COVER STORY, SEPTEMBER 2010

NET LEASE RISING
Investors are taking notice of net lease properties.
Amy Bigley

As the economy begins to regain its footing, experts are continuing to analyze the ins and outs of the commercial real estate market for signs of improvement and growth. But they needn’t look much further than the triple-net lease market, which has seen dramatic improvement since 2009. Although the market is not at the peaks of 2006 and 2007, the single-tenant net lease market is on the upswing and gaining interest across the board from seasoned and novice investors alike.

“We had the best of the world in 2007 and a big shift to very, very challenging in 2008 and 2009, but in 2010 I think we’re back to ‘normal’,” says Jim Gibson, director with Stan Johnson Company’s Stafford, Texas, office.

Bob White, founder/president of New York-based Real Capital Analytics, expands on the market’s favorable climate, “Single-tenant or net-leased properties are in a very desirable bucket [for investors] where there is lots of equity capital, competition for assets and increasingly more debt liquidity.” When equity capital, competition and debt liquidity combine investors take notice.

Interest and demand is on the rise, which is a positive marker for the investment climate. Investors are being more cautious and fully vetting potential properties and investments before they commit. In order for a transaction to stand on its own in this market three pieces must come into play, according Jeff Hughes senior director with Stan Johnson’s Tulsa, Oklahoma, office. “We use an analogy of a three-legged stool that needs all legs to stand on its own — one leg is the credit of a tenant, the other leg is the lease term and quality of lease and the third leg is the underlying real estate value and potential,” he explains.

Flight to Quality

The refocused perspective has led to a flight to quality in all aspects of the net lease market. Investors are narrowing in on high-credit tenants, growth markets and the underlying residual value of a property.

As investors search for properties, credit ratings are taking center stage, with credit ratings affecting transactions now more so than at the peak of the marketplace, notes White. All major household names, such as Walgreens, CVS/pharmacy, Lowe’s Home Improvement Centers, FedEx and Best Buy have proven success, and continue to actively trade in the market. In addition to traditional retail names, White notes that there has also been an uptick in bank-leased properties, especially JPMorgan and HSBC.

“It continues to be the investment-grade, triple-B or better credit tenants,” explains Jonathan Hipp, president/CEO of Reston, Virginia-based Calkain Companies Inc. “If an investor buys a net lease they want predictability of cash flow and predictability of cash flow comes from a credit tenant.”

For desirable property, credit rating and long-term leases combine to achieve the best investment. “[Properties] with an investment-grade tenant will receive strong consideration from buyers, providing the lease term has 10 to 15 years remaining,” says Alan Pontius, senior vice president and managing director in Marcus & Millichap’s San Francisco office. “For lesser tenants, prospective buyers are closely scrutinizing rents and evaluating whether they will be achievable when re-tenanting.”

Another top priority for investors is location, which generally tightens in challenging markets. Major metropolitan markets continue to be the golden ticket for national and international investors, as the markets promise growth, property value increases and fewer challenges in re-tenanting. Investors gravitate toward familiarity and proven markets whether it’s the Sunbelt, California, New York or Chicago, notes Gibson. In the wake of the rush toward quality investments, many tertiary markets fall to the wayside, not because of a lack of quality investments, but due to a less proven track record and perceived less growth potential.

The Transactions

On the money and transaction side, cap rates are compressing and deals are getting done. A narrowing in the buy/sell gap and the build-up of equity is allowing transactions to flourish. Larger transactions are popping up across the country, which brings optimism to investors and industry experts.

Brandon Duff, associate director of Stan Johnson’s Chicago office, credits the recent drop in cap rates in part to the dynamics of supply and demand. “I think supply and demand has affected the cap rate market as the number of deals available has slowed down due to the stalled construction pipeline and tenant slowdown,” he says. “There’s less of a supply, which has pushed cap rates down, but it’s generally narrowed in the seller’s favor.”

Although cap rates are falling for assets in top-tier markets, the disparity between cap rates of top-, second- and third-tier markets and properties is widening due to the increasing popularity of top-tiered properties. “Buyer/seller disconnect is more apparent for lesser quality, Class B and C assets, and has prolonged marketing times,” explains Pontius. “Owners do not want to mark down prices and take a loss on equity, but prices paid during the market’s froth were based on lease rates that are no longer achievable.”

For investors, the financing and debt markets have opened in favor of new deals, which is making the market very competitive. “There was ready, willing and able equity culminating during the last couple years, but historically equity always needed to be complemented with decent debt terms,” explains Hughes. “Today, we’re seeing a more effective financing market, which is stimulating a lot more transactions.” The net lease market is still being bolstered by all-cash investors, which are able to act now and refinance later when the financial markets are more reliable and stable.

The Players

As one of the more conservative forms of real estate investments, net-lease properties are becoming an attractive alternative investment to a variety of investors. New investors are looking for higher yields than the stock market and bond markets are offering, which can be achieved with well-placed net-leased properties. Also, nontraditional real estate investors looking for secure investments are moving into the net lease market.

“Personally, I’ve seen a lot of people in the equity-preservation mindset versus trying to hit a homerun,” says Duff. “They’re saying ‘I have money and I want to preserve it’ instead of ‘I have money and I want to triple it.’”

The mix of net-lease regulars and novice investors is fairly evenly split, with new sources of capital ranging from institutional-quality clients, middle-tier private equity funds and individual investors. “New equity with an appetite for single tenant comes from the simple problem of an alternative investment question — Are we dying to go into the stock market today? Is the bond market particularly attractive? The answer is no,” says Hughes. “So allocations come to the commercial real estate market, but specifically the triple-net lease market, which is always considered a safe haven.”

For the traditional players, both private and public REITs are still the big buyers in the marketplace. According to White, the largest deal this year was Dividend Capital Total Realty Trust’s $1.3 billion net-lease portfolio purchase from iStar Financial Inc. The portfolio included 32 office and industrial properties located in 16 markets within the United States totaling approximately 11.3 million net rentable square feet.

Investors who have been timid about the market are emerging from the sidelines with culminated equity waiting to be deployed to carefully vetted investment properties. White explains that buyers are still being very circumspect about tenant quality, lease length and terms, and the tightness of contract covenants. The market continues to attract passive investors looking for a stable and reliable long-term investment. The demand for 1031 and 1033 exchanges  — once a large driver of the net lease industry — has been mixed across the country with upticks and declines specific to markets and product availability. Overall the exchange markets are stable, if not slightly increasing, but exchanges are driven by high profits, which are not widely available in the market right now.

The Future

The general consensus is that the net lease market will continue to rise in popularity and increase in strength, although industry experts have raised concerns.

The general lack of product from stalled development and retailer closings may pose a problem for future investors but it may make the market even more active today. “I think some people are thinking that the chance to get product today is going to be more advantageous than potentially next year, because there’s not going to be a lot of new product delivered,” explains Hipp. Specific markets may be more affected by a lack of product, as some cities and markets are experiencing a loosening of the development gridlock. Additionally, with a threat scarce product availability, property owners may re-enter the game in an effort to sell properties in a sellers’ market.

As the net lease market becomes more familiar to investors looking for alternative investments, a natural uptick is expected to occur in the market. The market is already seeing an increased interest for medical and healthcare properties, notes White. The driving perception for healthcare investments is that people will always need medical and healthcare services ensuring a stable, long-term investment for investors.

One obstacle on the horizon for net-lease properties is the Federal Accounting Standards Board’s proposed changes to the regulation of lease agreements, which would make obtaining long-term leases with tenants more difficult. Although, the upside is that the proposal, which will not be decided on until 2012, may cause an additional increase in net lease transactions for the next few years.

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