Lack of supply and sustained demand in the sector pushes cap rates for top properties to record levels.
The single-tenant net leased retail market has seen a lot of change in the past 5 years. It is change for the better, say most executives in the sector, as sales transaction volumes have increased. The change most refer to is in the preferred retailer category. Five years ago, new, freestanding drugstores, bank properties and quick-service restaurants with top credit ratings were most frequently traded. Today, due to a slowdown in retail expansion and development, and a low interest rate environment, new properties from those retailers are hard to come by. When they are developed and sold, they set record cap rates. Most tend to sell to larger institutional investors who have deep pockets and require the yields the properties will pay. That has left individual and smaller investors searching for properties that have strong fundamentals and good performance history.
To get an update on the sector, Shopping Center Business spoke with a number of executives in the net lease sector. Among them were investment sales brokers, 1031 exchange specialists, and acquisitions specialists for investment funds and REITs.
Net lease has been, for several years, the most active sector for investment sales in retail real estate. Those active in the sector saw a slowdown in the market in 2009, but business gradually began to pick back up in 2010 as investors returned to real estate. Net lease became an obvious choice for many acquirers, since the majority of assets trade under $10 million, with most of the volume coming through transactions less than $5 million. At those prices, many investors were able to forego financing altogether and pay cash, allowing them easy entry into real estate assets that provide income with no management necessary.
"There has been a lot of money looking for yield," says Jason Fox, managing director with W.P. Carey. "With the uncertainty in the economy, there has been a flight to safety. There is safety and income in net lease real estate. We have seen more money enter the sector, which has driven yields down lower, especially so, given where interest rates are."
Financing has since returned to the market. Marcus & Millichap reports that debt is available for the sector through banks, life insurance companies and CMBS products. During the first half of 2012, reports Marcus & Millichap in its fourth quarter 2012 Net-Leased Outlook Research Report, CMBS accounted for 44 percent of single-tenant transactions, compared with 32 percent for all retail assets. National banks contributed to 21 percent of all single-tenant deals, followed by local and regional banks, which underwrote 14 percent of single-tenant loans during the first half of 2012. The report also states that life insurance companies financed 13 percent of single-tenant transactions.
"Financing is very deal specific," says Glen Kunofsky, senior director of Marcus & Millichap's net leased properties group. "On the best credit quality deals, depending on cap rate, borrowers can get up to 75 or 80 percent financing. If a deal has lesser credit and is in a tertiary market and the borrower is getting recourse financing, you can expect 50 to 60 percent loan-to-value."
Large acquirers like W. P. Carey and Cole have been diligent about creating strong relationships with brokers, retailers and merchant developers who supply them with a steady stream of properties. Both companies prefer to find deals that have been marketed to a limited audience, if at all. W. P. Carey has found a niche with retail net lease properties in Europe. It has been able to do sale-leasebacks there with strong retailers like Metro, Tesco and Agrokor that create good yields. The company looks for strong operators with a proven track record of sales in sectors that create consistent demand, like grocers.
"In retail, we look for critical operating assets," says Fox. "We like to get store level numbers and understand how profitable that store is. We also like to know where we are relative to replacement cost and what the market dynamics are in terms of growth prospects."
Cole Real Estate Investments, the country's largest buyer of single-tenant retail properties according to Real Capital Analytics, projected in December that it expected its 2012 volume of single-tenant retail to be $1.2 billion, including about $400 million in sale-leaseback transactions, according to Vice President Brian Garrigan. The company looks for high-quality, credit-rated tenants but has also bought properties leased to other retailers who fit its criteria for stable returns.
"While we remain focused on high-quality, credit rated tenants like Walmart, The Home Depot and Walgreens, there are a number of quality retailers that aren't rated but that have strong operations and financials that our underwriting team is comfortable with," says Garrigan. "These types of operators include Tractor Supply, LA Fitness and Hobby Lobby — strong businesses that are among the leaders in their industry sector."
Among Cole's purchases in 2012 was a portfolio that included 19 Stripes convenience stores in Texas and one Ranger store in Illinois that are operated by Susser. Cole also purchased a portfolio of 13 Benihana locations in a sale-leaseback transaction. The properties had new 20-year net leases with options.
The up-and-down pricing over the past few years in the real estate sector has enabled many larger, experienced players in the net lease industry to take advantage of the market. Many have been able to sell assets at high prices and buy at higher cap rates than many of the low cap rates seen in 2006-2007.
"Public and private REITs are right-sizing their portfolios," says Patrick Nutt, managing director at Calkain Companies. "They are making strategic selling decisions, and some of those are looking at what their overall exposure or risk is to specific tenants, credits and geographies. They are also capitalizing on some great purchasing decisions. In the slowdown of 2008-2009, they were the most active buyers. When cap rates shot up as prices came down, they were able to buy."
Looking for strong operators in healthy retail segments of retail is not just a method used by the big guys. Individual and smaller buyers are also looking for assets whose affordability is enhanced by location, lease term or lack of credit, despite strong performance.
"We have seen investors start to move down the location spectrum," says Ken Hedrick, senior director of investment sales at Stan Johnson Company. "If the retailer still has credit, investors are willing to go to tertiary markets. The appetite from buyers is so strong right now and there is a lack of properties on the market. Funds and individual investors are looking at assets that are single tenant but have shorter lease terms of 7 to 10 years. They are able to get a little bit higher yield, and the cap rates on the longer term leases have been pushed so low."
Moving to secondary and tertiary locations, as well as changing preferred retailers is a trend that continues from the recession as buyers weigh their risk in the market.
"Less risk is what most net lease investors are looking for today and they are willing to take a smaller return on their investment in return for taking on less risk," says Bill Wright, vice president of Mid-America Real Estate Corporation in Oakbrook Terrace, Illinois. "We expect this mindset to continue throughout 2013."
For some buyers, like San Francisco-based Sansome Pacific Properties, looking for net lease properties out of the norm has always been a strategy.
"We look for properties that don't necessarily fit in other people's boxes," says Partner Paul Souza "We are opportunistic. We are trying to get higher yields. To do that in today's market you need to take on greater challenges like shorter term leases, tougher credit, or quicker closes. These don't necessarily fit with other larger net lease buyers."
Sansome Pacific bought approximately $800 million in properties in 2012, including some sale leasebacks of corporate campuses. The company purchased a large note that had a number of single-tenant assets in it as collateral, and at the end of the year it had several portfolios of properties with shorter-term leases under contract.
Record prices — for recent years — were set for net leased assets in 2012. In May, Marcus & Millichap closed the sale for a 16,016-square-foot Walgreens store on the Las Vegas Strip to a foreign fund for $27.8 million. The sales price of $1,736 per square foot made the property the most valuable single-tenant drugstore ever to trade in the United States. In early December, Marcus & Millichap sold a two-story, 22,857-square-foot Walgreens on Collins Avenue in Miami Beach to an international investor for $30 million, a high for that market. In October, Hanley Investment Group Real Estate Advisors and Pacific Commercial Investments sold a new property net leased to McDonald's in Santa Ana, California, to a family trust from Southern California for $2.83 million, representing a record 4.25 percent cap rate. Hanley Investment Group sold a CVS/pharmacy in Fresno, California, in September at a 5.25 percent cap rate. At the time, the sale was the lowest cap rate for a CVS/pharmacy in the past 4 years. These deals are just a few of the samples SCB saw in 2012.
"The best properties in major MSAs with credit worthy tenants are trading at all time low cap rates," says Marcus & Millichap's Kunofsky. "Investors want to put their money somewhere that is safe. They want long-term leases and good real estate. Anything that falls into that category is trading at a super premium today."
Demand for A quality properties with top credit tenants in strong locations is driving cap rates lower and increasing the interest in such assets.
"Buyers seeking credit backed properties are competing for deals," says Barry Silver, president of Larkspur, California-based The Silver Group, a net lease investment sales brokerage. "We have seen cap rates on McDonald's ground leases drop 50 to 100 basis points in 2012 because of the increased demand. Walgreens and CVS cap rates are back down to their lows of 2005 to 2007."
"We think that cap rates are going to stay compressed through 2013 and maybe into 2014," says Sean O'Shea, managing director of The O'Shea Net Lease Advisory of Los Angeles-based BRC Advisors. "The debt rates seem to guide us in terms of what cap rates can be achieved for sellers. Part of our job for the past year has been saying to buyers, 'This is the new reality; you have to either adjust your return expectations or buy a good asset with a risk-adjusted return.'"
Among the hottest tenants in the net lease sector are the dollar stores like Dollar General and Family Dollar. Generally non-investment grade, the properties offer long term lease rates by retailers who have a strong track record. These properties also tend to be in suburban or rural locations. While they have location and credit against them, the real estate fundamentals, sales and corporations backing them are strong, making them fit the bill for many net lease investors.
"These retailers are among the highest cap rates in our universe," says Ann Natunewicz, senior director of research for Colliers. "Dollar stores are trading between cap rates of 7.7 percent and 8.3 percent, depending on the deal."
These trends are reflective in the cap rates seen in transactions during 2012.
"The best credit quality deals are trading at all time lows in cap rates," says Kunofsky. "The highest [quality] deals are trading in the 4's and low 5's with investment grade credits and long term leases in major markets. For investors to get a little more yield in the 6's and 7's, they have to be willing to go down the credit spectrum a little bit to non-investment grade or trade for lease term."
Kunofsky says that some investors may purchase a drug store with a higher yield, but it will have 14 years remaining on the lease instead of 20 years. Or, they will buy retailers backed with private equity versus investment-grade properties.
Eric Wohl, senior vice president with Irvine, California-based Hanley Investment Group Real Estate Advisors, continues to see strong demand for core single tenant net lease assets.
"Buyers are looking for strong credit behind the lease," he says. "They also want strong locations with good traffic counts. They like outparcels of major power centers and grocery-anchored centers so there is a strong draw to the property from those anchors. They like tenants that have low rent-to-sales ratios — strong sales coupled with a low rent — that is very attractive to a buyer, as are rental increases built into the leases."
Changes in The Market
Those active in the sector have seen a few trends appear over the past year or two.
First, larger deals are in demand. With supply constrained among top credit retailers who build net lease properties, those properties — or portfolios of those properties — sell for top dollar.
"In transactions of $25 million to $200 million, there is a size premium," says Kunofsky. "The more sizable deals are trading at lower returns because it moves the needle for the institutions who are buying. The REITs and larger buyers would rather focus on bigger deals. They will get more aggressive on pricing and cap rate if it is a sizable deal."
One other uptick in the market during 2012 was a return of 1031 exchange buyers. This is a good sign, says Ricky Novak, CEO of Atlanta-based Strategic 1031 Exchange Advisors, because it means that investors are creating gains by selling real estate assets.
"We have seen an increase in 1031 exchange activity from multifamily assets to single-tenant net lease retail properties," says Novak. "In 2011, these exchangers would be selling A quality multifamily properties and replacing them with single tenant net lease assets with strong national credit tenants. Now, we see them exchanging B and C quality multifamily properties into retail properties that are B quality retail assets with lower quality credit."
Novak says that 1031 exchange buyers today are a healthy mix. Many of clients his firm advises are wealthy families who have owned assets over a long period of time. They see now as an opportune time to sell because cap rates are low on multifamily properties and other property types offer more upside. Many are partnering with developers to create construction exchanges that result in the partial ownership of new assets in a tenant-in-common structure. Many of these multifamily owners like net leased retail as a replacement for multifamily, Novak says, because these properties provide the same cash flows — with fewer management hassles — than multifamily assets.
"A lot of times, clients were not even thinking of putting their property up for sale, then they get an offer at a cap rate that is 50 or 75 basis points less than what they would even imagine they would get," Novak says. "If I closed my eyes and told you what year it was based on the volume of exchange calls we are getting today, I would tell you that it is 2006. That is how busy the market is right now."
Another reason exchange activity has picked up is the benefit of timing. Many buyers who had sales in late 2012 are planning their sales as exchanges. If the exchange fails due to the fact that they did not find a replacement property in the 45-day window, they are able to elect to recognize the gain in the year the property was sold (2012) or the year in which the exchange was deemed to fail (2013).
"The benefit is if you sell at the end of 2012, and you don't find something you like in early 2013, you can elect to be taxed under the 2012 regime. That is highly likely to be a better tax liability than 2013," says Novak.
The current economic climate has also proven a good one for entering the sector. Atlanta-based Halpern Enterprises, a privately held shopping center owner, has launched a division to develop single-tenant net leased properties. The company has done build-to-suit development for a number of years around its own shopping centers, and now is looking to take that expertise and focus on finding sites for retailers and restaurants around the Southeast. It's a creative way for this company to grow its business.
"Our goal is to build and charge rents where tenants can make money," says Steve West, the company's vice president of development. "Everything we buy and build, we do so with the idea of holding it as a long term investment. We're in a position to offer good opportunities to all types of retailers, including small franchise owners who have a good concept and successful locations."
Another change to the market has been the increase in the power of fund buyers. With individual investors seeking shelter from the volatility of the stock market during the recessionary years, many parked their money in funds — like those run by Cole Real Estate Investments, American Realty Capital, W. P. Carey, AEI Funds and others — that boosted the reserves and buying power of these institutional investors. Additionally, some wealthy investors sought a combination approach of entering the market directly through property investment and indirectly via high net worth funds.
"Not long ago, individual investors needed about $1 million to get in the game," says Silver. "Now, private and public REITs focused on the single-tenant net leased property sector are attracting hundreds of millions of dollars from investors with $5,000 or $25,000 who can buy stock in a huge pool of diversified properties, and there's no sign of this letting up."
"Real estate as an asset class is finally coming to its full status," says O'Shea. "It is essentially an alternative to the bond market."
That, says Nutt, is creating a gap between supply and demand.
"We are drastically undersupplied and over-demanded for product," he says. "As you increase the number of buyers and the appetite from the institutional buyers, you don't have the national retailers expanding."
2013 And Beyond
Because of uncertainty with the presidential election and the tax events that it could bring, investment brokers saw a slowdown in transaction velocity during the third quarter of 2012, especially among individual investors.
"There was a reluctance from investors to jump into some of the lower quality assets," Natunewicz says. "If the tenant doesn't have credit and [lease] term, we are seeing buyers pull back. That is different than what we saw at the beginning of the year when cap rates were driven down on those less-than-perfect assets."
By the end of the fourth quarter, interest in those properties had returned. Brokers saw an influx of interest from buyers and sellers to the market after the presidential election. Unsure of tax implications after the new year, they began wanting to pare properties from their portfolios or acquire from those who wanted to do so. A 3.8 percent increase in tax on unearned income to cover Medicare costs took place January 1, 2013; regardless of the fiscal cliff and other possible tax concerns, many investors wanted to sell properties to avoid the additional tax.
"After the election, I had 30 deals pending where the client said they wanted to sell in 2012," says Kunofsky.
Likewise, Colliers International had an influx of activity during the fourth quarter from clients who were pushing properties to the market.
"The uncertainty in the market has driven a lot of the deal activity," says Natunewicz.
California-based Hanley Investment Group also saw a large volume of business in the fourth quarter.
"December is going to be at least what any other month was this year," says Wohl.
Many in the sector are predicting that an increase of supply may be on the way toward the end of 2013. Retailers began their pipelines for 2014 and beyond in mid-2012, and many are increasing store counts, predicting that the U.S. economy will be growing again.
"The development pipeline has started again with some tenants," says Kunofsky. "It is an 18-month to 2-year process to get a store built. [The pick-up in development] just started 12 to 15 months ago where tenants and developers are entering into new deals. In 2013, I'm hoping some of those deals cut 6 to 12 months ago will start to come to market."
Kunofsky's group has been trying to engineer pre-construction takeout deals, where a developer has the security of an institutional or private buyer purchasing the property as soon as the store is built.
"Developers, tenants and sellers are really pushing to get that product out to the market," says Kunofsky.
Wright, of Mid-America Real Estate Corporation, also sees a light at the end of the supply tunnel.
"We have experienced a significant lack of supply and pent up demand, which has resulted in very aggressive cap rates," he says. "As more new projects get built and taken to the market, we will see that imbalance begin to even out. That has the potential to slow and even halt the cap rate compression we experienced in 2012."
Buyers like Souza at Sansome Pacific also believe that 2013 will be a year that sees a lot of transactions.
"There is still a lot of money out there," he says. "Lenders have officially come back to the market and that just greases the skids. I think 2013 will be very robust from a transaction standpoint."
Cole has high prospects for the year as well, targeting up to $1.4 billion in single-tenant acquisitions.
"We continue to be excited about the prospects for retail," says Garrigan. "Overall, we are seeing job creation, and from a commercial real estate perspective, more jobs typically means more workers, more paychecks to fuel spending at shopping centers and more goods circulating through the nation's warehouses. These are positive factors entering 2013 that we believe will have a positive impact on the single-tenant retail market."
— Randall Shearin