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Feature Article, January 2009
Triple-Net Leased Properties See Opportunity in 2009
There may be a silver lining for opportunistic buyers as sellers are forced to bring properties to market.
Randall Shearin
The market for triple-net leased, single-tenant properties, like the rest of the retail business, is having its woes. During 2008, market activity slowed as the year went on. The marketplace for 1031 exchange intermediaries and TIC sponsors has thinned as well, with the most notable milestones the unfortunate bankruptcies of LandAmerica and DBSI. However, the sales of triple-net properties did not slow as much as the sales of shopping center properties, according to brokers who are involved in both property types.
“There is a lot of apprehension in the marketplace,” says Jon Hipp, president of Calkain Companies in Reston, Virginia. “There is a disconnect between buyers and sellers. Anyone who is buying in this market is pretty sophisticated and has the ability to put down 50 percent or pay all cash. If someone is selling, they have a need to sell.”
“While nothing fundamentally has changed about who the sellers are, the buyers today are the few people who want to put their money in because the timing is right for them,” says Lori Schneider, senior vice president, investments, in Marcus & Millichap’s Fort Lauderdale office. “They are making offers at their comfort levels. We’re seeing a lot more astute buyers.”
“The marketplace is in the process of recalibrating and making a profound adjustment,” says Sean O’Shea with BRC Advisors in Los Angeles, whose company did about $80 million in transactions in 2008. “That will take some time. There is about a 100 or 150 basis point difference between what buyers want to pay and where sellers want to sell. We do see on a daily basis that this gap is beginning to close.”
The adjustment comes as markets use to trading at 5.5 cap rates become markets trading at a 9 cap rate.
“We predict the recession for the industry will last about 8 quarters,” says O’Shea. “During that time, a lot of really good people are going to fall by the wayside.”
Changing Market
To show how the market has moved over the last year, in June 2008 Calkain Companies put under contact a Walgreens in Virginia at a 6.375 percent cap rate, which closed in September 2008. In December 2008, Walgreens were selling from 6.75 to 7.25 percent cap rates. Says Hipp, “While you may see a Walgreens for sale today occasionally at a 6.5 percent cap rate, it is more common for you to see them on the market at cap rates of 7 percent or above.”
Rob James, managing director of Kimco Realty’s Kimco Exchange Place, also reports he’s seen pricing change at least 100 basis points over the last 12 to 18 months.
“There’s no doubt that prices have gone down and cap rates have increased,” says James. “The spread between what the seller wants and what the buyer wants to offer has closed. It did take a while for the sellers to react to the lower values of their properties, but we feel like they’ve gotten the message now. They are much more willing to take less for their building than they were 6 months ago.”
“There is no activity on the overpriced deals,” says Schneider. “It is very much in the seller’s hands how they want to react on deals that are otherwise marketable.”
What caused this change? Sellers are anticipating higher capital gains under the new Obama administration, so a number of sellers were motivated to get properties to closed by the end of 2008. A second factor, according to James, is that many sellers realize the bottom of the market hasn’t hit yet, so their properties may continue to lose value. Many are taking lower prices than they want because they believe that value will continue to decline.
Some owners, like AEI Fund Management, who buys net-leased properties via investment funds, are continuing to buy. The company’s funds purchased over $100 million in net leased properties in 2008.
“We only invested in very strong balance sheet tenants that are the leader in their respective vertical [market],” says George Rerat, vice president of acquisitions for St. Paul, Minnesota-based AEI Fund Management. “Throughout 2008, many investors sold out positions in stocks, bonds and oil. This investable cash is now in short-term cash and cash equivalent investments, earning close to a zero percent return. That money will start to look for yield, having been burned badly in both the stock and bond markets. We should see a return to a suggested 15 to 20 percent investment portfolio allocation to real estate.”
Miami-based United Trust Fund is another buyer who sees opportunity in this market. Because UTF is an all cash buyer, it is unaffected by the credit markets. The company specializes in sale-leasebacks with large corporations, including retailers. For UTF, the real estate comes first and the credit of the tenant comes second.
“It used to be that companies would come to us with all these terms; they would insist on a 7-year leaseback with flat rents,” says Paul Domb, asset manager at UTF. “Now, they just want to know how quickly we can close. It’s the polar opposite of how it used to be.”
Inventory
As you might expect, there are a lot of properties on the market. Most of the brokers SCB spoke to reported a backlog of properties; quite a change from a few years ago when we reported that a number of 1031 exchanges couldn’t be completed because traders couldn’t locate a property in time.
“A few years ago, you would see five buyers for every property,” says Gill Warner, senior director of Stan Johnson Company in Tulsa, Oklahoma. “Today, that’s reversed, and the buyers are looking carefully.”
“Activity has slowed, causing a backlog of inventory,” says Barry Silver, president of San Rafael, California-based The Silver Group. “There are more than 180 new Walgreens currently on the market. Cap rates hit their lowest point at the beginning of 2008 and have jumped above 7 percent. There are also scores of Advance Auto, Dollar General and Family Dollar deals on the market. Some sellers are being pressured to retire construction loans or add equity. Those unable to secure debt will become aggressive sellers.”
While inventory may be out there, bringing buyer and seller closer together may still be part of the problem. Looking to do a 1031 exchange in 2008, Paul Souza, principal of San Francisco-based Sansome Pacific Properties, Inc., looked at over 200 available net leased properties and came up empty handed at the end of the search.
“The basic fundamental intrinsics we need weren’t there,” he says. “We made offers on 10 properties and ended up not buying anything. We paid our taxes.”
Souza sees a flood of properties entering the market in 2009 as financially strapped developers are forced to sell properties in an environment with rising cap rates. For retail, especially, he sees a hard year ahead with financial pressures on consumers keeping them away from stores.
What is selling in the net leased market?
“Deals with a story,” says Hipp. “Properties that are fundamentally real estate plays and not credit plays. In a market like this, there is a flight to quality. Other properties that are selling include those that may have a B credit rating, but the rent is well below the market or the sales are high for the location.”
“It used to be we would package properties from the same seller into a portfolio to get a premium,” says Schneider. “Now, it’s quite the opposite: the smaller a deal is, the easier it is to get done.”
“Foreclosure, pre-foreclosure and other distressed properties are selling because they can be obtained for a fraction of their value,” says James Miller, vice president and Southwest regional manager for Investment Property Exchange Services, Inc., in Phoenix. “The buyers are purchasing with cash or huge amounts of equity down payment so they are less affected by the credit markets.”
All cash deals and deals that require small loans are what many brokers report selling.
“The majority of deals are in the $1 million to $2 million range,” says Warner. “Institutional deals greater than $5 million are virtually non-existent.”
Geographically, none of the brokers SCB spoke to saw much difference in activity between one part of the country versus another. However, nearly all pointed to the size of market as a differentiating factor in both deal pricing and popularity of properties.
“People pull away from tertiary markets in a time like this,” says Hipp. “That also goes for leasing today. If there is any leasing going on, it is happening in urban and high growth suburban markets.”
Most buyers are still looking to place a little debt into new acquisitions, which can complicate deals. Buyers are finding this debt with regional banks.
“Net leased property owners have suffered along with the owners of other commercial property when seeking debt,” says Silver. “If we can get some liquidity into the market, I believe we can work our way through this low point.”
1031 Market
1031 exchange buyers have been troubled by the economy as well. With lending more difficult to get, those doing 1031 exchanges have a more difficult time trading up to properties with higher values.
“We had a number of would-be 1031 buyers this year opt to pay their taxes because they didn’t like the way the economy was going or couldn’t get financing,” says O’Shea. “In the economy that we are in, with the psychology that exists today, nobody wants to buy anything right now. Sales will come from smart investors who see value in today’s market. Some sales will also come from investors who are buying for tax planning reasons rather than real estate reasons.”
“We see a lot of demand for 1031s,” says Hipp. “The reality is the pace of the market isn’t what it was. People are not just trading everything and moving up.”
Some intermediaries are even seeing buyers leave the table with deals they no longer see as advantageous. Stan Johnson Company’s Warner estimates that the number of 1031 buyers is down by about 75 percent in 2008.
“We are seeing deals where the buyers are walking away from substantial deposits they made a year ago and not buying the property, which is now being appraised 30 to 40 percent less than the year-old contract price,” says Marie Flavin, vice president and Northeast regional manager for Investment Property Exchange Services, Inc.
Kimco Realty, which sells triple-net properties for Kimco Realty Trust and other clients into the 1031 market through Kimco Exchange, has seen activity remain robust in its intermediary business.
“1031 buyers still have to buy something to avoid paying capital gains taxes,” says Rob James. “The market is busy with properties valued at $3 million or less. Once you get into the larger, institutional size deals, the buyer pool is thinning considerably. The institutional investors are on the sidelines. We are mainly seeing private individuals and wealthy families as our buyers right now.”
Kimco’s average deal size is $5 million. The company currently has 70 properties listed, the majority of which are triple-net ground leases and triple-net buildings like banks, grocery stores, drug stores and restaurants.
Schneider, of Marcus & Millichap, anticipates that multifamily apartment sales will be impacting the sale of single-tenant retail properties through 1031 exchanges. With financing more difficult for homebuyers, demand for apartment rentals is up, which creates more of a premium on apartment complexes. Sellers of these properties often opt for 1031 exchanges into less management intensive properties like triple-net lease, single-tenant retail properties.
“We may also see an up tick from investors who are looking for an alternative to the stock market,” says Schneider. “Even small shopping centers have also been increasingly difficult to underwrite, so there may be an increase in demand for single-tenant properties from buyers who would otherwise have purchased a multi-tenant shopping center.”
“Buyers are slowly starting to come back,” says IPX’s Miller. “However, there are a lot of people still sitting on the fence. When credit markets thaw, I think we will see a considerable amount of activity, quickly. At the present, most of the activity seems to be coming from investors or investor groups buying all property types at discounted values. This doesn’t translate into exchanges yet, but it is the first important step. Most of the exchanges we are seeing are from the clients we have been working with for a number of years and who are always in the real estate market to one extent or another doing deals.”
Some brokers see 2009 opening up new opportunities because of the number of distressed assets expected to hit the market.
“The last few years have been marked mostly by what we call the ‘good problem’ — high capital gains resulting from high sales prices in a seller’s market,” says Carl Christensen, managing director of Nashua, New Hampshire-based Net Lease Capital Advisors. “We think in 2009 we will be seeing more of what we call the ‘bad problem” — workouts and foreclosures that produce capital gains tax problems for sellers. It’s tough to watch. While it’s tough to see clients go through the pain in this part of the cycle, we are often able to help them with strategies addressing the tax problems resulting from forced sales.”
Buyers also see changes in 2009.
“I see a thaw happening in the second half of 2009,” says AEI’s Rerat. “Some buyers, like AEI, will continue to invest in high quality deals in early 2009. The future for transactions with little or no credit and poor cash flow is dark. Those deals will no longer be sold, except for land value.”
Some in the business see a silver lining in the clouds.
“At the end of the day, real estate is a hard asset,” says Hipp. “Good real estate will always trade in the market. With the amount of loans coming due over the next year, there will be a lot of property hitting the street. There’s also a lot of cash sitting on the sidelines with private owners as well as institutions. I’m cautiously optimistic that it could be a better market in 2009 than most people think.”
New Like-Kind Exchange Considerations
Many real estate investors utilize a provision under the Internal Revenue Code allowing for tax deferred “like-kind exchanges” of real property (known as Section 1031 exchanges). Under this arrangement, a property owner may sell business or investment property, and upon compliance with certain procedures, utilize the proceeds from that sale to acquire replacement real estate also used for business or investment purposes. By utilizing the Section 1031 procedure, a seller is able to defer the gain (and consequently, the income taxes) on the sale of the real property until a subsequent sale of the replacement property (at which time a further 1031 exchange may be available for further tax deferral).
Section 1031 exchanges are frequently carried out by purchasing replacement real estate in the form of an undivided tenancy-in-common (or TIC) interest in real property, where several owners separately hold undivided interests in a single parcel of property. In addition, partnerships and limited liability companies often combine the distribution of TIC interests with Section 1031 exchanges to maximize individualized tax planning. Although the IRS considers a number of specific factors in determining whether or not to recognized a particular transaction or ownership arrangement as valid for Section 1031 exchange purposes, there remains some ambiguity, and thus flexibility, in structuring these transactions. Further, the IRS, in the past, has not regularly scrutinized Section 1031 transactions. However, recent events may serve as a harbinger of changes to come.
The IRS has been working on a project to revise IRS Form 1065, which is the tax return filed by partnerships and other entities such as limited liability companies that are taxed as partnerships. Beginning with the 2008 tax year, the revised partnership tax form requires these entities to disclose certain Section 1031 and TIC transactions that were not required to be disclosed in the past. Specifically, the IRS has added, beginning for the 2008 tax year, two new line item disclosures relating to Section 1031 exchanges and TIC distributions as follows:
“13. Check this box if, during the current or prior tax year, the partnership distributed any property received in a like-kind exchange or contributed such property to another entity (including a disregarded entity).”
“14. At any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property?”
These new specific and conspicuous disclosure requirements insinuate the IRS’s intent to take a closer and more concentrated look at certain Section 1031 like-kind exchange activities. Such scrutiny may foreshadow coming IRS enforcement actions, a development that real estate investors in particular should carefully consider when structuring their Section 1031 exchange transactions.
William Quick is a shareholder with Polsinelli Shalton Flanigan Suelthaus PC specializing in commercial real estate finance. He may be reached at wquick@polsinelli.com.
Virginia Gross is a shareholder with Polsinelli Shalton Flanigan Suelthaus PC specializing in taxation. She may be reached at vgross@polsinelli.com. |
Continental Real Estate Opportunity Fund
While many developers continue to experience limited access to capital markets and other challenges stemming from a sluggish development market, Continental Real Estate Companies is looking to actively pursue quality investment opportunities with the unveiling of the new Continental Real Estate Opportunity Fund. The Fund expects to raise $150 million in equity from both private and institutional investors.
The name of the fund itself reflects the optimism with which Continental is approaching the marketplace, explains David Kass, Continental’s president of retail development.
“In today’s environment, with significantly higher equity requirements, we feel like we are well-positioned to identify and help bring to fruition those truly exceptional opportunities,” he says. Kass expects that Continental’s extensive retail background — the firm has executed over $2 billion in retail joint ventures and sales — makes it an attractive investment partner. “Our deal structures and pricing will be competitive, and reflect our intimate understanding of the retail marketplace.”
The Fund will be invested primarily in retail projects in the neighborhood of $50 to $100 million, and although the firm anticipates “sweet spot” investments of approximately $10 million to $20 million per project, Continental remains flexible and open to quality opportunities of all sizes. Continental has also identified key institutions for co-investment opportunities for promising projects that require higher amounts of equity. Targeted projects will include acquisition redevelopment, ground-up development, and mezzanine refinancing loans for existing, stabilized centers in need of capital.
Geographically, Continental plans to take an opportunistic approach that is very similar to the way in which the company structures its core development business. “We are not going to be strategic in terms of geography. We will focus primarily on finding sponsors we have confidence in and finding projects that we believe have real opportunity.”
And what will it take to gain that confidence? “A proven and successful track record for delivering quality projects.” According to Kass, Continental’s advantage over other equity providers is not only based in the Company’s extensive experience building and selling successful projects, but in its ability to leverage close connections and established retail relationships.”
“We expect to be able to add significant value in our role as an equity partner. We are happy to be a silent partner, but we will certainly be willing and able to accommodate if one of our investment partners wants to utilize some of our stronger relationships with retailers. We will also be available to facilitate any construction, leasing, or development assistance they might need. We can be much more than just money; we can play a role with developers that typical lenders and financial institutions cannot.”
The Continental Real Estate Opportunity Fund will be fully invested within four years of the Fund’s closing, and Continental is generally looking to structure deals with an expected 5- to 10-year ROI. The first half of the fund will close this winter at $75 million.
— Randall Shearin |
©2009 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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