Though retail sales are slowing down, the net lease finance industry continues to surge.

U.S. economists say it won't be long before the nation's recent boom corrects itself, putting an end to the free-spending consumer habits that drove retail development during the past few years. However, many net lease professionals remain unconcerned.

They believe their business ventures will continue to thrive in spite of any economic slowdown, due to an increasing number of corporations monetizing assets and retailers pursuing aggressive expansion plans.

"Regardless of where interest rates go in the months ahead, our business can only get better," says Paul Domb, an asset manager at United Trust Fund, a privately held firm that buys strictly for its own account. With no shareholders to keep happy or to demand dividend pay-outs, Domb says his firm has an optimistic outlook.

"Even an increase in interest rates as high as nine or 10% will not slow down net lease financing," Domb says. In his 15 years of experience, Domb has learned that increasing interest rates often serve as a prod to corporations and result in better business.

Others, such as Richard Kaplan, an expert in 1031 financing and president of Syndicated Equities Corp., Chicago, are convinced that interest rates are coming down. "The economic climate within the next year will keep interest rates lower," Kaplan says. "And anytime you can lock in long-term interest rates below 8% you should take advantage of the opportunity."

Still optimistic

Nashua, N.H.-based Net Lease Capital Advisers Inc. is on track to close more than $500 million in transactions for its clients this year, says company president Bruce McDonald. Approximately 60% or $300 million of that originates in the office and industrial sectors. That's up from 1999 when office/industrial deals came to about $80 million, or 27% of the firm's $300 million total volume.

"Unfortunately, the retail sector is viewed as being weak," says Jonathan Molin, president of U.S. Realty Advisors in New York. "However, the credit-tenant-lease market overall is so healthy that a great many deals are getting done." Molin's firm could be described as a buyer or wholesaler and, increasingly, as a long-term holder.

"We view the market as being `stable' for the foreseeable future," he says. "There are the same players with possibly a few new buyers seeking attractive, risk-profitable transactions."

Failures in the retail sector apparently haven't fazed those involved in net lease finance. As Molin pointed out, his firm and many others have become quite skilled at underlying real estate appraisals. "Even when large deals go belly-up," Molin says, "an accurately valued property will increase in value. Instead of holding an empty property, we view it as an opportunity to find another tenant - to provide a higher rate of return or to sell at a profit."

Off the balance sheet

Corporations in many industries are recognizing, and taking advantage of, the benefits of pushing real estate off their balance sheets and "monetizing" those assets, MacDonald says. "Why have $50 or $60 million tied up earning a rate of 8% when you can get that asset off your balance sheet and into your core business where you will make a greater financial return?"

As a result of competition in many industries as well as pressures from Wall Street to enhance performance, companies are likely to adopt the net lease concept even more in the future. "Each year net lease financing seems to be gaining wider acceptance," he adds.

The investor's perspective Net leases continue to attract investors because they are a secured corporate obligation based on the credit of the tenant or tenants. The obligation to pay the debt service comes from the rent and that is attractive to many lenders. If the tenant is viable, the rent gets paid. The downside, according to many experts, is if something happens and the lease is disaffirmed in bankruptcy.

Corporations are asking themselves whether they want to take a bet on interest rates in three, five or seven years or lock in rates now for 20 years.

It should also be noted, pooling net leases or mortgages from a diversified group of companies provides improved access to capital. U.S. economists believe there will be an increased demand for high-grade, fixed income securities in the future. This bodes well for the securitization of credit-tenant lease loans as an efficient capital channel.

REITs will continue to prefer office and industrial properties in the double-B to Triple-A credit rating range, according to a recent study by PriceWaterhouseCoopers L.L.P. However, according to the study, private investment firms will prefer office, retail, industrial, banks and restaurants, all either above or below investment grade.

More concerns

"I believe that, particularly in the retail sector, we may soon be reaching a development saturation point with competing stores on all four corners of intersections," Domb says.

Kaplan notes that, due to fears of overbuilding, lenders and investors might limit their exposure to drug store tenants. As more drug store chains scale back growth, investors could be left with empty buildings to re-tenant. However, the success of e-commerce could curb the number of brick-and-mortar shops on the drawing board.

There are concerns about net leasing that apply to the office and industrial sectors as well. While the general consensus seems to support the theory the net lease industry is growing, there are certain aspects to the waning technology "boom" that are raising concerns, notably the creditworthiness of many of those companies.

"Corporations will need capital for new infrastructure - technology, processes, facilities and the like," says Gary Ralston, president and chief operating officer of Orlando, Fla.-based Commercial Net Lease Realty Inc. Net lease opportunities in the future appear to be significant: Industry sources have estimated that corporations own $17 trillion in real estate.

Net lease properties are attractive to taxpayers seeking replacement properties and tax deferral under the "like-kind" exchange rules of Section 1031 of the tax law. Thus, Section 1031 exchange buyers are frequently part of the equity component of net lease properties. "We believe that there will be a rationalization of the 1031 exchange market. Commercial Net Lease expects to emerge as the change agent," Ralston says.

Sale-leasebacks are becoming more popular, according to C. Frederick Webba Sr., chairman of the Bentley Forbes Group. "We're seeing a lot of headquarters buildings and industrial properties being sold, mainly because of the good economy," Webba says. "They are redeploying the cash into their business to expand. I see that trend continuing."

Imagine this situation: A partnership is interested in capitalizing on the appreciated value of a New York office building. A straight sale, which was already moving forward, would garner a whopping $70 million.

However, the partnership acquired the property many years ago. The appreciated value and depreciation claimed meant a capital gains tax bill of almost $20 million. When the partnership realized the capital gains would pass directly to the partners and their personal tax bills, Net Lease Capital Advisors was invited into the transaction by the partnership's accountants.

Discussions beginning in September 2000 are expected to conclude by year's end. The property will be sold for $70 million. However, that previously punitive tax bite will be reduced by an estimated $15 million under this unique strategy: a Code Section 1031 "like-kind" exchange for so-called "credit-tenant" property financed with net lease financing.

The returns from the new, highly leveraged property, will pass through to the partners, effectively eliminating them from the benefits of capital gains. However, in addition to their basis in the comparably valued 1031 property, the partnership will receive earnings, admittedly fully-taxable, at current market rates.

Best of all, as Bruce MacDonald of Net Lease Capital Advisors points out, "although we didn't seek a private letter ruling from the IRS for our specific strategy, there are enough similarities in the existing rulings, in our opinion, to satisfy any future questions."

Even better, according to MacDonald, situations similar to this partnership and its office building would also be applicable to shopping centers.