The author of this article sets out the case for investing in what is called net lease real estate, an asset class, he says, that fits well with the requirements of family offices.

The following article, about what is known as “net lease real estate,” comes from David Leavitt, partner, ElmTree Funds, a firm based in the US. We hope that this article is useful to those managing this portion of the property market and, in turn, the broader “alternative” asset allocation conversation. The usual editorial caveats apply to views of outside contributors. We’re grateful for the opportunity to share insights on this sector. Please email the editors at tom.burroughes@wealthbriefing.com and amanda.cheesley@clearviewpublishing.com if you want to react.

As family offices and institutional investors seek to diversify their portfolios, net lease real estate is continuously emerging as a highly attractive asset class. The reasons for this are since it combines stability, predictable income, and long-term growth potential and, overall, the investments offer unique advantages that set them apart from more volatile alternatives in the public markets, where market forces outside of the asset class may impact investment values. 

Predictable income growth in the space is due to long-term fixed rents and annual rent escalations – where re-leasing and vacancy risk are minimized even in varying market conditions – and favorable tax treatments of net lease real estate are what make it a unique opportunity for family offices. For example, unlike debt investments, these types of investments allow for depreciation and interest expense deductions. In addition, investors face limited exposure to rising expenses and do not have unexpected capital expenditure risk because net leases typically allocate these expenses to tenants.

However, with all the positives, navigating net lease investment in this market can be a challenge, so it is important to understand the nuances of the sector, particularly when it comes to lease terms, tenant quality, and asset type. This article explores how net lease investments can deliver reliable, bond-like returns with equity upside while enabling investors to capitalize on their unique structural advantages.

Understanding subsector variations 
When evaluating the many subsectors that are in net lease, it is important to recognize that not all investments are created equal. Each sub-sector – retail, medical, industrial, quick-service restaurants, and more – has distinct return profiles, tenancy dynamics, and lease structures. 

For instance, build-to-suit industrial assets, a specialized subset within net lease, differ significantly from other classes of net lease assets, such as retail and office assets. Build-to-suit industrial assets are often mission critical assets to the tenant’s overall operations. The leases are long-term, and the core landlord relationships emerge during the development phase of the asset. Success in industrial build-to-suit requires a combination of tenant familiarity, development knowledge, and knowledge of net lease mechanics.  

Build-to-suit net lease investments stand out for their distinct benefits, including favorable economic and tax characteristics. These investments share many characteristics of credit investments through their structure of contractual long-term rents. For context, investment-grade tenants may see corporate bonds trading 100 to 150 basis points tighter than lease rates on comparable assets. In addition, net lease build-to-suit investments may provide equity upside in addition to contractual streams of income and, unlike corporate bonds, net leases often provide contractual annual rent escalations. From a tax perspective, unlike corporate bonds, which generate taxable ordinary income without corresponding items of deduction, net lease assets provide tax advantages, including generating depreciation and interest expense deductions, which may offset the corresponding items rental income from taxes. 

To navigate any of the above net lease subsectors, what is most important is to focus on both the tenant’s credit quality and the asset’s strategic importance to the tenant’s operations. Industrial net lease properties stand out due to strong tailwinds from e-commerce growth and supply chain restructuring, including the reshoring and nearshoring movements. 

These assets are often mission critical for their tenants and they are also often investment-grade tenants with 15 to 20-year leases and built-in rent escalations, providing stable cash flows and predictable yields. Their resilience during economic fluctuations and ability to attract long-term, creditworthy tenants add to their appeal. With a unique structure offering predictable income streams, tax benefits, and reduced landlord responsibilities, industrial net lease properties are an opportunity for a family office seeking both growth and reliability. 

From a portfolio perspective, whatever the subsection of net lease, the investments combine the appreciation potential of real estate with the stability of credit-grade tenants, effectively categorizing net lease investments as a hybrid asset. All these characteristics combined provide diversification, buffer against market volatility, and meet the dual objectives of income generation and capital preservation.

Optimizing tax advantages
The potential tax benefits in the net lease real estate sector for family office or institutional investors consist of traditional advantages, such as interest and depreciation deductions, which can significantly reduce taxable income derived from these assets – allowing investors to enhance their total returns. 

In specific sectors like single-tenant net leases for industrial, investors can access private credit-like returns in the real estate equity market. These types of properties are typically custom-built to tenant specifications for long-term occupancy, which brings added negotiation leverage for rental yields and escalations. These kinds of leases also typically feature fixed initial yields and built-in annual rent increases, resembling corporate bonds while providing additional equity upside through real estate ownership.

What family offices should know when entering the net lease space
Due to the variety of investment approaches within the net lease space, it is important for family offices to pay close attention to the investment sponsor of a particular net lease strategy. Track record, experience, and focus on a particular net lease niche are often critical to the success of an investment.  

It is important to assess a sponsor’s expertise in both development and investment when evaluating. A well-rounded sponsor should have a deep understanding of tenant creditworthiness as well as the underlying real estate of the asset. A proven track record of a sponsor is also essential. Look for those with consistent capital deployment and a low rate of default. Another consideration is to know the sponsor’s focus on specific markets or asset types. Do they have experience and commitment to those types of investments? Do they have relationships within that sector to potentially attract investment opportunities and garner favorable pricing? 

Best practice for investors, guided by a sponsor, is to seek those who can also manage assets from inception through operation, ensuring that they have the necessary expertise and experience to handle all aspects of the investment.

Challenges and misconceptions
A common hesitation among family office investors is the perceived risk of single-tenant structures compared with multi-tenant properties, which offer rent resets and less reliance on a single tenant. However, this concern often overlooks the credit quality and mission-critical nature of many net lease tenants. For example, major retail tenants typically operate facilities that are integral to their business operations – from last-mile fulfillment centers to specialized cold storage facilities – significantly reducing vacancy risks.

During the Covid-19 pandemic, this resilience was on full display. Our portfolio, made up of investment-grade net lease industrial assets, experienced zero rent defaults across millions of square feet during this period. 

In family office portfolios, the traditional 60/40 equity-to-debt allocation model is increasingly being reconsidered. More investors are directing higher allocations toward real estate and net lease assets. Academics and economists now, in fact, suggest that allocations to net lease investments could climb to 15 to 20 per cent, reflecting their attractive risk-adjusted returns in private markets. Institutional investors are making similar moves, increasing their real estate allocations as they recognize the performance stability and risk mitigation that net lease assets provide. There is a growing acknowledgment of the strategic role net lease investments can play in a diversified portfolio.

Overall, net lease real estate offers stability, tax advantages, and predictable income that aligns well with what family offices are looking for with their investments. By carefully evaluating sponsors, tenant creditworthiness, and asset quality, long-term success can be achieved.

The author

David Leavitt is a partner and head of strategy at ElmTree Funds. Leavitt is responsible for overseeing the firm’s strategy, including the launch of new investment products across ElmTree’s institutional and retail clients. Leavitt has over 18 years of experience in the real estate industry. Over his career, Leavitt has advised on over $30 billion of real estate transactions.