For more than a decade, Commercial Net Lease Realty has maintained a narrow focus by owning single-tenant net-lease retail properties. Then in July, the real estate investment trust (REIT) began changing course. Seeking to diversify, the company bought a 540,707 sq. ft. Class-A office building in Pentagon City, Va., for $142.8 million.

Now, the company is shopping for more offices and examining industrial properties. Management's long-term goal is for the portfolio to be composed of 60% retail, 25% office and 15% industrial assets.

But not everyone is impressed with the new strategy. Ross Nussbaum, an analyst with Salomon Smith Barney, says CNLR (NYSE: NNN) paid too much for its first acquisition, a property located at 601 South 12th Street in Pentagon City. The high-priced purchase will not produce strong earnings growth, he says. Moreover, he worries the company lacks the experience to compete in the office market arena.

The Pentagon City building includes space occupied by the Transportation Security Administration, which signed a 10-year lease. Nussbaum says the initial cap rate of 8% is competitive with other high-quality office properties, but he fears the REIT overpaid because there is little provision for rent growth. “Effectively, CNLR just bought a 10-year bond,” he says. “We expect companies to increase their cash flow over time, and we are disappointed that there will be no growth in this asset.”

Nussbaum estimates that CNLR's earnings will increase 1.5% in 2004, below the industry average of 5.1%. “I cover 23 REITs, and 20 of them have better growth prospects than Commercial Net Lease Realty,” he says. CNLR paid for the acquisition mainly by issuing $115 million in common equity, Nussbaum says. The new property will deliver earnings, but because the company paid a high price for it, the result will be a minimal increase in earnings per share. CNLR's stock has traded in a narrow range, hitting a 52-week high of $18.38 on July 15, 2003, and closing at $17.69 on Jan. 7.

Company executives dismiss such negative views. They began planning the shift in strategy three years ago, convinced that owning several property types could provide a more secure income stream. Besides providing investors a safety net, management feels that diversification enables the REIT to snap up attractive deals outside the retail arena.

“At certain times in the property cycle, one property type trades at cheap prices, while another is expensive,” says David Cobb, executive vice president and chief investment officer. “We want the flexibility to buy the best bargains.”

Stratton Monthly Dividend REIT Shares, a mutual fund that holds 265,000 shares of CNLR, professes confidence in the new strategy. “As long as they stick with high-quality tenants, the earnings should be stable,” says James Beers, a portfolio manager of the fund.

CNLR owns 350 properties in 39 states with 7.3 million sq. ft. Tenants include solid retailers such as Barnes & Noble, Best Buy and Home Depot. In the past, a typical investment was a single-tenant retail project valued at about $5 million. Now, the REIT expects to buy office projects worth $25 million or more. While some of the retail investments are considered below-investment grade, the REIT plans to limit risk by acquiring only investment-grade office properties. On average the company funds acquisitions with 60% equity and 40% corporate bond debt.

Will the Tortoise Win?

While the overall portfolio mix is changing, the company will continue to purchase the same type of retail assets. CNLR has increased the dividend for 14 years and produced a total annual return of 11.6% for the past decade, outperforming the National Association of Real Estate Investment Trusts (NAREIT) Equity Index. Dividend payments have risen slowly. The current annual payment is $1.28, up from $1.27 in 2002, $1.26 in 2001 and $1.25 in 2000.

“We have acted like a tortoise, and we have beaten many of the hares,” says Cobb. The company has raised its dividend by making acquisitions and increasing rents. But because earnings have not been growing much, the company increased the dividend by paying out a higher percentage of earnings. The current dividend yield is 7.3%.

A Tough Row to Hoe

Venturing into new property types also poses a risk for a company with little experience in the office arena, Nussbaum says. To prepare for the challenges of operating in various product types, Cobb counters, CNLR hired a half-dozen employees with experience in the new areas.

But Nussbaum is concerned that extra staff isn't enough to compete with seasoned REITs that specialize in the office and industrial sectors.

Still, Nussbaum rates the stock a hold. The analyst concedes that the income stream is safer than that of the average REIT, and the balance sheet is strong.