Nothing But Net (Lease)
Real Estate Forum
There are many factors to net lease that lend this market to sellers—a distinct lack of product being one of them. With an abundance of cheap capital and steady returns, net lease is fast becoming the vehicle of choice for private and institutional investors. Trends point to larger transactions as institutions are emboldened, moving outside their traditional investment landscapes and in some cases considering the real estate to be as important as the credit of the tenant. Still, the traditional net lease format remains the norm, with credit tenants and lease terms at the forefront of decision making—the proverbial kicking of the tires still a popular way to lend credibility and comfort to a transaction.
“The Phoenix net-lease market is as active as we’ve ever seen,” says Darren Pitts, executive vice president of Phoenix-based Velocity Retail. “The number of investors is overwhelming—we used to see a lot of 1031 trades.”
Pitts says over the past five or six years he’s seen larger institutions and REITs acquiring single-tenant retail spaces, although he says about 85% of net-leased properties are still privately held in the Phoenix market. And that, he says, points to a more efficient system. In the short term, he sees more competition, but the long-term outlook will appear more like the stock market.
“Net-lease is a safe vehicle with tax advantages,” says Pitts. “The returns are better than CDs or bonds and there is an element of safety in owning that hard asset.”
Pitts says there is a comfort in knowing the tenant—be it a drugstore or an auto body shop. Investors have information on the tenants at their fingertips and that makes the investor feel safe in placing their dollars. He says the $1- to $3-million market pace is a good number for individual investors.
“Phoenix is definitely a seller’s market,” says Pitts. “If a property goes to market, we’ll have several offers within weeks. The buyer market is as aggressive as I’ve seen it, putting downward pressure on cap rates. The demand is intense right now.”
Daniel Herrold, a senior director with Stan Johnson Co., finds the net lease market on the whole to be very aggressive. “Demand has risen and grown, there’s a limited amount of supply, and this is compressing cap rates,” says Tulsa-based Herrold.
From a private investor standpoint, Herrold says it’s easy to understand the attraction of net-lease properties. “We might see a group of doctors, for example, wanting to get out of active investment and into passive investment. They see a Walgreen’s with a 25-year lease. It’s something they know—a strong credit tenant. They can see the traffic on the street in front of the Walgreen’s; they know what goes on inside the Walgreen’s—it’s something they can get their hands around.”
Herrold says REITs are also a viable option for those without a sizable portfolio. He’s also calling the current state of net lease a seller’s market. “For every one dollar of product, there’s five dollars of demand,” says Herrold. “Sellers can hold out for cap rates that they want. And sellers are now defined as developers. I don’t see that changing—and that will keep cap rates low.”
Rob Bickel, managing director of capital markets for Jones Lang LaSalle, says he’s seeing “absolute record volume” in net-lease transactions this year.
“With cap rate compression, it’s an attractive buying market and an attractive debt market,” says Bickel. “It’s more of an exercise in capital preservation, relying on the credit of the tenants themselves. But the investors have to be comfortable with the locations as well. We’re talking about 5.5% to 7% returns on assets with a minimum term of 10 years.”
Bickel says that in the private equity capital market of $10 million and under, he’s seeing the most diversity and most aggressive pricing. He’s also quick to call a seller’s market with demand going through the roof. “There is incredible demand,” he says, “and a serious lack of supply. I think we’ll see strong third, fourth and even first and second quarters, with perhaps a slight rise in interest rates—then stability in the fourth quarter of next year.”
- P. Carey managing director Gino Sabatini says that in the United States right now, the net lease market remains uber competitive, with a search for yield maintaining a downward push in cap rates and low interest rates in the US. “The same is relatively true of other countries,” says Sabatini, whose company operates in 21 countries. “But the markets are thinner so there is a somewhat better yield.”
In the search for yield, Sabatini says he often sees investors coming out of money market accounts and into the net lease arena. Many of them find retail net lease to be the vehicle of choice.
“Retail is generally sold to investors nearby,” says Sabatini. “You have that Walgreen’s that everyone drives by and sees every day. Industrial tends to attract more of corporate market.”
On the supply side, he’s seeing a lot of leaseback activity and build-to-suits. “Astute CFOs are realizing they can lock in those low interest rates,” he says.
Sabatini also says WPC has expanded its view on what constitutes a good net lease proposition. Where the company used to mainly consider the credit of the tenant and the terms of the lease, it now takes the real estate itself more under consideration.
“We just did a $47-million deal in Boston,” he says. “There was just 11 years remaining on the term. But we liked the submarket. We usually want 15 years or greater on the lease and consider the credit of the tenant. In this case it was the love of the underlying real estate.”
David Kay, president of American Realty Capital Properties, says the net lease sector is robust across all property types. “We’ve seen a lot of granular, self-originated deals; it’s a good acquisition market,” he says. “Net lease is the most commonly held type of property today. The investment spreads are wide and cap rates are good, debt is cheap. Cap rates are averaging a solid 7.7%, which by historical measures is good.”
Kay says he won’t choose favorites when it comes to who has the upper hand, buyers or sellers. “There’s a willingness on both sides; it’s a good, stable market for both parties,” he says. Net lease is trending toward bigger, broader investors due to cheaper capital. “We’re going to see companies grow. We’ll see the deals get larger and larger.”
He points to ARCP’s recent Red Lobster transaction: a $1.5-billion direct sale-leaseback. “These larger transactions will cast a broader net across all property types,” Kay says. “Now we can allocate capital as we see fit. We are not beholden to one sector. We can direct our capital to where the best returns are. Twenty percent of our portfolio is in office, but we can expand in other areas for the best returns for the shareholders.”
Kay says he believes the market will remain similar in the near future. “I don’t see interest rates rising, but the market and economy can tend to be fairly volatile, globally. I still see a robust acquisitions market.”
Ed Hanley, president of Hanley Investment Group, also sees a very robust market. “This year is the most active in terms of the number of transactions,” he says. “As public and private investors struggle to find returns, they’re seeking that security. Net lease offers creditworthiness.”
Hanley says although private investors like a product that is easier to manage, institutional investors are seeking built-in rent increases that protect against inflation.
As far as who holds the upper hand? “It’s easy to say it’s a seller’s market,” Hanley says, “but the market offers something for buyers and sellers. Cap rates have dropped dramatically and supply is slowly increasing.”
One trend Hanley sees is larger and larger portfolios hitting the market. For example, a 25-property portfolio of Family Dollar stores sold individually or in groups hit the market recently. He also has seen an increasing supply of sale-leasebacks. Usually on an institutional level, these types of transactions have now trickled down to the open market.
Hanley has also seen an influx of foreign capital and more diverse product types. Past net lease transactions that dominated the market took the form of drugstores and fast food chains. Of late, he’s seen more interest in auto parts stores and convenience stores.
“One thing that’s new to the Southern California market is that we’re seeing California buyers leave the state in a search for these types of assets. They’re looking to the Midwest and the East Coast for higher return,” Hanley says.
Demand is high. “I do see more supply coming, but not enough to meet demand at this point,” he says. One trend Hanley sees is a majority of transactions occurring on an all cash basis. “It’s a testimony to the amount of capital out there and the ultra-low cap rates. Also, investors are more debt averse than ever. Lenders and borrowers are more conservative than in some points in history when it comes to placing debt.”
Shelby Pruett, chairman and CEO of Chicago-based Equity Global Management LLC, sees signs of significant acquisition velocity in the past several quarters. He says net lease industrial is landing larger deals as the institutional buyer camp takes individual buyers out of the market. “Retail is still seeing the majority of the smaller investors,” says Pruett. “Though REITs still tend to be retail focused.
“The interest in industrial has grown,” he adds. “The logistics supply chain is churning the distribution and it all ties in with e-commerce. For the port cities and cities near major distribution cities, we’re seeing a lot of activity—and the buildings are not only larger, they’re vertical, too.”
Pruett says the cap rate compression makes for a good time to be a seller. Though, he adds, there are plenty of opportunities on the buy side.
Some areas of risk Pruett points to are a potential rise in interest rates and a potentially large stock of obsolete industrial spaces—though those assets will eventually find their way to other uses. “It’s not a speculative market,” says Pruett. “Build-to-suits have helped control that.”
He points to a $2-trillion-plus market in which less than 10% is publicly owned. “It’s still a fragmented sector,” says Pruett. “But corporations are using the capital markets as a tool. Debt is inexpensive and we’re seeing them taking advantage of a lot of sale-leasebacks.”
In a recent GlobeSt.com article, Brad Richardson, associate director of Stan Johnson Co., says there are many factors to the Southwest market that lend itself to investors. According to Richardson, who is based in Scottsdale, AZ, the proximity to Californian investors and their capital is the primary driver.
“As is the case in most parts of the country the state of the market in Arizona and the Southwest could be described as a feeding frenzy with properties being sold at near record cap rates,” Richardson says. “The shortage of new net leased product along with a large buyer pool equipped with cheap debt has created a historic market for sellers. The large amount of institutional and exchange buyers focused on acquisitions in the Southwest have made it difficult to source deals. In most cases, deals are sold prior to hitting the market. The product hitting the market is typically second- or third-generation properties with shorter-term leases.”
Who holds the upper hand in this market? “Sellers hold the advantage in today’s market because of the significant difference between the supply and demand,” says Richardson. “It is a great time to be a seller as many properties are being sold at record cap rates and buyers are willing to accept very aggressive terms. The two main factors are the lack of new supply in the Southwest and large amount of buyers. The supply may not change in the near future as many retailers are still expanding at a fraction of the pace seen from 2004 to 2007. The large amount of buyers in the market is due primarily to the debt markets and the ability to get cheap financing. The 1031 exchange markets have been driven by sellers of multifamily properties where there are debt options in the 3% range. The debt markets also affects the ability for institutional investors to raise capital and place debt on properties after closing. Overall, if I was an owner of net leased property and not a long-term holder I would consider selling in today’s market.”