Equity Returns to the Net Lease Market, Increasing Sales Volume

By Jeff Hughes, Stan Johnson Co.:
While the smaller, commodity type deals -- the Walgreens and CVS drug stores, the Best Buy stores and similar retail assets -- continue to trade quite well as they did during the downturn, we have recently noted a return of the structured transactions of larger office, industrial and medical real estate assets as well.

There seems to be no lack of conjecture these days that the net lease property market is showing signs of a pickup in sales transaction volume and a stabilization of cap rates. Anecdotally, Stan Johnson Co.’s team of net lease brokers is seeing a transaction market that is not only experiencing a very significant increase in activity level, but an increase that is across the board in terms of transaction type and size.

While the smaller, commodity type deals—the Walgreens and CVS drug stores, the Best Buy stores and similar retail assets—continue to trade quite well as they did during the downturn, we have recently noted a return of the structured transactions of larger office, industrial and medical real estate assets as well. In fact, we are assisting buyer clients in bidding on numerous large transactions, including sale-leasebacks, that are scheduled to close soon. These deals reflect a mix of property types—office and industrial as well as retail—and have been spurred on by favorable terms returning to the market. Likewise, we see evidence of a pick up in the build-to-suit market as well, with numerous high quality transactions bidding in the current market; following two years of little new construction, projects that were put on hold are now moving forward.

Anecdotes aside, recent market data is arguably the best indicator of an increasingly active equity side of the capital equation. With one exception, sales volume for the three main property types within the net lease market increased during the second quarter, on both a sequential and year-over-year basis.

By dollar amount, the biggest increase was in the single-tenant office sector, which saw $1.91 billion of properties trade hands during the second quarter, according to the most recent data from Real Capital Analytics Inc. That increased from $1.08 billion of sales during the first quarter 2010 and $780 million during second quarter 2009. Sales of single-tenant retail properties totaled $250 million in the second quarter, up from $160 million in the first quarter and up from $150 million during the second quarter of last year, according to RCA, which tracks sales of properties and portfolios of $5 million and greater. Meanwhile, single-tenant industrial sales totaled $500 million in the second quarter, a slight increase from the $480 million of the previous quarter but less than the $640 million of sales during the second quarter of 2009.

The kinds of buyers who are active in the net lease marketplace today is a diverse list. We believe it is likely to remain so, given that, generally speaking, allocations to real estate are holding their own if not growing a bit relative to historical norms.

One of the most active and visible groups of net lease buyers are the REITs, both those publicly traded as well as their non-traded and private counterparts. Given the great success REITs have had in raising equity (public REITs in particular have arguably had the greatest access to all types of capital during 2009 and 2010), it is no surprise to see them putting that capital to work. Likewise, private equity funds large and small have been actively raising equity and deploying it in real estate acquisitions, including net lease properties. In addition, the private investor universe of high-net-worth individuals and family offices continues to be a perennial force in the net lease market, and overseas investors remain a factor in the market today as well.

We attribute the increase in net lease sales activity to a few factors. One is improvement in the debt markets. While we’re still a far cry from the peak of the market when debt flowed freely, the fact is that debt terms have improved sufficiently enough that equity investors are now coming off the sidelines. After a two-year period during which debt financing was either at a gridlock or on such onerous terms that few were willing to accept them, lenders today have loosened their underwriting a little. Lenders aren’t just dipping their toes in to test the water, they are in the pool, and lenders with decent allocations to real estate are actively lending again.

Another factor is that equity investors—the borrowers—appear to have established a new reality. They are more accepting today than they were a year or two ago of the fact that they will need to put more cash in a deal (perhaps getting only a 60-65 percent loan-to-value ratio), so long as they can get decent terms and rate from the lender in exchange. And needless to say, interest rates are at incredibly low levels today.

In addition, we perceive that general fears of a worsening economy and real estate market have waned, and with good cause. Unlike a year or two ago, few people today worry that the economy might be in a freefall. It appears we’ve been bouncing along the bottom, and while the economy is certainly not going gangbusters—and not likely to anytime soon—there have been numerous indicators of incremental improvement. In the real estate world in particular, values have stabilized.

But make no mistake about it: The cliché “cautiously optimistic” holds true today. The pick up in activity that is taking shape is not a feeding frenzy of stupid money. It is money that is going into the net lease property marketplace cautiously, with more conservative underwriting, targeting a bull’s-eye that is smaller and more precise—with greater scrutiny of tenant credit, lease term and underlying real estate fundamentals.

As a result, prime deals are enjoying great competition among would-be buyers and commensurate cap rate compression. (And it’s worth noting that, with little new product built over the past two years, the inventory of quality net lease product will remain slim for some time to come.) Outside the bull’s-eye—secondary or tertiary markets, lesser credit quality, shorter remaining lease terms—a wide disparity in cap rates is evident. A prime deal might price at a low-7 percent cap rate today, but a deal outside of that bull’s-eye would likely sell in the 9s.

Let’s take by way of example a middle-of-the-road deal that trades at, say, an 8.25 percent cap rate. Given that you can borrow today in the mid-5s on that kind of a property, it’s easy to see that the spread between the cap rate and the borrowing rate is back to a historical norm. Because of that spread, equity investors are enjoying a healthy cash-on-cash return, making commercial real estate an especially attractive investment option today.

And given today’s investment alternatives—an uncertain stock market, a paltry 3 percent on 10-year Treasuries—it’s no wonder investors are increasingly looking to real estate, and in particular the predictable cash flow of net lease properties, for their investment dollars. Barring some sort of catastrophic event in the economy, we expect to see a continuation of the current state of the market, primarily characterized by a greater supply of equity than there is of quality product to purchase. And while the debt market is still in the process of improving, we are of the opinion that if the current reasonable debt terms remain a constant, let alone improve further, sales transaction velocity will continue to increase for the net lease marketplace.