Net Lease May Wobble But It Always Remains Steady

Article originally posted on Globe St. on September 16, 2022

Despite some deal volatility, net lease is awash in capital and investor interest remains strong.

Capital has flooded the market over the course of the pandemic, with investors feverishly chasing net lease deals across all asset classes. And while the appetite for those transactions doesn’t appear to be waning anytime soon, investors appear to be adjusting their approach and taking a harder look at how long-term net lease deals will pencil.

“This is a very challenging market to predict 18 months out. There is uncertainty on where rates will settle, if we experience a recession and its severity, and the potential for near-term corporate earnings weakness,” said Mark West, senior managing director and co-leader of JLL’s Capital Markets net lease group. “We expect net-lease investors to be more cautious going forward and to make more defensive investments while avoiding less certain industries and tenants. Underwriting will be more measured and disciplined for both credit and residual value.”

West said JLL believes deal volume will increase as owners gain the perspective that pricing has reset from 2021 highs and as the debt market activity improves. He also expects sale-leaseback activity to increase “because it has become comparatively more attractive capital than in recent years.”

“Liquidity remains strong and there is a sense that capital will be more fluid post Labor Day,” West said. “Momentum should continue from there.”

According to research from The Boulder Group, cap rates in the single-tenant net lease sector hit historic lows for retail, office and industrial in the first quarter of 2022. Single-tenant cap rates compressed by 13 basis points for retail, by 10 bps for office, and by 17 bps for industrial, a phenomenon the firm’s analysts say is motivated by the “significant demand” for net lease properties across all three asset classes. Net lease deals saw record transaction volume in 2021, and that velocity continued apace in the first quarter, with deal flow up by more than 10% year-over-year.

But against that backdrop, supply for net lease product slumped by more than 5% in the first quarter of the year, with new construction further hampered by supply chain issues and delayed expansion plans by retailers. Cap rate compression was greater in the first quarter for new construction properties with credit tenants like AutoZone (20 basis points), CVS (15 bps) and Dollar General (10 bps), while the bid-ask spread for net lease product compressed by 2, 5, and 7 basis points, respectively, for the retail, office, and industrial sectors.

At GlobeSt’s Net Lease Spring conference in March, virtually every speaker spent time discussing their best strategies for protecting assets from volatility wrought by rising geopolitical tensions and inflationary pressures. Boulder Group Senior Vice President John Feeney noted then that interest rates and inflation began to concern investors toward the end of Q1, as the 10-Year Treasury yield rose by 70 basis points, leading net lease investors to target properties with fixed rental escalations over the term of their leases.

Rising interest rates are also playing a role in both the timing and structure of net lease deals. The Fed appears poised to implement more hawkish policies this year, with a series of rate hikes on the horizon.

“We’re watching interest rates,” said Gino Sabatini, managing director, W.P. Carey. “I think we’re getting some better traction than two years ago when many CFOs believed low interest rates were going to last forever. Clearly this movement has encouraged a few of them to do deals they weren’t doing in the past.”

Sabatini also noted that decision-making around longer-term debt is less cumbersome in the current interest rate environment. He said that rising interest rates could potentially be a positive for the supply of product in net lease, particularly in the sale-leaseback market, and could encourage corporate sellers to lock in long-term sale-leaseback financing instead of traditional debt. That will in turn increase sale-leaseback activity overall.

“Trying to get a CFO on board with the concept that it’s a good time to lock in a very long-term piece of debt like a sale-leaseback is easier in a rising rate environment, because all the other debt on their balance sheet is being impacted and they know they’ll need to refinance that,” he said.

BUT WHAT ABOUT CAP RATES?

Other experts suggest that the amount of capital flooding the market may continue to compress cap rates and delay any significant widening of spreads. And as demand continues to outweigh supply by a considerable amount, they expect cap rate expansion will be further tempered.

“Cap rates probably should have gone up a while ago,” Gordon Whiting, managing director at Angelo Gordon, said this spring. “Now that they’re finally starting to change, you don’t need to price gouge. A lot of people will take losses.”

But the correlation between interest rate increases and cap rate expansion isn’t immediate. Marcus & Millichap’s John Chang has said in the firm’s recent research offerings that he predicts rising interest rates are unlikely to push cap rates up this year, counter to what many investors may believe. While the interest rate on 10-year Treasuries has nearly tripled since the end of July, when it was at an all-time low near 50 basis points, rates remain near historical lows—and that’s a good sign for investors. Chang challenges the commonly-held investor beliefs that cap rates move with interest rates: “Historically, that’s not true,” he says. “Yes, over decades both have trended together. But when you look at year-to-year movement the spread narrows and expands.”

To wit: in 2007, the yield spread narrowed to just 200 bps, and then opened to 580 bps during the Great Financial Crisis, when interest rates went down and cap rates went up. As of March, the spread was 480 bps.

Chang posits that even if rates rise, they probably won’t push caps rate up—and says an argument could be made for downward pressure on cap rates for popular assets like industrial and multifamily and recovery types like senior housing and retail.

“I encourage every investor to set aside the idea that interest rates and cap rates will move together,” Chang said. “Focus instead on the outlook for each asset. What’s on the horizon for demand driers and supply risks? That combination can put the long-term context of an asset into a much better perspective.”

The Boulder Group’s Jimmy Goodman said cap rates for institutional quality net lease properties are expected to widen due to the new interest rate environment.

“It’s just a fact,” he says. But on the other hand, “a substantial amount of capital from funds and 1031 exchange investors that buy single-tenant assets will counteract that upward pressure,” he continues.  “It’s just a matter of buyers and sellers determining agreeable pricing.”

The sub-$10 million segment of buyers also tends to be less dominated by institutional investors, Goodman says. This segment is less impacted by cost of capital or interest rates, as a portion of private capital or 1031 exchange buyers use nominal or no debt in their acquisitions.

Goodman predicts that REITs will come in wider on cap rates in the future for deals exceeding $10 million in the near term. Properties in the sub-$5 million range will experience a slower change in cap rates as 1031 buyers don’t have the liberty to wait around for market conditions to change given their tax consequences.

W.P. Carey’s Sabatini noted that the firm invested a record $1.7 billion in 2021 and continues to have strong momentum this year with $1.1 billion in completed investments by the end of June. But “as an investor with nearly 50 years of experience in the market, I do think we benefit from a number of potential avenues of deal flow that some new entrants don’t have,” he said.

Other experts make clear that asset value matters when it comes to predicting how cap rates will move.

“We really think that on the most affected assets, cap rates will move 50 bps in the coming year, and for most assets we think there will be very nominal movement,” said Camille Renshaw, CEO and co-founder of B+E Net Lease. “The belief of our house is that anything over $100 million will probably have cap rate compression depending on quality, and also for the best assets. For everything else, it’ll be pretty stable.”

And for smaller deals, buyers are “very motivated,” she says, adding that B+E Net Lease has more than $1 billion in 1031 exchange needs right now.

“As we look at the $1 million to $7-8 million subset, where primarily exchangers are playing, they’re just not as impacted by the mortgage rates because they typically don’t take on as much debt,” she said. “Their ultimate IRR is just not as impacted. And it’s impossible to buy enough product.”

The flight to quality is also ongoing, Renshaw says, noting that the market is suffering “such a shortage” of quality assets.

“I’m not talking about added-value, risky credits, short-term leases,” she says. “We’re looking at 10- to 20-year leases with strong private credit or investment rate credit and for the most popular uses. That’s what everyone is in a slugfest for and we’re not seeing any movement away from those assets.”

SHORT-TERM DEALS ABOUND—WITH A CAVEAT

Since the beginning of the year, more institutional and private equity buyers are looking for net-lease deals with shorter terms—but experts agree that such deals are best for high-demand assets in prime locations. That includes the booming industrial and multifamily sectors, which can better withstand substantial rent increases and inflationary pressures.

Conversely, longer-term leases (think 20 years or more) are easier to finance and allows owners more time to recoup their investments. At GlobeSt’s Net Lease conference earlier this spring, CBRE’s Spencer Levy noted that many short-term net leases are trading at a premium vis-à-vis longer leases—but experts there agreed that fundamentals matter.

Key for investors: look at what the rent increases will be and whether the asset will be able to reset to market. Most successful short-term deals these days are in markets with significant rent appreciation. Experts also suggest that short-term net-lease deals may not be a good fit for secondary or tertiary markets. Shorter lease terms effectively increase the risk that owners won’t get a full return on investment during the lease term, and net lease assets essentially function as fixed-income products.

“If we have a deal in a secondary or tertiary market, we absolutely want a longer term to amortize out our basis and the credit of the tenant we’re underwriting is much more important than building in a better location,” said W.P. Carey’s Sabatini.

ALL EYES ON RETAIL

The retail sector continued to attract significant capital from all types of investor sources in 2022, from those dabbling in smaller transactions to private client capital and/or 1031 exchanges. But since the onset of the pandemic, there’s been a noticeable uptick in additional capital sources that are focused on net lease retail in particular, and those tend to be institutionally-focused, whether through foreign or domestic funds or REITs.

The Lockehouse Retail Group tracked $22.6 billion of deal activity in the US in 2021, a 21.5% uptick from 2020’s $18.6 billion. And that’s “despite the fact that there has increasingly been a shortage of quality properties available for sale,” said Garrick Brown, the firm’s director of advisory services and business development.

“For the past decade, despite retail disruptions, demand has remained strong for best-in-class fast food with drive-thru capabilities—Starbucks, McDonald’s, Chick Fil-A are among the gold standard credit tenants that drive the most demand and highest pricing—as well as grocery and drug stores, especially CVS and Walgreens,” Brown said. “But that demand has spiked across the board for single tenant net lease properties across the board, from dollar stores to automotive retail.”

As a result, Lockehouse is seeing properties that used to command pricing in the 5% cap rate range increasingly moving in the 4% range. And dollar stores, which typically traded in the 6% or 7% range prior to the pandemic, are averaging in the mid-5% range, according to Brown.

“The fact is that demand far surpasses supply and this is driving pricing up, and cap rates down. However, we still are not seeing the type of cap rate compression for gold standard net lease properties that we have seen in best-of-class industrial distribution or multifamily product,” he noted. “That said, for some of the net lease subtypes like dollar stores, these are record-low cap rates–especially considering that these properties usually lease on a much shorter term than fast food, drug or grocery stores.”

It’s a sentiment echoed by multiple sources, who note that the wash of new capital flooding net lease retail is running up against a supply imbalance.

“The pandemic exacerbated that supply demand imbalance between product and capital because of supply chains that were disrupted for both human capital as well as goods, i.e., construction, so that retailers and developers couldn’t build as many additional new units as their investment plans called for,” said Daniel M. Taub, SVP and national director of Marcus & Millichap’s Retail Division and Net Lease Division.

“That supply chain has yet to fully recover to pre-pandemic levels, thus continuing the imbalance between demand from capital and supply of product to meet investor needs or investor return parameters. That has created aggressive pricing and cap rate compression for certain retail net lease assets, both from private and institutional capital.”

Lockehouse’s Brown predicts that the supply-demand imbalance is likely to stick around through the remainder of the year, though “rising interest rates may start to slow the brakes on the trend by late in the year—especially if the Federal Reserve becomes much more aggressive in hiking rates (as they are expected to do),” he says.

INVESTORS ‘GENERALLY REMAINING DISCIPLINED’ IN CURRENT APPROACH

Going forward, experts look for the net lease sector to remain stable, despite the fevered competition for quality assets. Experts agree that investors should remain disciplined in their approach to ensure they’re getting appropriately risk-adjusted returns. They say inflation and interest rates may continue to impact pricing, but the exact implications of those factors may be best viewed as speculative in the current environment.

“Interest rates and inflation have tempered the level of froth in the market, but activity is still strong,” Sabatini said. “Investors are generally remaining disciplined in their approach and ensuring they are getting appropriate risk-adjusted returns in today’s market.”

For others, the pace of the market underscores the need for investors to have strong advisors on their team when they go out to bid.

“I don’t think the market is frothy,” Renshaw said. “Would I say it’s expensive? It is—but it’s a very thin margin to get the low risk we offer along with all the tax benefits. I think when you’re coming in right now, you have to have an advisor. Without one, you’re going to struggle to get the deal done and struggle to win. If you find a deal and you’re inexperienced, you’re not the only one who found it if it’s worth something. You have to know how to manage the acquisition process so you win the bid.”

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