memorial Day weekend. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson work for Ritt Holt's Wealth Management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritt Holt's wealth management. This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Rittholt's wealth management may maintain positions in the security. securities discussed in this podcast.

We are sitting here with co-founder and CIO Fundamental Income, Alexi Paniota Coppolis. And not only is, are they the sponsor to the net least corporate real estate ETF, which is ticker NETL. He is also a member of a new private fund in concert with Brookfield Ascent Management. So first of all, thanks for being here.

Tell us about this new partnership that just came about in the midst of crisis, which had to be a crazy event. Thanks for having you guys. It's been a whirlwind to say the least. a little bittersweet and not being able to see your team and work as you're going through a monumental event. We founded fundamental income at the end of 2018 and launched the net lease corporate real estate ETF in March of 2019 to drive awareness and provide the first ever

exposure to the net lease sector in a public liquid fashion. And we did that because not everybody can access these markets in a liquid nature and just get overnight exposure through an ETF. But the plan all along was to have a multifaceted investment firm, and we found a great partner. My partner and I started our careers at store capital in the net lease space, and we ended up going out and cutting a deal with Brookfield Ascent Management and a fund managed by Brookfield, which committed $500 million in equity to our company. And we launched a joint venture called Fundamental Income Property. So we're actually going out and working to provide capital to businesses and operating companies in unprecedented times and unlocking the real estate value

that's stuck static on their balance sheet. So if you think about this, it's the Netley story that we always talk about. It's restaurants, it's gyms, it's coffee shops, it's daycares and automotive service centers and tire shops and just everything that's around the corner, things that you use in your daily life. And right now with COVID and coronavirus and everything going on, banks are deficient. There's a massive void in the marketplace for capital. And we in concert with Brookfield are trying to fill that void and do what's called a sale lease back where we actually go buy the properties and then lease it back to the company on 20 or 25 year lease. But what it does is it really replaces traditional debt and equity.

And so if they had a maturity wall or if they needed growth capital or they're just trying to shore up their balance sheet, they can sell us the asset and retain the cash to have a capital infusion essentially. So we started the process in January. Brookfield recognized the opportunity, our backgrounds in the space. And we have a tremendous team that we've put together. And Brookfield has been an amazing partner that we start to finish. We're able to raise the capital in roughly 90 days. And they are really a first class organization. They care about their people. They care about the businesses that they work with. And we're really here to try and shore up the businesses of America. Very cool, Lexi. Congratulations to you and the team. So, all right,

you were on the show last year when you launched the ETF. Refresh our memory. What is a net lease. Yeah. So a net lease is something that is most commonly known as a triple net lease, and that is where a operator or a tenant leases a property from a landlord and they pay the landlord the rent, but then they also pay property taxes, insurance, and they maintain the property. So those are the three ends in a triple net lease, property taxes, insurance, and maintenance. So for the landlord, they basically collect the rent. They don't have to. manage the property, they don't have to worry about. Is it a bad winter in January? Do I have to hire more snow plows or did the roof cave in? That's not their problem. So a triple net lease is

one of the most certain or I guess you want to call it least troublesome ways to collect rent because the tenant takes on all the exposure and uncertainty. The most common form of that would be you think about like a Walgreens that's freestanding or a Starbucks that's freestanding or Amazon Distribution Center or a Walmart, they take care of their own properties, but they pay rent to a landlord, and the landlord essentially just collects the rent. So explain to us what is going on there right now, because there was actually a story in the Wall Street Journal this week, and it said places like Chipotle and Shake, Shack, and even Starbucks are coming to their landlords and saying, we might need to defer some rent or

we might need to have lower payments. We've been paying on time. What is going on here? Because this seems like something everyone is talking about, who's going to end up being hurt the most here on these deals if businesses are in trouble. Real estate honestly is at the epicenter of the pandemic. And historically, real estate has been a diversifier within a portfolio where you do it because it is something completely different from the market and it's insulated. But right now, nobody's stress tests for zero customers or zero foot traffic. We never had a scenario in the history of the United States where people were told to

stay home to not go to work. The streets are empty. Not all real estate's created equal either. And so although it's hurting a lot, it's also helping a lot of others. You look at things like hotels, obviously those have nightly leases and they're being put in a really difficult position because there's no travel, there's no business travel, there's no leisure or vacations, things like office where people are not going to their offices or not using office. So maybe they were thinking about expanding or adding square footage to their lease. Now they're not. Maybe they're even thinking about getting rid of their lease completely. Same with multifamily.

If you live in a high rise with a six-month lease or a year lease, you may be not looking to renew that and you're moving into the suburbs. And so things like Chipotle and Starbucks, like you're talking about, they don't only run freestanding locations. They also have in-line locations. And so a lot of that was geared towards stores that were not opened. So you think about like Kroger and Albertsons or a safe way. You walk in, there might be a Starbucks within it or a business.

or a bank within it or a Chipotle that's in a shopping center that can't even open and operate. It's not a blanket statement that they're not paying the rent or they may need help. And part of it too is the unfortunate world. Fortunately, unfortunately, we live in the best country in the world and the most predictable country. And because of that, legalities matter and documents matter. And so you do also have businesses that are trying to capitalize on what's going on. And they're doing it because they can.

And it's tough to say whether they actually need it or not. So let's start with the obvious. And maybe this is like asking a barber if you need a haircut, which I don't have the pleasure of doing, have it in some years now. How screwed is commercial real estate? I think it goes back to that not all real estate's created equal. And you look at things that are flourishing, e-commerce is flourishing. You see Amazon and Walmart and all these distribution-type businesses hiring 500,000

workers and expanding as much as they can. And you see drive-thrus like raising canes and Dunkin' Donuts and places that you can still social distance, but you still want a coffee or you want to get out of the house that are doing extremely well. But there's pockets of real estate that are going to have trouble for a long period of time. Balls depend on foot traffic, but you can't have large groups. And there's reopening issues. Jims have trouble if you can't reopen and you can't put 500 people in the same building.

But at the same time, things like daycare. like this country is dependent on daycare and people working. And so at some point, people are going to have to drop their kids off at school or at daycare. And those are all freestanding properties. And that's really why we love the net lease businesses. It's really based on long-term contractual cash flows. And these properties have 12, 15, 20-year leases. So yeah, there may be short-term headwinds, but real estate that has short-term leases where tenants have the option to leave and forego renewing a lease are going to be in a much tougher spot like hotels and lodging. You can see Ben, you read the, or maybe it was Michael that read

the re-performance top to bottom. Hotels and lodging are at the bottom of that. And mainly because you have nightly leases and people just don't have to come. There's no lease contract. There's no obligation. Is the net lease space then actually in a better position to negotiate and maybe take down some rent or defer some payments because they know it's much more longer term deal? Are they pressing those contracts and saying, no, you're filing it to a T and is what the payment is. Yeah. So that's really one of the biggest benefits of the net lease reed space. We launched this ETF, first of all, to try and show people that this thing should stand alone. It should not trade the way other REITs and the way other corporate paper products

trade with the volatility. It should trade more in line with corporate debt because you have a 12 or 15 year obligation to a corporation that's paying you over a long period of time. And so what the REITs are doing now is they're being proactive and working with their clients to say, we understand you have short-term headwinds, we're going to give you three or four-month rent and deferral or pay half rent, and then we're going to amortize that over the cost of the rest of your lease. So they're not necessarily just abating rent and forgiving it completely. They're trying to do what's best in the tenant's interest to help them, but then they're also trying to do what's best for shareholders to get it back. So are any of these

companies, so the top 10 holdings, you've got WP Carey, Realty Income, National Retail, Safeholding, and others, are any of these cutting their distributions yet? So you've had a couple that have had higher payout ratios, as far as dividend payout ratios go in the past, that are in protection mode. Now, keep in mind, REITs have to pay out their taxable net income, 90 plus percent of it. And so to date, you've only had four companies within our index, which is 23 as a whole, that have touched their dividend. You have global net lease, which started out as 110% payout ratio anyhow, but they

still only cut their dividend by 20%. You have GLPI, which is essentially a casino reed that leases space to pen gaming. They cut by roughly 15%. And then you have essential EPR entertainment properties that suspended their dividend temporarily because those own like ski hills and six flags and entertainment properties that literally are still not open. And so that being said, they have a massive amount of liquidity to deal with short term headwinds. And these generally have been temporary in the past. You go back to 0809, you had a couple companies that really cut their dividend, but they really came back. Okay, perfect. Yeah. So obviously, there's going to be winners and losers here, but who is the loser? I mean, maybe in some of these

bad sectors, it could just be the investors, but is it the landlords they're going to have to eat some of this? Is it the banks? Like, who does it eventually roll up to? Is it the banks that have to eat some of this? Or how does that work when we have these situations where they just go into default or can't pay? Just to piggyback on, like, question. So it's great that these companies are in multi-year leases, but if they can't pay, who eats the loss? Well, first the landlord, which is the REIT. And then behind that, these REITs use fairly moderate leverage on generally a non-recourse basis or their corporate borrowers. And so there's a massive ripple effect to banks, to equity holders, to shareholders.

I mean, there's not really a winner or a loser. Everybody loses. If a tenant goes away, obviously that business who was the tenant loses because they file a chapter 11 or chapter 7 and have closed their doors. Then you have the landlord who's going to take a loss. And then you have the equity holder who's going to take a loss first because they own shares in that company. And then you have the banks that have finances properties. And so everybody loses. It's not good. But in the interim, these REITs are doing their best to try and keep everybody open. And obviously PPP helps. You're allowed to use 25% of that money to pay rent. So it's basically short term indirect revenue to landlords because these companies need to keep their doors open.

If you're a Starbucks or let's just use a regional brand like a Dutch brothers or or something like that that needs to keep their doors open and sell coffee, you can't do that without a drive-thru. So you're going to pay your rent. So you may furlough workers, but rent's going to be paid. When this first started to happen and there was a shutdown, did you immediately say to your partner, Chris, uh-oh, we were screwed. Big time.

we said that just because, I mean, the stock market's a leading indicator and people overreact, they make bets against which way things are going to go. What news is going to happen, what's going to come out, what the actual numbers may look like. And in the first nine days, I mean, we had hit a massive stride. We were breaking out. We started the fund at zero dollars in March 22nd or 2019. And in 10 months, we had grown to over 51 million in assets on an organic basis. That was not any one institution that was individual RAs like yourselves, individual retail investors, institutional players that were dabbling, trying to get to know the strategy. And we saw our fund drop 55% in nine days. Unreal. I mean, just unruly. You can't shut down an economy

and not expect the public entities to take massive hits. And then on top of that, you've got short traders that are shorting on top of it. Some of our constituents, had five, six, seven, ten times the average daily trading volumes. And there was one day I specifically remember, WP Carey came out with a great piece of news and their stock was down like 28% when the rest of the sector was up five. I mean, literally, out of 23 stocks in our index, 22 were up. WP. Care was down 25. And I called their investor relations head and he responded immediately.

He's like, I don't know what to tell you. Everything's great. So obviously there's like the babies being thrown at the back. bathwater here. So what are the opportunities? Do you have to take a 10,000 foot view right now and say, we have to segment this by sectors, or is it more, all right, we need to really focus in on the individual properties and holdings? Like, what are the opportunities now? Where are you looking? Well, I mean, look, as a whole, people have historically invested in real estate in a blanket fashion. And you saw the wealth of America be created in properties and buildings. And the reason a lot of that

wealth occurs in real estate is because if you wake up and you own nine West 57th or whatever building in New York, you can't just wake up and sell it one day because you had an emotional like blip. You have to think about it rationally and run a process and then sell it. And by that time, a lot of the fear has gone away. But that's not true in stocks. People can wake up and make emotional decisions. And you guys see this every day with your clients. You talk about it waiting for the long term. And so part of this is you have to look from 30,000 feet. You have to believe in America. And if you do, you have to believe that we're going to return to work and we're going to drop our kids off at school again and go to daycare and

get gas in our car and then go have a sit down dinner at your favorite Italian spot or whatever it is. I think maybe this is actually a good experience for your investors early on to learn the lesson because when we last spoke, we spoke about the business benefits of the net lease structure. But as we learned, equity investors don't care about the next three to five years necessarily. They care about the next three to six months. So they care about right now. I guess if there is good news to the extent that there is, it's that these holdings are diversified, not just across industries, but also across the entire country. You mentioned betting on America. You've got Texas, New York, Ohio, Michigan, Florida, Illinois. There's not a lot of concentration here. It's really all

over the map. Yeah. So, I mean, that's really the beauty of net lease is we didn't group these by property types. We didn't group these by business types. We grouped this by an operative document, which the word net lease basically translates to high margin because the landlord collects rent and they have to monitor their portfolio. But net lease as a whole, if you look at the 13 real estate sectors, and those are the main food groups, think about office, industrial, malls, multifamily, etc. Net lease have gross profit margins or going into COVID had gross profit margins of roughly 90 percent, EBITDA margins of roughly 80 percent. And those are backed by long-term contractual cash flows. And so those are backed further by diversification. So you have no more than 23 percent is

in industrial, 12 percent is in retail. But that retail is very different. If you actually look at the makeup, that is things like dollar generals and family dollars and T.J. Max is which before this were the best investment ever because you had to go there to get closed and it was resilient to e-commerce. So when you were resilient to e-commerce, that means foot traffic, but foot traffic can only be taken out by a pandemic. So like we're literally in the perfect storm, but it's also presenting massive opportunity. These reits were basically thrown in with mall reits. We were down some on a couple days more than Simon Property Group or Miserich, which had closed all of its properties. And there was irrational.

price dislocation. I remember seeing a couple days at one point, MGM, which is the operating company, leases its property from MGP, which MGP is MGM growth properties, which is the REIT that owns the Vegas strip, essentially, all the casinos. There was a point in time where MGP was down more than the operating company, but MGP has 20 plus year leases on a contractual basis and owns irreplaceable real estate. So one is trading on corporate. profitability, which is the equity. The other, which is the REIT, was hit harder because people were trading it like it was completely vacant and never coming back. And so if you look at 2008 and nine, this sector was trading at roughly 11 times equity cash flows. And we're only trading

at 11 and a half now. But these companies were way more profitable, way better capitalized. Going into this, they had moderate leverage, roughly 33 percent as debt to enterprise value. profitability was high. Diversification was high. No tenant represented more than for most of these guys, five percent of their portfolio. And we actually place concentration constraints within the ETF itself so that if anybody has over 50 percent concentration to one tenant, then they're automatically capped at three and a half percent within the ETF or within the index. So maybe this is a good segue into you, since you have a foot in both camps in terms of the private commercial real estate market and this more public one in terms of the rates,

what are the differences in terms of the things that you're looking at and things that investors take a look at for these things? I will say we've been extremely active over the last three weeks since we launched the new company that was backed by the $500 million equity commitment. We're seeing that business is actually a lot better than people may be letting on. And not across the board. There are pockets that are essential businesses that restaurants have figured it out and they're doing takeout and drive-thrues.

I talked to an operator this morning that's a regional coffee brand. And their sales year over year in this month, like since COVID started, are up 20%. We talked to an automotive dealer that has a little bit of a niche in the market. They're up 50% year over year from last year. So you're seeing consumer behaviors change. Peter Lugar is going to do delivery. They've never done that before. There you go.

It's exactly right. And you're seeing wine delivery, beer delivery. I mean, innovation happens in times of conflict. Are you allowed to change the. construction of the index to reflect your views of where corporate America is headed? Well, so it's a passive rules-based index. So technically we could change the index, but we would have to put out formal notices. There's a whole process to that. So I can't just wake up tomorrow during trading and say, hey, store capital looks great. I'm going to put 50% waiting.

It's not an actively managed fund. Just in the same way that S&P can change their index guidelines or any passive fund, we can too from the index side, but there's a whole process. procedure to that. In terms of your portfolio holdings and being diversified, it says that you guys have almost 25,000 properties or something on here. If you had to put a number on, what percentage of those properties would you say, okay, we're really worried about maybe even in the short term, but long term, everything's going to be fine. What is the percentage of the industry that people worry about now versus your own properties that you hold? I mean, if you look at our diversification table as far as the industries that these tenants operate in, obviously hotels,

gaming and leisure, which are at 10.5% weighting, that's just the exposure. That's not actually the weight within the index. That's a pass-through of what all the underlying REIT zone. But that's essentially from three companies in our index, which are MGP, Vichy, and GLP. Those are casinos. They're already starting to reopen. So while I'm worried about them at the same time, these are companies that are still well capitalized. In April, Vichy, which is one of our holdings, collected 100% of its rent. MGP, I'm just going through here, collected 100% of its rent. GLP, which is pen gaming, has a little bit more bifurcated tenant structure. They still collected 98.6% of their rent. So, I mean, you're not saying it, but I'll say it for you. Are people that are selling

misinformed? Are they dumb? Like, is the market really that inefficient? What's going on? I don't think anybody's dumb, but I will say people are making emotional decisions and they're coagulating causation versus correlation. And anything that has to do with retail is being thrown out in a baby with the bathwater scenario. So hotels were being treated the same as malls, which were being treated the same as casinos, treated the same as restaurants. And you look at Four Corners Property Trust, which is a holding within our index. And their primary lease to Darden. Darden paid all their rent. And all of gardens have been closed. I mean, that's an investment-grade company that leases from them. So people just don't,

really look below the hood. And that's why we create this ETF is because there's 52 publicly traded reed ETFs, but they're all broad markets. Diversification is one thing, but you start to over diversify, it can become a lot more difficult to actually separate yourself from the crowd. So you look at most of the public funds, they're heavily, heavily tilted towards office, malls, multifamily, and healthcare. And you see what's going on with senior living. You see what's going on with medical office buildings, which are massive towers with hundreds of tenants in them. Those are very populated, densely popular areas. Multifamily was hurting. I've heard Josh talk about it on CNBC. CNBC's talked about it. Suburban real estate is growing massively because

people are at a point where they're tired of being on the hamster wheel and being stuck in New York trying to make it. And then all of a sudden, like, Sandy hits. And then the pandemic hits. And you're not meant to be cooped up in a 800-square-foot apartment for four months. And so if you look at what's really going on, there's a lot of short-term headwinds, but there are reports today that Georgia, which was one of the first states to reopen, has seen a drop in coronavirus cases. So if we can find a way to control this and we can change as a population, we're going to return to some semblance of life.

And I always talk about the prohibition days. The human race risked going to jail so that they could drink in a basement. right so like you're telling me that you're really never going to go out and get your favorite bowl of pasta and open a glass of wine again for the rest of your life and you're going to hold on to your three kids all day every day and you're never going to work again i just i happen to believe in america and if we go back to cold war era or we go back to this like live in the woods our portfolios aren't going to matter and bitcoin is probably going to be the only thing that we can trade with if we have Wi-Fi so right now the third and

SEC yield on this thing is 6.6 percent. Is this sustainable? Look, I'm not a crystal ball, but if I could say, we are very confident, again, just in the resiliency of America and American business. And if you look around what net lease is, it is things we use every day. So everything we've talked about thus far, gyms, daycares, restaurants, coffee shops, distribution centers like FedEx and Amazon, casinos like MGM and Caesar's Palace, auto and retail service centers where you go get your oil change or your tires changed. These are things that are part of our daily life. All right. So make the case, why the REIT structure versus the equities? In other words, if you're bullish, and I guess it doesn't have to be either or I'm just putting it to you this way,

why not buy AutoZone or Dunkin' Donuts or any of these other companies? Why buy the REIT? Well, so look, there's two ways to play things. direct fashions, there's indirect fashions. I personally like to be able to identify exactly how I'm going to make money. And all 23 of these companies, you can break down margins, dividends, growth rates, internal growth rates, external growth rates. This business is built in a very identifiable fashion, and it's really built on the back of long-term contractual cash flows, and people discount that. When you sign a lease, that is a 15-year lease, you're obligating Dow Chemical or Nissan or FedEx or Dunkin Donuts.

to pay a lease under the law of the United States of America. And so the only time you can technically leave that lease and stop paying rent is if you go into bankruptcy and you reject the lease and you're liquidating your company, or if your lease expires and you're moving. So people discount the fact that just like you have a mortgage on your house and you have a contract, these are contractual cash flows. Beyond that, you have to think about priority of cash flows and priority of payments. everybody talks about, are you a senior corporate bondholder? Are you an unsecured corporate bondholder?

Are you whatever in the capital stack, but on a lease? Think about EBITDA calculation in the most common way possible. Revenue, less expenses, gets you net income and you're adding back depreciation, interest, amortization. But before you do that, you've got to pay your rent. And if you're selling coffees or you're selling burgers or you're taking kids into a school, you physically can't do that without the real estate. So rent is going to be one of the last things you stop paying. You may ask for short-term deferrals, just like everybody is, and we're all in this together. It's an unprecedented time. But long-term, these companies want to be there. It is imperative to their capital stack and their revenue stream and ability to create

EBITDA that they have this real estate. I get the sense. Michael and I have talking on the podcast about how a lot of the chains are probably going to end up being the winners from this. And a lot of the mom and pop small businesses are probably going to be losers. And it sounds to me like the majority of the people sending these leases for you are these chain stores. It's not like they're these small businesses that are probably seeing a little more world of hurt here. Yeah, everybody has different levels of sophistication. And there's definitely some smaller operators and larger operators. But each one of these REITs, although we're a passive index, and we really believe in investing in a sector, because I don't believe in stock

picking. It's very difficult to do month over month, quarter of a quarter, year over year and actually outperform the market. And so we're a passive index, but each one of these 23 companies in our index has active management. And so, like you look at store capital, which is a Berkshire Hathaway owned REIT, and Chris Vogue, who's the CEO, is one of the best credit minds

that I've ever worked for and met in my life. And they underwrite each and every deal. And they look at the tenant quality of what's going in their portfolio. Again, nobody underwrites for zero revenue. So a little bit of what's going on right now is not necessarily anybody's fault. But realty income, national retail, WP Carey, these companies,

do the same thing. And they've been around for 20, 25, 30 years and have been doing it year in and year out. And in this time, when you're an equity investor and you don't know what's going on, I mean, going into COVID and Morgan Stanley, UBS, all the big banks economists have put out equity return forecasts of four to six percent total return. If you can get an investment that is paying you a current yield, which has historically been in the six range, and you have 15-year or 12-and-a-half-year leases. And keep in mind, these rents have contractual increases in them. And so the lease is bumping one and a half percent a year. You're getting organic growth. Whether the stock is growing or not, your cash flow is growing. And that's really what's

driven outperformance. The story is very compelling. Ben, Alexi, anything that we missed? I just want to thank you guys. It's always great to get on with thought leaders. I think you guys do a great job of provoking great thought. Did you know that Ben's a Peloton influencer? I did not, but I would love to see him with a helmet on and some tight biking pants. All right, Alexi and Fundamental Income, thank you so much for coming on. We really appreciate it. Appreciate it time, guys.