FEATURE ARTICLE, MAY 2011

NET LEASE MID-YEAR UPDATE
The second half of 2011 should be a strong one for the net lease market as demand ramps up and cap rates move down.
Lara Fuller

While there is still a marked difference in the economic market of several years ago and today, many sectors are steadily on the rebound, particularly the net lease retail market. The uncertainty surrounding the investment market is decreasing as the expectation for solid returns increases. There is continued demand for everything from banks to drugstores to fast food restaurants, as both new and seasoned investors look for stable, secure assets.

“Demand for high-quality net lease product remains extremely strong,” says Joey Agree, president and chief operating officer of Agree Realty Corporation in Farmington Hills, Michigan. “Credit tenants, financeable leaseholds and assets in primary markets continue to see significant demand from prospective purchasers.

Adds Patricia Bennett, vice president with New York-based U.S. Realty Advisors, “The demand in the net lease area is undeniably strong and has been focused on long-term leases—those with greater than 10 years remaining lease term—and with credit-worthy tenants. Heavy buyer interest remains in core properties in the top 25 metropolitan statistical areas.”

Why The Boom In Activity?

There are a number of reasons that activity has been so robust in the net lease market. Net-leased properties offer built-in stability, are relatively secure and produce good yields for investors. These factors have helped keep the net lease market afloat as other real estate areas have struggled.

“Investors are increasingly considering the single-tenant net lease (STNL) retail market as an alternative to low-yielding CD’s and corporate bonds,” says Ken Shulman, partner with Capview Partners in Dallas. “A much larger investment community has realized that the safety, predictability and high occupancies of the STNL retail real estate market offer excellent risk-adjusted yields compared with many other real estate and non-real estate investments. This is especially true on an after-tax basis.”

Net Realty Advisors has also seen a larger number of clients looking for net lease properties. “So far this year, we’ve experienced a significant increase of demand from 1031 exchange buyers and buyers looking to buy new lease properties,” says Gavin Kam, president of Dallas-based Net Realty Advisors. “I expect that trend to continue as sales velocity picks up in other commercial real estate classes and those buyers transition into net lease. After experiencing the ups and downs of the past few years, a statement I hear often lately is, ‘I just want to put my money in something I don’t have to manage and that creates steady income.’”

The market current fundamentals are encouraging activity for both new and experienced investors. Compared with other fixed income classes, net lease properties offer good yields, especially as interest rates have dipped to historically low levels.

“Market activity is being driven by new sellers coming to market as cap rates continue to drop,” says Randy Blankstein, president of The Boulder Group in Northbrook, Illinois. “This is especially evident for core net lease assets, such as long-term leased investment-grade tenants in major metro areas.

Adds Agree, “Market activity continues to be driven by a combination of factors including yield-seeking investors, low interest rates, a greater availability of debt and the stability inherent in long-term net lease structures.”

According to Kam, the main drivers of net lease activity are an increase in liquidity and demand, coupled with a decrease in supply. “The lack of new development has created a shortage of net lease properties and is the main factor driving the cap rate compression,” he says. “In 2011, non-recourse financing has returned for long-term investment-grade credit, which is further fueling the demand.”

What Investors Want

Demand for a property is influenced by many things, including location, lease terms and the availability of financing. With little new development coming to market, demand for existing properties is strong.

This demand is driving market activity and encouraging investors to put out capital. “Buyers have raised equity war chests and need to put the money to work,” says Bennett. “Additionally, short-term interest rates have fueled acquisitions with cheap five-year money offering strong levered returns. However, this does create refinance risk as historically low interest rates begin to rise over the next five years.”

“The majority of the demand is for properties located in primary and secondary markets,” says Shulman. “When priced appropriately, there is high demand for everything from franchisee-operated quick service restaurants to Kohl’s department stores.” Last year, Capview Partners helped investors acquire a full range of properties that included banks, auto part stores, fast food restaurants, casual dining restaurants, wireless communication stores and dollar stores.

According to Tim Marshall, principal with TM1031 Exchange in Venice, California, even though there is high demand, the majority of buyers are still looking for a property with good real estate fundamentals. “Most buyers want properties in A locations,” he says.

Adds Kam, “Whether a buyer is looking for a long-term A credit or a shorter-term, value-added deal, the number one concern is whether or not they can replace the rent if the tenant leaves. As a result, buyers are very price sensitive in that they would rather buy a $4.5 million Walgreens than a $7 million Walgreens in a similar location.”

Change For The Second Half Of 2011?

The first half of 2011 got off to a relatively good start, with the market showing continued improvement. Investment sales volume is up over previous years and demand is high. There has also been significant cap rate compression on net leased properties over the last few months. It still remains to be seen whether decreasing cap rates signal long-term changes in the market or are just a short-term fluctuation. As for the remainder of 2011, interest rates will be one of the biggest factors in determining how the rest of the year plays out. Investors are watching to see what rates will do as the market changes.

“The second half of 2010 and the first quarter of 2011 have shown signs that the net lease market has rebounded significantly,” says Bennett. “CMBS shops are now competing for business and cap rates are creeping lower. The net lease market should move with interest rates over the next couple of quarters.”

Adds Marshall, “Since the beginning of the year, quality product has become scarcer and cap rates have compressed. There is more money chasing even less product.”

“The continued cap rate compression is due to increased demand along with diminished supply from limited new development and many existing properties never reaching the market due to continued credit and collateral issues between developers and lenders,” says Shulman. “Investment-grade properties are experiencing the greatest level of cap rate compression as investors seek more secure rental income backed by higher quality credit.”

Blankstein and Agree believe that the dropping cap rates will soon level off. “Since the start of the year, net lease cap rates have continued to compress, driven by an improved CMBS market, low interest rates and a lack of new development,” he says. “I believe that cap rate compression is close to reaching a plateau as an influx of new product is being brought to market to take advantage of the improved pricing fundamentals.”

“Although we continue to see cap rate compression in the STNL market, we believe that the rate of cap rate compression seen in 2010 will tail off as interest rates begin to rise,” says Agree. “Everyone will be watching interest rates very closely for the remainder of the year.”

As for the rest of the year, most expect the market to remain about the same. Interest rates might move upwards, but for the most part, the year will end in about the same state as it began.

“It is our opinion that the market will not change dramatically throughout the remainder of 2011,” says Shulman. “There is a steadily increasing demand from investors for new STNL retail properties. However, limited new development will result in continued low cap rates. Of course the lingering concern for many investors is the specter of inflation and higher interest rates. Interestingly, STNL retail cap rates and interest rates are not as closely correlated as one would imagine they would be. Cap rate levels are also impacted by the credit spreads charged on debt and the subsequent availability of credit.”

Most Growth In The Coming Year

As for areas that will have the most growth this year and next, corporate sale-leasebacks and 1031 exchanges are at the top of the list.

Sale-leasebacks are popular because they allow companies to free up money for other uses. “The sale-leaseback sector will begin to take off in 2011 because of the pent-up demand from corporations to monetize their assets to fund corporate expansion that was tabled during the downturn,” says Bennett.

Marshall agrees. “The sale-leaseback area will see the most growth in 2011,” he says.

Others predict that 1031 exchanges will attract the interest of more investors. And as the market improves, there are more properties available for exchange transactions. “The most growth in 2011 will come from high net-worth individuals in 1031 exchanges,” says Blankstein.

“1031 transitional activity will pick up in the coming months as redeployment of proceeds and replacement of yield again becomes important to sellers of net lease product,” says Agree. “The sale-leaseback market could pick up significant steam as well. We believe much of this will be dependent on the outcome of the proposed financial accounting standards board (FASB) accounting changes and retailers’ reactions to its possible implementation.”

Shulman believes that the most growth in STNL retail development will come from the fast food sector. “There are various capital resources that are forming to provide development capital more efficiently than how this sector has been financed in recent years,” says Capview. “There is built-up demand from franchisors for new units and there is significant long-term hold investor interest in the sector.”

Future Of The Net Lease Sector

The optimism prevalent in the companies’ outlooks and plans for 2011 and beyond is reflective of the positive changes in the market. The downturn of the real estate market caused many to put plans on hold, but now companies are revisiting growth strategies.

“Our firm is focused on acquiring over $200 million of long-term net leased assets across the country,” says Bennett. “We will focus on quality assets leased to strong tenants for a minimum of ten years.”

Agree Realty plans to launch a joint venture capital solutions program in order to help developers bring more projects to fruition. “We plan to continue to execute on our strategy of growth and diversification via development, acquisitions and joint venture of first-in-class tenants and superior underlying real estate fundamentals,” says Agree.

Capview Partners plans to stay focused on single-tenant net lease retail properties. “We intend to continue to expand our three core services of private equity investing, consulting and brokerage,” says Shulman. “2010 was a good year for us and it is our goal to double revenue in 2011. If we do this, it means we have done very well for our clients.”

“It has been an exciting year for Net Realty Advisors, having transacted 35 net lease sales in Texas,” says Kam. “Part of our success has been our embrace of social networking, leveraging the viral marketing opportunities and extending our reach. In 2011, we will continue to use social networking platforms, search engine optimization and partner websites to gain exposure for our clients.”

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