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Feature Article, January 2007
The NNN Market: Back On An Even Keel
As compared to years past, the triple net leasing market was quite unpredictable in 2006. The market saw interest and cap rates rise and fall, though they eventually stabilized. Will 2007 be more of the same?
Lara Fuller
The past year proved to be a positive one for the triple net leasing market, though it didn’t start out that way. The early part of 2006 was greatly affected by interest rates, making it difficult to close deals. By the end of the year, however, the market was as busy as ever. Now, demand for property is high and the market looks like it is on track to remain active in 2007. Shopping Center Business recently spoke with a number of triple net leasing companies to get their take on the past year and provide an outlook on what to expect in the future.
Riding the Ups and Downs
Overall, the triple net leasing market was strong in 2006, though uncertainties in the economy created a few bumps along the way. By the time December rolled around, the market had stabilized and reached a balance. “2005 was pedal to the medal the entire year with huge demand and low rates,” says Bruce McDonald, president of Net Lease Capital. “2006 started out the same way, but then rates trended upward, making it more difficult to do deals in the first half of the year. The market then responded this summer as cap rates went up and freed up deal flow.”
Rob James, managing director with Kimco Realty Corporation, saw a similar situation with changing cap rates. “2006 saw an increased number of triple net leasing properties. Cap rates increased by 35 to 60 basis points. The rates have now stabilized and much of the product has been absorbed.”
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Retail and restaurant tenants are popular, in part, due to brand recognition.
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Though there were some ups and downs throughout the year, the market eventually found its balance, which had a great impact on both buyers and sellers. “It is still a seller’s market for the most part, but there is definitely more of an equilibrium,” says McDonald.
Michael Houge, owner and principal with Upland Real Estate Group, agrees. “There has been an availability of better product this year more than in the past. Buyer exuberance that abounded less than a year ago has died down, creating an equilibrium, which is positive for our market.”
For some companies, the new equilibrium and the increase in cap rates helped make 2006 one of the most productive years in recent memory. “United Trust Fund has never been busier and we have been doing sale-leasebacks for 35 years,” says Paul Domb, vice president of asset management with United Trust Fund. “We saw diversity in terms of credit and real estate as well as a 25 percent upsurge in activity from 2005.”
The Usual Suspects
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Retail remains the most popular property type in the triple net leasing market.
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Though the market changes from year to year, one thing remains relatively constant. Retail has been, and continues to be, the most popular type of property in the triple net leasing market. Everything from drugstores to gas stations to restaurants has remained a hot commodity.
“The most active tenants are restaurants such as Taco Bell, Burger King, Captain D’s, KFC, Wendy’s, Applebee’s, IHOP and Logan’s Roadhouse; auto-related businesses such as Jiffy Lube, Advance Auto, AutoZone, Tire Kingdom, Firestone and CSK; financial institutions such as Chase, Wells, WAMU and Bank of America; and of course drugstores such as Walgreens, RiteAid and CVS,” says Barry Silver, president and CEO with The Silver Group.
Retail products remain popular because it is the property type that buyers are most familiar with. People have experience with retail stores on a regular basis, whereas office and industrial properties are more unfamiliar. “Retail is always a darling,” says McDonald. “This is particularly true for smaller NNN buyers as people feel more comfortable. Office and industrial tends to be reserved for more sophisticated buyers.”
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KFC is an active triple net lease tenant.
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Jonathan Hipp, president and CEO of Calkain Realty Advisors, agrees. “Retail continues to be hot because people are familiar with brand names such as Walgreens, CVS and McDonald’s. People go with what they know.”
Adds Houge, “Retail tenants are typically the fastest growing segment for triple net lease because the sale/leaseback option offers them a way to expand their market share quickly, which is integral to growth, without owning all of their real estate. And, individual and institutional buyers can investigate these companies’ operations easily through online research and personal tours as patrons.”
Active Buyers and Sellers
For the most part, the most active buyers and sellers in the triple net leasing market tend to stay the same from year to year. Sellers tend to be concentrated to a few groups, such as REITs and institutional sellers, while buyers tend to run the gamut. Because of the popularity of 1031 exchanges and the use of real estate assets as an investment option, many of the buyers are individuals from all walks of life. Says James, “Buyers can range from anything from mom-and-pops to institutional buyers.”
Houge has a similar take. “The most active sellers of NNN leased properties are developers, retailers and franchises, as well as individual owners and REITS. Buyers are across the board from all over the country through investment and 1031 exchanges.”
“REITs and portfolio buyers are the most active sellers, along with preferred developers of other retail property,” says Silver. “On the west coast, the most active buyers continue to be investors trading out of multifamily product. Buying a more reliable stream of cash flow is very attractive.”
Darryl Steinhause, partner with Luce, Forward, Hamilton & Scripps, also sees many individual investors looking at NNN properties as a more stable investment. “The most active buyers are investors who are maturing and minimize their management activities at their properties,” he says.
Predictions
The past year proved that it is hard to predict just what interest rates and cap rates will do in regards to the triple net leasing market. However, most people in the triple net leasing industry believe that the market will stay relatively healthy and stable in 2007, though, as usual, much of that depends on the economy. “The net lease market for 2007 will be based on two factors,” says Steinhause. “The first is the overall real estate market and the second is any movement in interest rates.”
McDonald also recognizes the unpredictability of the market and the reliance on interest rates. “The coming year could be a tricky one,” he says. “It is an unusual time right now. It will really be a function of where interest rates go. Most likely, however, the market will be strong and healthy with a lot of supply and demand.”
“There will likely be a high demand for single tenant property for the foreseeable future due to the ease of ownership,” says Silver. “Unless we see a rapid spike in interest rates or another national security breach, 2007 should be similar to 2006. A factor could be the changing political balance in Washington, but we will just have to see.”
As long as rates remain relatively stable, the triple net leasing market will remain popular for the foreseeable future. “If rates stay where they do, there should be the same amount of activity,” says Hipp. “Real estate is a hard asset. People like owning something concrete. For example, even if a tenant vacates, the owner still has an asset. That is one reason why the triple net leasing market will continue to be popular.”
“In 2007, cap rate will most likely decline, making prices go up,” says James. “This class will continue to be popular in the near future.”
“As long as treasuries and interest rates remain stable, without many spikes or uncertainty, buyer and seller activity in the net lease property market will stay on track,” says Houge. “Cap rates should move up slightly, but not significantly. This, combined with steady interest rates, should keep the net lease market balanced for 2007.”
1031 INTO A TIC
A new product has emerged that is raising standards in the due diligence market. Barbara Halper, with partners Renee Brown, Joe Techar and Steve Fischer, have launched a new Web site that gives broker/dealers access to a comprehensive list of the current tenant-in-common (TIC) offerings in the market. This can aid securities’ professionals who assist buyers who are interested in TICs. Buyers only have a 45-day window in which to identify a replacement property under IRS code §1031. The new product, FactRight, might be the first step in the direction of an entirely new way for broker/dealers to do business.
“FactRight is another way for broker/dealers and reps to perform due diligence on the tenant-in-common offerings that are out there,” says Halper. “It gives them an opportunity to have a fairly comprehensive list of the TIC offerings in the market and compare them to see what is available.”
Convenience is an important part of the new site. The user-friendly Web site makes it simple to search specific categories to find what a client is looking for. “You log onto the Web site, www.FactRight.com, you search by whatever category you think your client may be interested in, whether it’s the sponsor, type of building, the location, and it pulls up a list of what is out there,” Halper says. “Then you can go and look to varying degrees of detail.”
“If you take the typical rep, a client comes in and says, ‘I’m in my 30th day, I need a replacement property, what’s out there?’ Now what they have to do is start wading through the books that are gathering dust in their office, start calling sponsors, and then they find out what offerings are out there. They have to start digesting the information and figuring out which property has what.”
Halper has worked as a due diligence officer for a large broker/dealer and understands the amount of time consumed performing this job. What used to take hours — wading through books, calling sponsors, etc. — now takes just a few minutes with a quick online search.
By offering access to the current TICs in the market, Barbara Halper and FactRight are saving 1031 buyers time, money and stress.
“We’ve been told by different professionals that this product really raises the bar on what is considered a reasonable standard of due diligence in the market.”
— Stephen O’Kane |
THE 1031 MARKET
The health of the 1031 exchange market and the triple net leasing market are closely linked as many involved in the 1031 market look to NNN assets as replacement properties. The 1031 market has remained steady for most of 2006 and is expected to do the same in 2007. Shopping Center Business recently spoke with Michael Howlett, partner and member of the real estate and construction group with Cherry, Bekaert & Holland; Michael Houge, owner and principal with Upland Real Estate Group; Barry Silver, president and CEO with The Silver Group; David Pawlowski, regional account manager with OREXCO 1031 Exchange; Paul Domb, vice president of asset management with United Trust Fund; Jonathan Hipp, president and CEO with Calkain Realty Advisors; and Darryl Steinhause, partner with Luce, Forward, Hamilton & Scripps, and to find out who’s buying what in the 1031 exchange market.
SCB: How healthy is the 1031 exchange market at the moment?
Howlett: We continue to see steady activity in the 1031 area. While the total number of transactions are down due to a slowing housing market, we continue to see the same level of interest in 1031 exchanges with clients who are selling real estate.
Houge: The 1031 market is vibrant and active, despite the slowdown from California that we have experienced over the past year. There is a steady flow of investors looking for many different property types to satisfy a 1031 exchange and defer capital gains tax.
Pawlowski: From a commercial real estate standpoint, 1031 activity is healthy. Residential activity has decreased along with the housing market.
Hipp: It is still really active. Small and big transactions are happening. Buyers are looking to place equity.
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Darryl Steinhause, Luce, Forward, Hamilton & Scripps
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Steinhause: The 1031 exchange market is still very healthy and continues to thrive. As the sale of real estate cools generally, there has been a slight slowdown in available 1031 dollars compared to past years. However, good properties continue to sell at a relatively fast pace.
SCB: Who are some of the most active buyers and sellers of 1031 exchange properties?
Howlett: There are two general types of sellers we are seeing. The first are real estate investment groups who are looking to change the mix of their portfolios, either in terms of age of the property, location or type of holding. The second are individual owners of residential rentals who are exchanging properties to utilize equity to move up-market into better properties. From the buyer side, we see a very diverse group of buyers of our client’s properties.
Houge: The most active buyers of exchange properties in our niche market of commercial net leased and TIC properties are individuals who have had their wealth realization event and are seeking a lifestyle change, including less (if any) management responsibilities, while still enjoying the benefits of real estate ownership. The most active sellers are large REITs and developers who are trying to keep a stable balance sheet by holding some property while also selling individual assets to 1031 buyers.
Silver: Several REITs and portfolio buyers are the most active sellers in the current market. They are able to acquire large portfolios at prices that allow for an arbitrage when selling to 1031 buyers. The spreads are getting thin, meaning the risk is elevated. If there are no major changes to the economy, interest rates and conflicts affecting our national security, the exchange market will continue at this pace into 2007.
Hipp: Mainly people trading out of assets. Many are selling properties such as multifamily in order to simplify.
Steinhause: The typical buyer looking for a replacement for section 1031 purposes has owned investment property that has significant appreciation. Many of these buyers have owned property in places like California where there have been high increases in property value. While any seller can utilize a 1031 buyer’s need to find replacement property, the most active pursuers of 1031 dollars are tenant-in-common sponsors.
SCB: In retail 1031 exchanges, what property type are you seeing most?
Howlett: On the retail side, we are seeing activity in the sale of small- to mid-size strip shopping centers, usually with a single grocery store anchor. We have also seen a fair amount of activity in the $10 million to $15 million office building price range.
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Michael Houge, Upland Real Estate Group
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Houge: Drugstores (Walgreens and CVS), automotive properties (AutoZone, Advance Auto Parts, Jiffy Lube) and many national restaurant chains are among the most popular property types on the market. Recently, there has been an influx of more office, medical and senior housing properties available to 1031 exchange buyers as well.
Silver: In the retail sector, there has been a continuous supply of corporate and franchised restaurants, drugstores, auto related facilities and ground leases.
Pawlowski: By far, shopping centers are the most frequent retail property type involved in exchanges.
Domb: We are seeing an unusually high volume of non-rated companies together with the usual CVS, Walgreens, etc.
Steinhause: Most of the retail business involves neighborhood shopping centers. Occasionally, we see some acquisitions of regional malls; however, these are not as active as in the past.
SCB: What are your predictions for the 1031 exchange market in 2007?
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Michael Howlett, Cherry, Bekaert & Holland
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Howlett: I believe 1031 exchanges will continue to be a primary tax deferral tool for sellers of real estate. With the slowing housing market, 1031 exchanges become easier. The lengthening of the number of days properties are on the market gives sellers more properties to choose from and will give them more time to locate property once they’ve made a decision to sell. It should also help with keeping sellers of a 1031 property from overpaying for their replacement property, which was a problem in a very hot real estate market when supply was light.
Houge: I think the 1031 exchange market will remain steady as even more real estate owners consider this option when considering the sale of an asset.
Silver: I see the market remaining healthy, with a buyer for every deal. Cap rates continue to be at record lows. Some buyers have voiced concerns about their ability to get out of these properties at some future date, believing that cap rates have got to increase over time.
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David Pawlowski, OREXCO 1031 Exchange.
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Pawlowski: We believe the market will slowly strengthen over the course of 2007 given that inflation remains in check.
Domb: A deterioration of credit quality, but still a robust market.
Hipp: Rates are coming back and the Fed will most likely ease rates even more. The market should be just as active.
Steinhause: I think that the 1031 exchange market will continue at the same pace in 2007 as it has in the last half of 2006, which is down from the past few years, but not a drastic slowdown.
— Interview by Lara Fuller |
©2007 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.
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