Keeping Deals Moving
Volume was off in the triple-net transaction market by more than 50 percent in 2009. Still, say our experts, it is the bright spot in the retail transaction business.
Randall Shearin

2009 was a tough year for the single-tenant triple-net retail market. With 1031 activity down substantially, buyers entering the market were those looking for a deal. But there weren’t many deals to be had, say many experts, because long-term, solid investors were still paying market pricing for the good credit properties to hit the market.

Shopping Center Business spoke with a number of experts in the triple-net and 1031 exchange fields for this article.

1031 Slowdown

Lack of investment sales in every sector has caused the 1031 market to drastically slow down. For many years, one of the preferred properties on the downleg of 1031 exchanges was single-tenant triple-net retail properties. That market has not been immune to the slowdown in 1031s.

“With the market leveling off and declining, the exchange buyers have really slowed down considerably,” says Bernard Haddigan, senior vice president and managing director of retail for Marcus & Millichap. “This capital source that was motivated to leverage into net lease deals is largely gone. The market for triple-net retail properties today is largely driven by after tax cash.”

A number of 1031 exchanges this year have traded from retail to other interests, reports James Brennan, managing director of Reston, Virginia-based ES Group, one of two qualified intermediaries in the state of Virginia. A Dollar General store in Ohio that Marcus & Millichap sold for $400,000 was traded into an oil and gas royalty interest in Texas. There are still some exchanges being done into retail. Brennan cites a deal he is working on where a vacant office building, which sold for $5 million, is being traded into a Walgreens.

“Most of the deals trading have been below $5 million,” says Brennan. “Most of the exchangers are trading property that they have held for 10 years or more. They have had a low [cost] basis for that property and so they are still seeing gains in this market. When they sell, they are not taking on more than 50 percent debt on the new property. They tend to trade even, and if not leverage up.”

“We have done a fair amount of 1031s for people that had tenant-occupied buildings and the opportunity is right to execute a purchase and control their own real estate,” adds Jon Hipp, president and CEO of Reston, Virginia-based Calkain Companies, an investment broker of triple-net retail properties.

Similarly, for Nashua, New Hampshire-based Net Lease Capital Advisors, the slowdown in the market wasn’t due to property availability.

“Investment sales are way off,” says Bruce MacDonald, president of the company. “To generate a 1031, you need a sale first. It has been hard to sell. No one is really motivated to sell. For the most part, people do not want to sell unless they have to in this market.”

Another problem with 1031, says MacDonald, is financing for large amounts.

“People cannot finance the replacement property in many cases,” he says. “This isn’t the case with credit tenant lease properties, but with many others, it is.”

Many intermediaries — those qualified by the IRS to arrange 1031 exchanges — have left the business because volume is down. Brennan reports that the number has dropped from around 300 intermediaries in 2005 to 75 in 2009. In Virginia, the state legislature plans to enact the Exchange Facilitator Act that will regulate qualified intermediaries there. The legislation, says Brennan, is in response to the failures and scandals by two Virginia-based intermediaries, LandAmerica and 1031 Tax Group.

The 1031 exchange industry has seen smaller shops open doors in this recession as larger companies like title companies, wealth management firms and banks scale back their interests in the area. Additionally, individual investors would rather deal with someone they know than an institution.

“Bigger isn’t always better,” says Brennan. “Post Bernie Madoff, clients want to come to your office and deal with people that they know and trust rather than wire money over the Internet.”

Brennan reports volume in 1031 transactions is off by 70 percent compared to 2005 levels, and that commercial real estate is not the hottest sector to trade into. Where are his clients going? Oil and gas, coal interests, and program fleets.

Single Tenant Properties

While volume in the single-tenant triple-net lease market is slower, it is not as bad as transactional volume across the retail sector as a whole. Haddigan reports deal volume is off in retail north of 80 percent, as compared to the go-go years of 2005 and 2006. Within Marcus & Millichap’s triple net-lease business, volume is off 40 percent. Other companies reported transaction volume off between 60 percent to 80 percent.

“Relative to investment sales, the net lease business is the bright spot,” says Haddigan. “The market right now is fraught with risk and uncertainty. In triple-net, you have properties that are easily understood; easy to assess risk and forecast income stream. The deals are easier to get done.”

What types of deals are closing? Haddigan says deals that are either very safe, well located and quality credit; or those that are inexpensive and untenanted that have future potential.

“Everything in the middle is languishing because there is very little debt available,” he says.

Among tenants Marcus & Millichap sees trading are Walgreens and CVS/pharmacy. Walgreens are still trading between cap rates of 7.8 and 10 percent.

“What’s happening on a lot of non-investment grade single-tenant deals is the lenders are looking very carefully at replacement rents,” says Haddigan. “On an investment grade deal, like a CVS or Walgreens, it’s contract rent minus vacancies, reserves and management fees to get to get to a net operating income.”

“In a market like this, there is a wide gap between what is considered credit and what is non-credit,” adds Hipp.

Investors and lenders are also being much more cautious when it comes to the income of the properties now. As a result, ground leases are also highly coveted, says Haddigan.

“They are typically considered to be the lowest risk investment you can buy in real estate,” he says. “They also have low price points.”

Marcus & Millichap recently traded a McDonald’s ground lease at 6 percent cap rate.

Hipp, who arranges a lot of triple-net retail sales across the country, estimates that Calkain Companies will have completed 35 triple-net single tenant sales transactions by the end of 2009.

“The big trend we see is smaller transactions,” says Hipp. “None of them are over $10 million. Since October 2009, we’ve seen an increase in the number of 1031s, but they are still in the $6 million and under range. The regional banks who are doing the financing on these deals do not want to stretch over a few million for debt.”

For some, this market is a good time to acquire. Miami-based United Trust Fund has been acquiring a lot of high credit sale-leaseback properties in 2009.

“The market is such that a lot of companies are looking to monetize their real estate,” says Paul Domb, vice president of asset management for UTF. “What we’re seeing when we look for properties is substandard credits and, instead of packages, we’re seeing a lot of properties being sold as one-off deals.”

United Trust Fund has always negotiated directly with the credit owner; in the case of retail properties, the retailer. UTF has purchased a number of bank locations this year.

“We are looking at deals now that we may have passed on a year ago because of market conditions,” says Domb. “There are always companies who will do sale-leasebacks as a matter of business because the mandate is that they don’t want to own [property].”

Likewise, for St. Paul, Minnesota-based AEI Funds, who uses pools of investors’ money to purchase triple-net properties on a cash basis, it’s time to buy.

“Being an established all-cash buyer, we are seeing a very strong deal flow,” says George Rerat, vice president of acquisitions for AEI Funds. “There is an abundance of strong net-leased properties in today’s market to accommodate our investable funds. The true challenge is picking through what’s available and selecting the very best.”

AEI has been buying retail properties like Staples, Best Buy, Tractor Supply, Jared Jewelry and Petsmart.

“We have been following the vertical leader strategy for many years, only investing in the strongest, with the strongest balance sheets,” says Rerat. “It has paid off well for our investors over time; today our net-lease portfolio is 98 percent performing.”

Walnut Creek, California-based Presidio Realty Advisors is bringing back a popular program it had in place before the real estate boom called Net Zero, which concentrates on credit tenant net lease properties.

“The program really is appropriate for owners whose property is facing foreclosure or they need to sell it,” says David Waal, principal with Presidio Realty Advisors. “Our program will allow them to exchange into a triple-net property with anywhere from 88 percent to 94 percent financing. We are really underwriting the credit of the company versus the real estate.”

Many, like Presidio and UTF, are relying on the corporate credit, not the real estate, to get financing. That, says MacDonald, of Net Lease Capital Advisors, is the magic of the credit tenant net lease.

“If you have investment grade credit on a long-term lease, you can still get financing in this market,” he says.

When we reported on the market at the beginning of 2009, the market for triple-net retail properties had stalled because there was a disconnect between the pricing sellers wanted versus what buyers were willing to pay. While some of that remains, there has been somewhat of a meeting of the minds on some properties.

“Certain projects have been priced well and have sold,” says Barry Silver, president of San Rafael, California-based The Silver Group, a broker of triple-net retail properties. “Some projects are still over priced and sit [on the market] while others may not sell at any price due to lack of credit and no available debt.”

Uptick in 1033 Exchanges

While the 1031 market has slowed down, intermediaries and brokers have seen an increase in the demand for 1033 exchanges. Similar to a 1031 exchange, the 1033 exchange is an IRS ruling that allows those who have had their properties involuntarily converted — primarily through eminent domain — exchange the proceeds into like-kind properties. Thus the owner of a gas station whose property is converted to public use through eminent domain to build a highway, can use the proceeds to purchase another commercial property. Unlike a 1031 exchange, which provides a 45-day period to find the replacement property after the original property is sold, a 1033 exchange allows 2 years for a replacement property to be found. In some cases, owners have taken that entire timeline to find a replacement. Net Lease Capital Advisors, for instance, had a client for which it closed a $12 million 1033 exchange deal in May 2009 on the day before the time limit was to expire.

“In a 1033, another advantage is that you don’t need to match the debt and the equity,” says MacDonald. “Investing proceeds in an investment grade credit deal is a good solution.”

“We have done a fair amount of 1033 business this year,” says Hipp. His Washington, D.C.-area practice is benefiting from the expansion of the Metro system to Dulles Airport, which is converting a lot of private land to public use. 

Market Business

The single tenant triple-net retail property business still remains a business that has variables market-by-market. Some geographic areas are seeing more trades than others, and pricing varies between many markets. Washington, D.C., is one of the most vibrant markets for triple-net retail properties, according to Jon Hipp.

“We sell all over the country and we continue to get more aggressive pricing in the D.C. market than we do in some of the other markets,” he says.

Across all markets, buyers haven’t been too willing to adjust their parameters, meaning they are searching longer for the right property — if they are searching at all.

“We have spent the whole year providing market intelligence to assist buyers and sellers to recalibrate their expectations,” says Sean O’ Shea, managing director of Los Angeles-based BRC Advisors. “It has been tough on both parties to adjust to new underwriting standards and the lack of credit.”

Used to narrowing clients’ options from thousands of available properties, brokers are now waiting for a single property to show up that meets the client’s needs, which mainly revolve around its ability to borrow money. Even with tons of properties on the market, few will fit a buyer’s qualifications when there is no debt available and the margin for return on investment is smaller. In the case of a 1031 exchange, time may run out before that one property happens along.

“Some [clients] have waited fo cap rates that may be achievable in the future, but not in the current market based on the risk-adjusted premium,” says O’Shea. “Fear and uncertainty have been palpable.”

2010

Many of the brokers, owners and intermediaries we spoke to reported that there has been an uptick in the business in general beginning in October 2009, with one even reporting that lenders are getting more fluid with capital. Others report buyers starting to do a 1031 transaction, then opting to pay taxes and buy property.

“In the last 60 days, there has been a credible pent up surge of 1031 and 1033 transactions that have closed and required replacement solutions,” says O’Shea. “Nonetheless, many sellers are opting to pay the capital gains tax since they assume it may be predictably higher in the next year as the Senate Finance Committee and House Ways and Means Committee struggle to identify critical new revenue sources.”

Some feel that there will be opportunities to be had with some of the properties lingering on the market.

“There will be ongoing opportunities over the next few years, either due to underperforming assets, overleveraged assets, or loan maturities in the retail sector,” says O’Shea.

Many see that the options for investors will pick up over the next year.

“My opinion is that there will be a gradual increase in investment activity,” says Silver. “Capitalization rates have risen to levels that have attracted increased investment.”

“In 2010, the greater net lease market should start to show some signs of improvement as some debt begins to return and there becomes a footing under both store sales numbers and the real estate market,” adds Rerat.

©2010 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.