The already small number of publicly traded companies involved in commercial net lease financing got much smaller in 2001. As a result, companies that rely on this type of financing — such as retail chains — face a very different market.

However, while there are fewer net lease sources to choose from, those remaining companies should be a lot stronger.

In the most recent deal, Orlando-based Commercial Net Lease Realty Inc. agreed to acquire Ann-Arbor, Mich.-based Captec Net Lease Realty Inc. in a deal valued at $225 million. This followed a transaction earlier in the year in which GE Capital, General Electric Co.'s Danbury, Conn.-based financial arm, swallowed up Franchise Finance Corp. of America (FFCA), based in Scottsdale, Ariz., for $2.1 billion.

Driven by capital

Consolidation has left about a half dozen non-specialty REITs involved in commercial net lease — this at a time when this type of financing appeals to companies eager to monetize assets.

Net lease firms purchase real estate leased to national companies on a long-term, triple net basis (the tenant pays all of the ongoing operating expenses, property taxes, insurance premiums, maintenance, etc.). The financing mechanism has been very popular in retail, but has long since jumped to the industrial and office markets as well.

In a sense, the FFCA and Captec deals were done because both companies needed capital to expand. For the latter, the inability to raise capital was dire. “Captec was a small cap REIT and because of the fundamentals of the REIT industry in general, small cap REITs were unable to raise equity capital on an accretive basis,” says Ross Martin, Captec's chief financial officer. “We could not access capital on a basis that would have been advantageous to our shareholders.”

For Captec it was simply a matter of bad timing. The company went public in late 1997, only to see the once-rampaging REIT market nosedive the very next year as momentum investors moved from real estate to high tech. Meanwhile, Wall Street turned off the finance spigot. REITs, which were once able to finance expansion through sales of stock, found themselves shut out of that market.

Captec tried some joint ventures that focused on the acquisition of restaurant and retail properties, but the capital in those funds eventually dwindled as well and further capital was not being added.

“The net lease sector really needs capital to grow, because you do not get a lot of internal growth from leases,” says Martin. “The benefit of the net lease is that it is a stable, long-term stream of income. On the other hand it doesn't give you the opportunity to generate a lot of new income.”

Making the move

Captec considered a number of options, including going private, but as early as January it hired UBS Warburg LLC as its financial advisor in connection with a possible sale.

“There was surprisingly a lot of interest,” notes one industry insider. “Whereas Captec on a stand-alone basis was troublesome financing, CNL, now with over $1 billion in assets, will get better access to financing and have the ability to expand and consolidate more of the industry.”

What is happening in the REIT world, notes Gary Ralston, CNL's chief executive officer, is that “the rich are getting richer, while the poor are getting poorer. It's happening with banks, so why wouldn't you expect to see it happen in real estate?”

REITs are generally listed by asset class, so what one finds in, for example, the retail (non-mall) sector, is a small group of billion-dollar-plus companies representing almost 50% of the total valuation of the sector, a large heap of smaller companies and very few mid-tier players. This is the polarization that Ralston says the industry is experiencing. The commercial net lease sector was fairly tiny, about $3 billion in valuation (total REIT valuation as of the first quarter, $138 billion), and it too will be dominated by a couple of companies, in particular CNL and Realty Income Corp.

“As time goes on, you will see more consolidation,” speculates another source, “and then you will see a separation of the haves and have nots. As the haves continue to grow, they will get more of a following, more equity research and there will be more opportunities for them.”

A nice fit

On a corporate basis, CNL decided to buy Captec because of the nice fit between the portfolios. CNL's properties were dominated by such retailers as Eckerd, OfficeMax, Barnes & Noble and Best Buy, while Captec held a large proportion of restaurants.

“Captec's properties are very consistent with our focus on high quality, free-standing retail subject to long-term leases with major retail tenants,” notes Ralston.

When the merger is finally complete, CNL will end up with 377 properties in 40 states leased to 96 different retail concerns in 26 lines of trade.

The merger could give CNL a welcome boost, because as Scott Campbell, an equity analyst with Raymond James & Associates Inc. in St. Petersburg, Fla., notes, “the company had some performance issues over the last year and half.” Indeed, the company's FFO (funds from operations) last year dropped to $44 million, or $1.45 a share, compared to $46 million, or $1.51 a share the prior year. Things hadn't yet straightened out by the end of the first quarter as the company reported FFO of $10.9 million, or $0.36 per share, as compared to $11.32 million, or $0.37 a share, the same period the year before.

CNL was focused on the retail end of the property spectrum, reiterates Campbell. “With Captec being more restaurant-oriented, we look for CNL's portfolio to be roughly 80% retail and 20% restaurant. This helps the company from a diversification standpoint and hopefully it will open some doors as they build relationships with other tenants.”

Steve Bergsman is a Mesa, Ariz.-based writer.