Can Net Lease Keep Up the Pace?

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Real Estate Forum

Everybody and their uncle wanted to own a net-leased property in 2014, and for good reason. By nature, the asset class is low maintenance for owners, the properties are usually occupied by single tenants on very long-term leases, and the purchase prices tend to be lower than other asset classes like office and industrial.

But statistics show that returns on these properties continue to decline, creating challenges for investors. The Boulder Group, a boutique investment real estate firm specializing in single-tenant net-lease properties, reports that during fourth-quarter 2014, cap rates for net-leased retail properties remained at a historic low level for the third consecutive quarter, and 83% of active net-lease participants expect cap rates to remain unchanged or increase by the end of 2015. The sector is in so much demand that the overall supply of retail, office and industrial net-leased assets decreased by 6.5% from Q3 to Q4 2014.

Real Estate Forum spoke with several net lease industry experts to find out their position on net lease’s strength for the current year. All are still bullish on the category. “Net lease sales volume as of September 2014 reached $32.5 billion, originating from 32,000 transactions,” Adam Petriella, EVP at Coldwell Banker Commercial Alliance, tells Forum. “With expectations of strong demand and restricted supply, this steady pace will more than likely continue throughout the coming year. The real catalyst that has yet to surface is the irrefutable increase in interest rates and its effect on cap rate compression. As for the start of 2015, cap rate compression will almost certainly continue until other variables such as an uptick in development and an increase in the cost of capital have time to take their effect in the marketplace.”

Edward B. Hanley, president of Hanley Investment Group, tells Forum his firm anticipates continued popularity and demand for net-leased properties in 2015 nationwide, especially because of the volume of investors coming into the net-lease retail space from other product types via a 1031 exchange. “Because of the chatter about a potential change in the 1031 exchange tax code, property owners that want to take advantage of these tax benefits and current low interest rates should move into the net-lease space as soon as possible.” He adds that as owners identify their opportunities, net-lease transaction volume will increase this year.

Rick Chichester, president and CEO of Faris Lee Investments, concurs with Hanley that the pace of dealmaking in 2015 will continue to be robust and most likely outpace 2014 activity. “Not only can I base this statement on the increased amount of new capital coming into the market from traditional investment sources, but we will also see a rise in foreign private investment from areas such as Eastern Europe and Asia,” he tells Forum. “Even more significant is that funds have announced their intentions to invest a targeted $20 billion-plus in the single-tenant, triple-net-leased property segment. Where this was once a niche business, it has now evolved into a core investment category. Overall, net-lease investment will be a very strong market in 2015, with more capital than available supply.”

According to Gino Sabatini, managing director and co-head of global investments for W. P. Carey Inc., the ongoing search for yield should continue to draw investors to the net-lease market. “The prospects for positive economic growth in the US, combined with what appears to be a moderate approach to increasing interest rates by the Fed, will, we believe, result in additional market activity from both the buyer and seller standpoint as companies looking to expand and increase their physical facilities take advantage of the attractive financing environment.”

Gordon Whiting, managing director of Angelo, Gordon & Co., tells Forum he believes the pace during 2015 will be on par with what we saw last year. “Low interest rates will help keep cap rates low or perhaps even allow them to go lower, and the number of investors chasing yield that also has increasing cash flows over time will help keep the pace the same or even higher.”

Like his colleagues, Craig Tomlinson, senior director with Stan Johnson Co., says velocity in the net-lease space will be curtailed only by supply. “There is still excess demand across all subsectors of the single-tenant market. All available assets will clear the market quickly, and cash buyers will maintain the upper hand they have enjoyed for the past several years.”

 

Most Popular Net Lease Categories

Petriella says the net-lease market continues to be an attractive investment alternative for those looking for conservative long term growth. Unfortunately for investors, exceedingly limited supply has in turn created a fiercely competitive marketplace. “With several new players such as REITs and other high-net-worth investors entering the playing field, most investors are being forced to look to the secondary and tertiary markets for net-lease opportunities. For example, retail moguls CVS and Walgreens continue to be some of the most sought after assets due to their high credit rating and long-term leases, but the waiting list for potential buyers is only getting longer.”

Petriella adds that dollar stores are becoming the new center of attention due to their increasing supply across the US. “Currently, Dollar General operates 11,000 stores across 42 states and has plans to expand in the upcoming year. Other asset classes such as health clubs and big-box retail will also see a lot of action due to investors’ adjusted appetite for risk in this supply-driven environment.”

The single-tenant grocery-store category will be one of the strongest in net lease due to the recent mergers within the grocery sector, says Hanley, with his firm anticipating an uptrend in the number of transactions for this category across the West Coast. “We’ve seen the now-merged Albertson’s and Safeway divest 168 stores in eight states due to FTC regulations, which has opened a platform for other companies to grow in the grocer sector. For example, Haggen Food & Pharmacy, a Pacific Northwest retailer, is purchasing 146 of those stores across Washington, Oregon, California, Nevada and Arizona. This is positioning the company as a potential acquirer of additional West Coast chains and a major player seeking a greater scale.”

Hanley says his firm also anticipates that grocery stores in outlying areas (secondary and tertiary markets) across the nation will have increased transaction activity as tenants decide to offer sale-leasebacks to these new and growing grocery retailers like Haggen that may have less of an operating history in the area. “Additionally, discount stores will remain active as we’ve seen through 2014, and auto and fast-food net lease properties will remain opportunistic in varying markets and cycles.”

Chichester says he sees the dominant category in net lease as quick-service restaurants and fast-casual dining—the fastest growing segment of the restaurant industry—followed by pharmacies/drug, banks, grocers, home improvement, fitness, automotive and lastly, dollar stores. Meanwhile, Tomlinson says retail properties in the $5-million-and-under category have always been the largest market by deal count. “Look for mid-sized office and industrial assets to grow in volume this year, especially in the $5-million-to-$15-million range,” says Tomlinson. “These groups are a new breed of single-tenant investor that will not shy away from office buildings, and their lenders will accommodate them.”

All areas will see a lot of activity this year due to the demand for product, says Whiting. “Given the downside protection of owning the real estate and the built-in hedge against inflation you have due to rent increases—particularly if tied to CPI—I see strong demand for the product.”

Sabatini says his firm expects to continue to see attractive investment opportunities globally. “Because we are not driven by or limited to investing in any particular geography or sector, we focus on transactions that offer the most-attractive risk-adjusted returns, whether they be de novo sale leasebacks or existing net-leased assets. In 2014, many of our investments involved existing net-leased assets that we purchased, providing liquidity and an exit strategy for both developers and investors with shorter investment timeframes.”

 

What to Be Aware of When Investing in Net Lease

Due to mergers in the grocery-store realm causing new tenants to take over existing leases, Hanley says it’s important to know who the guarantor on the lease is, the operating clauses in the lease, landlord rights for the recapture of the space and reported sales for the location. “These are some of the most important pieces of information that we investigate and bring to the table when marketing a net-lease property. Investors need to be informed and comfortable with what they’re about to invest in.”

Chichester adds investors need to be disciplined in their underwriting and keenly aware of the real estate and tenant fundamentals because this property segment is so competitive. “This includes an in-depth understanding of the real estate location, creditworthiness of the tenant, lease rate, lease term, replacement cost, rent-to-sales and replacement-tenant options should the property become vacant. Of course, this is nothing new; however, in today’s competitive market, disciplined and comprehensive underwriting is even more important to making good risk-adjusted investments.”

Investors are generally attracted to the “lower-maintenance” indication behind net-lease investments due to the tenant being responsible for the majority of costs associated with the property, so it’s imperative for investors to make due diligence a priority when considering investing in this class, says Petriella. “For example, ensuring that the lease is a true triple-net lease ought to be the first thing on the list. There can be several instances where a lease may require the owner of the property to be accountable for roof repairs, building maintenance and other structural repairs that may hinder the investor’s forecasted return.”

As Chichester mentioned, the lease term is another essential item to look at when investing in this category, says Petriella. “The term of the lease is normally determined by the creditworthiness of the tenant. Generally, the better the credit, the longer the lease. Investors need to think about the ‘re-leaseability’ of the property in case the tenant vacates. This risk is associated with all single-tenant net-lease investors and a tolerance for this risk must be evaluated before a decision can be made.”

Sabatini points out that as attractive as all net-lease properties are, the fundamentals still count and should not be overlooked. “Are you buying the real estate at the right price relative to its physical replacement cost and relative to other properties in the market? Is the asset critical to the tenant’s business? If the property were to become vacant, could it be easily adapted to the needs of an alternative tenant or tenant? So, the first point is you have to buy the property right.”

The second point, Sabatini notes, which many people in the net-lease space tend to overlook, is having the capability to manage the property right. This means “having a strong asset-management team that maintains an ongoing relationship with the tenant, stays up to date on the market and is aware of opportunities to enhance the value of or expand a property on behalf of a tenant—or, in the case of a vacancy, is positioned to release or sell the asset at a price that maximizes value for the portfolio.”

For Tomlinson, it’s all about real estate. “For instance, don’t buy a concept retail unit that costs three times the market price for comparable in-line shop space. While it’s true that retail corners and outpad space sells at a premium, it’s usually not that much. Sometimes it’s easy to get lured in by a strong credit on a 10-year- plus lease. Those buyers may experience a hangover if they have to cut their rent in half to re-lease a building in an otherwise subpar location.”

Whiting says all leases are not created equal, so investors should make sure leases have all the protections a landlord should have. “For example, you do not want the tenant to have the ability to ‘go dark’— that is, be able to vacate the building but still pay rent—since that makes it harder to refinance out of mortgage if the tenant is not actually operating in your building and will also likely mean that will be one of the first leases that tenant rejects in the event of a bankruptcy. You also do not want cancellation clauses whereby the tenant can cancel the lease by making a termination payment, and you also want to make sure that you have longer-term leases (15 to 20 years).”

 

The Biggest Challenges to Net-Lease Success

Continued lack of supply remains one of the biggest challenges to success in net lease, the experts agree. “Investors have to have clear objectives when they’re searching for investments, learn about and understand the opportunities and be able to react fast in an active hunt for valuable properties,” says Hanley. “Once an investor understands its own investment parameters, we can help move quickly when the right opportunity presents itself.”

Pricing and discipline to underwrite appropriately against the investment risk in such a competitive market is another challenge, says Chichester, and Petriella adds that values have been driven up at an alarming rate due to the lack of supply and increased competition in the category. “More and more investors are willingly purchasing these properties at below-market cap rates, creating a shaky environment for potential investors. This is one of the biggest challenges to look out for in 2015. Investors need to weigh the risk vs. reward in this type of situation and consider the losses they may incur purchasing properties at such low cap rates. With interest rates remaining considerably low, the pursuit for considerable returns appears to be a daunting task.”

Sabatini says when certain markets get hot, one of the biggest challenges is to avoid overpaying. “This is where the fundamental analysis I described is critical. For sellers, one of the critical factors is dealing with buyers who have the capital and are able to close on a timely basis. The highest price is not always the best price. Some of our best opportunities have come where we were the runner up and the initial buyer drops out.”

Firms competing on lease structure and terms is another big challenge, according to Whiting. “That can lead to reduced asset quality and over time that can lead to problems that might never have happened if the leases were structured properly. I think that both the investment-grade and less-than investment-grade segments will have an excellent year.”