The credit crunch has had a profound chilling effect on investment for much of the retail real estate sector. When the crisis first began, players in the net lease market — where top-notch credit tenants pay most of the expenses associated with ownership — thought they might be spared. That belief stemmed from looking at the characteristics of the prime investors. One chunk of the industry includes 1031 exchangers that need to move cash from one property to another to avoid capital gains taxes. Meanwhile, all-cash buyers, who should be exempt from the vagaries in the capital markets, dominate much of the under-$5 million market.

In fact, that's not how things have played out. Net lease investors and brokers say that while the market held up alright over the summer, the second wave of problems that hit the market this fall have crippled the sector. “It was looking like it would be another good year until the summer,” says Randy Blank stein, president of the Boulder Group, a North brook, Ill.-based brokerage firm that specializes in net-leased retail properties. “Deal flow for net leases has dropped 30 percent to 40 percent for the second half of the year.”

The numbers don't yet bear out the problems that have beset the sector. According to Real Capital Analytics (RCA), during the third quarter of 2007 $1.4 billions' worth of single-tenant retail properties changed hands — an increase both over the second quarter figure of $1.3 billion and the $1.1 billion in deals during 2006's third quarter.

Those numbers are misleading, however, because RCA's statistics only include deals worth $5 million or more, missing the bulk of the net lease market. Boulder Group also tracks deal volume and pricing, but the firm last updated its numbers after the second quarter of 2007 and isn't planning on compiling third quarter figures.

The culprits, of course, have been the broader problems on Wall Street. “It's hard to overemphasize how much the current dislocation in the capital markets is having on the broader market,” says Paul McDowell, CEO of CapLease, a New York-based REIT that both finances and invests in net lease properties. “Although the net lease marketplace has some insulation because the credit of the tenants remains an attractive investment, the net lease market cannot be divorced from the broader trends.”

To understand what's going on with the net lease world, it's convenient to break the market into two segments dividing buyers into two groups: those that buy properties worth more than $5 million and those that invest in sites worth less.

Investors who purchase the larger, more expensive properties typically use debt while smaller buyers don't. To be sure, there are exceptions on both sides of the line, but the trend generally holds true. But what market pros have underestimated is the disproportionate weight leveraged buyers carried in pushing deal volume and pricing. “When it comes right down to it, there are not enough all-cash buyers to replace the leveraged buyers who were in the marketplace,” McDowell says.

For those buyers who employ debt, the credit crunch has been especially painful and has forced them to retreat to the sidelines or try to wrangle a lower price and higher cap rate from sellers because deals simply don't work at old prices given the new, higher cost of debt.

“I just talked to a guy today who said he was going to wait awhile and try to find a property with a higher cap rate and a lender that would offer better mortgage rates,” says Christian Marabella, president of Marabella Commercial Finance, a Carlsbad, Calif.-based mortgage banking firm that specializes in net lease properties.

Exchangers pull back

Compared to 12 months ago, the amount of 1031 exchange buyers in the market looking for net lease deals has dropped 25 percent to 40 percent, says Bernard Haddigan, managing director of Encino, Calif.-based Marcus & Millichap Real Estate Services National Retail Group. Part of the reason for the decrease is that apartment transactions are down in many areas of the country. Last year, many 1031 investors were exiting apartments and switching over to retail. But with volume on apartments down, fewer buyers are exploring the retail market.

And, remarkably, some 1031 exchangers — spooked by the market's uncertainty — are actually today opting to take the capital gains tax hit they've been postponing for years rather than enter a new exchange. “The types of investors that look for net lease assets are doing so because they like the stability — they like to know they'll be able to invest and maintain the pricing level,” says Russell Brenner, senior principal of Syndicated Equities. Experts estimate that as much as 25 percent of the 1031 market today is opting to pay the capital gains tax rather than enter into new transactions.

Jonathan Hipp, president and CEO of Reston, Va.-based Calkain Companies Inc., says he has $45 million in 1031 money that he's trying to place. But, he says, buyers are expecting higher cap rates. “People tell me that if they can't find the right deal, they're just going to pay taxes,” he says.

But even if 25 percent of potential 1031 exchangers are opting out, that still leaves a huge pool of buyers looking at net lease deals. Joe Caccamo, senior associate with Capital Pacific, a San Francisco-based brokerage firm, says he put six Applebee's restaurants on the market in late October and all the properties were under contract within three weeks.

For its part, CapLease, one of the few REITs playing in the net lease world, closed roughly $500 million in net lease transactions in 2007. But now it is opting to sit things out until the market settles. “We are watching and monitoring the markets carefully because we intend to hold our properties for a very long time, and we need to be very confident that we're buying at a good price and financing it at a reasonable level,” McDowell says. “We're not rushing in to catch the falling knife, and we'll reenter the market when the marketplace stabilizes.”

That patience is essential in the current climate. The diminished pool of buyers combined with the higher cost of debt means that investors aren't bidding as aggressively on the properties in the market, putting pressure on cap rates to rise and keeping properties on the market longer. “It feels like some deals aren't moving as quickly,” says Keith A. Sturm, principal of Upland Real Estate Group Inc., a Minneapolis, Minn.-based brokerage firm. “It has to do with sellers coming around to the reality that the market has changed.”

Gill Warner, senior director of Tulsa, Okla.-based net lease brokerage Stan Johnson Co., for example, had a $7.3 million Walgreens store in Missoula, Mont., on the market for six months before it went under contract. Granted, Missoula isn't a major market, but Walgreen Co.'s credit is considered the gold standard of net leases. Nonetheless, the store traded at a 6.3 percent cap rate when its seller was initially seeking a 6.1 percent cap rate. Still, a lot of sellers aren't yet willing to accept that reality, creating a disconnect that may take time to resolve. “Sellers have expectations of pricing from six to 12 months ago,” Haddigan says. “Meanwhile, buyers are sharpening their knives thinking they should be getting better deals.”

With pricing dislocation rampant and sellers largely unwilling to budge on their pricing, there's little incentive for all-cash buyers to jump into the market either. While they don't have to wade through higher spreads and more costly debt, they're also standing on the sidelines. As a result, for one-off transactions, cap rates have softened 20 to 40 basis points over the past six months. The cap rate spread, however, isn't consistent across credits or markets. “Most widening has occurred for non-credit tenants or properties in secondary and tertiary markets,” Hipp says.

On larger net lease transactions, cap rates have increased by an even greater amount. Jeff Fleisher, senior vice president of acquisitions for Spirit Finance Corp., has noticed an uptick in cap rates of 75 to 150 basis points in the wholesale market.

The credit crunch has also caused net lease investors to have a renewed focus on credit quality. But investors who are holding out for strong retail credits may be disappointed, according to Fred Berliner, senior vice president and director of acquisitions for United Trust Fund. The Miami-based firm did about $400 million in net lease acquisitions in 2007, but only 10 percent were retail. That's a big decrease from the 30 percent to 50 percent in previous years. “There just doesn't seem to be as big a supply of credit retailers because it seems that the creditworthy retailers have pulled back on their expansion,” he says.

Not only has there been a flight to quality for net lease retail, some experts say retail assets are less attractive than they were earlier [last] year. “Retail properties had reached a premium to the office and industrial properties, but that premium is disappearing now that the outlook for the retail sector is similar to office and industrial,” Blank stein says. “Cap rates are moving accordingly.”