Headwinds Mount For Single-Tenant Net Lease

Article originally posted on Globe St. on September 15, 2022

Deal volume is up, but rising interest rates and surging capital costs pose headwinds for the sector.

Headwinds are mounting for the single-tenant net lease sector after a strong first half of 2022.

The STNL space saw a record $40.1 billion in investment sales in H1 2022, 12% above the same period in 2021 (also a previous record) — but research from Colliers shows that the pace of sales is slowing, with volume in the second quarter falling 35% from Q1 and 17% year-over-year. Deal count was also down 42% year-over-year in the second quarter.

“Rising interest rates have made transactions more challenging to complete, particularly for the private owner reliant on debt,” the Colliers report notes. “Predictable cash flow has been critical in the STNL space. While that is still the case, modest rent increases built into lease structures are less appealing to today’s investors, thanks to stubborn inflation. Likewise, the cost of debt has increased, so non-cash buyers are asking for price discounts that some owners are unwilling to accept. This dynamic has caused the market to show signs of peaking.”

The four-quarter moving volume clocked in at $108 billion, a slight decline from Q1’s record pace of $111 billion.

“While long-term leased assets are not as attractive as they were just a few quarters ago, this is likely a blip and not a sustainable market situation,” according to Colliers analysts. “Forecasts for inflation predict that today’s levels will ease in the quarters ahead, allowing the market to return to normal, albeit with higher interest rates than seen in 2021. Today, investors are focused on their ability to get to the lease roll quickly, particularly on the industrial side, where rent growth has been strong.

Analysts from JLL have noted some “real-time pricing discovery“ underway in the market, with deals repricing versus peak values as rate hikes mount.

“Investors are ‘stress-testing’ based on future rate increases and the potential for a recession,” the JLL report notes. Debt markets are also volatile and posting upward pricing pressure across assets.

For the industrial sector, investors appear focused on short-term leased or multi-tenant assets, a trends Colliers says will likely be temporary as investors acquire assets with negative leverage for a short time to acclimate to market conditions.  The sector saw record-breaking volume in the first half of the year, but the sales pace fell sharply in the second quarter and was off 32% over Q1. Colliers analysts also expect that volume will slow even more in the third quarter.  Cap rates have also showed signs of upward pressure and clocked in at 5.1% in the first half of the year.

“Industrial is in a unique situation. Fundamentals remain phenomenal with insatiable tenant demand and rising rents,” the Colliers report notes. “However, single-tenant transactions, particularly with term, are currently out of favor. Investors are interested in getting to the rent roll quickly.”

The office sector is slumping, with first half volume hitting $12 billion and second quarter volume down 50% over Q1. Deals in the first half were down 25% over 2021 and pricing continues to rise. Median cap rates were 5.9% for H1 2022.

“Given that the typical office lease structure has annual rent bumps well below current inflation levels, some investors are taking a wait-and-see approach. As a result, volume and overall deal activity have cooled,” the Colliers report notes. “Like industrial, long-term leased assets are temporarily out of favor, although we don’t expect this to last. As inflation eases, investor interest should rebound.”

Cross-border capital activity has “all but ceased” for office as well, accounting for just 1.7% of activity through Q2. REIT activity has fallen from 13% to 6.9% as well, bu institutional and private capital sources have been net buyers.

Retail was a “mixed bag,” with sales volume on track to match or exceed 2021 but volume in Q2 down 20% year over year and transactions down 50% in the same period.

“The average price per deal is up now that investors are targeting higher-quality assets and locations,” the Colliers report states. “Cap rates fell in the first half, with nearly all movement occurring in Q2. This is likely unsustainable, particularly for the top quartile of deals, which saw cap rates fall to 4.8%.”

Buyers for retail STNL were predominantly institutional and REITs, while cross-border and private investors have been net sellers.

“Investors are still attracted to STNL retail properties,” the report notes. “Pricing will likely adjust in the months ahead as a bid-ask spread has emerged across the broader marketplace. As inflation shows signs of easing, capital should pour into STNL assets again.”