The abundant supply of net lease properties for sale is doing little to spark investor enthusiasm. Net lease real estate sales dropped sharply in 2008 with even lower sales predicted for 2009.

A number of factors have stymied deal flow in a market where buyers are nervous about making a misstep as the economy and financial markets remain in crisis. The continued gap between bid and ask prices and a shakeout in the retail industry are creating a drag on sales activity, while the biggest stumbling block remains the lack of available financing.

In the fourth quarter of 2008, 2,411 net lease properties sold—a 63 percent decrease compared to the fourth quarter in 2007, according to a research report by Boulder Net Lease Funds, an investment firm in Northbrook, Ill. Retail properties represented 53 percent of those transactions with 1,277 individual sales.

Capital constraints are impeding investment sales as buyers struggle to find financing or instead opt to preserve capital amid the uncertain market conditions. “We’re still investing capital, but just at a slower rate right now until we see the capital markets open up again,” says Steve Horn, senior vice president of acquisitions for National Retail Properties (NYSE: NNN), an Orlando–based REIT that buys single-tenant retail properties.

National Retail Properties has issued guidance for a conservative target acquisition volume of just $60 million in 2009, well below the $355 million it spent in 2008 for 109 properties. “That’s not because the opportunities aren’t there. It’s because we are getting stricter on the underwriting side of things because we are uncertain as to where retail sales are going,” Horn says. “We have always been conservative, but even that much more scrutiny is going into the deal. So it is tougher to close on a property in today’s environment.”

Even though sales volume is down, there are a number of opportunistic buyers combing the market as competition wanes and cap rates rise. “If you’re a buyer and liquid, there are some excellent buys out there,” says Christian Marabella, president of Marabella Commercial Finance, a Carlsbad, Calif.–based firm that specializes in arranging financing for 1031 exchange commercial investment properties.

Surplus inventory
Buyers are able to shop from a wide variety of properties. While retailer expansion has indeed slowed, there are still a number of projects in the pipeline boosting supply. “Inventory levels are continuing to go up because there is not enough velocity to take deals off the market,” says Daniel Herrold, regional director for the Houston office of the Stan Johnson Co., a commercial real estate brokerage firm specializing in net lease property sales.

Of the 20,918 net lease offerings Boulder is tracking, 11,388 are retail, 5,994 are office and 3,536 are industrial. Retail properties on the market run the gamut from an American Lubefast in Montgomery, Ala., listed at a 10 percent cap rate to a Walgreens in Valdosta, Ga., offered at a 6.5 percent cap.

Despite an abundance of listings, there are not a lot of “fresh” properties coming on-line. Rather than put properties up for sale in a soft market, owners have chosen to hold onto them. In the fourth quarter, 34 percent of the total assets available were new to the market compared to a historical quarterly average of 43 percent being new, Boulder reports.

Prices slow to adjust
A deterrent to transactions being completed is sellers’ reluctance to reduce their prices. Buyers are experiencing a disconnect between what they see as overinflated prices for properties amid deteriorating market conditions. Still reeling from a dismal 2008 holiday season and the downturn in consumer confidence, the ICSC forecasts same-store sales could be negative through June of this year after the first negative holiday shopping season on record. “I think retail is the worst of the three sectors, at the moment, in terms of fundamentals—store closings, consumer spending, et cetera,” says Randy Blankstein, president of Boulder Net Lease Funds.

Many prospective buyers say retail properties are still priced too high in this environment. Retail cap rates have started to inch up and are likely to continue as the year progresses. “I think there is going to be a big movement in retail cap rates this year, and I see them ending the year higher than office and industrial,” Blankstein says. Retail cap rates are expected to increase at least 50 basis points for quality properties and upwards of 150 basis points for properties of lesser quality. Net lease retail properties posted average cap rates of 7.5 percent during the fourth quarter, which were lower than office at 7.7 percent and industrial at 8.0 percent, according to Boulder.

“Pricing has shifted a little bit, but not enough to spark deal flow,” Horn says. “Sellers haven’t completely come full circle to realize how bad it is out there.”

There are some better prices to be found among developers who are trying to get out of deals, he adds; although some sellers are still stuck on 2006 prices.

Even “A” credit retailers like Walgreens are not immune to the pricing shift. A year ago, Walgreens stores were selling at cap rates of 6.25 percent regardless of their location. Today, those Walgreens are closing at cap rates of 7.25 percent and even 7.5 percent, notes Herrold.

“Those cap rates continue to move up simply because there is a growing supply of inventory and buyers can be picky and choose the premier locations.” Herrold estimates there are between 200 and 250 Walgreens for sale compared to less than 100 in mid-2007.

Quality vs. opportunity
The net lease properties that are trading are split into two categories and are at opposite ends of the spectrum. On the one end are opportunistic buyers chasing stressed properties or those in which the owner is being forced to sell at a discount. On the opposite end are those investors seeking “A” quality properties in top-tier locations. Few of the “middle market” properties are trading, in large part because their prices haven’t dropped enough to spark investor interest.

The flight to quality is not a surprise in this volatile market. Buyers are targeting high-credit tenants in major metro areas and retailers who sell necessities such as groceries and gas. “We always like the convenience store industry,” says Horn. “That is one industry that has not been significantly impacted by the economic downturn.” National Retail Properties closed on the purchase of several Stripes convenience stores in Houston and Lubbock, Texas, in December. National Retail Properties also likes solid- performing quick service restaurants like Taco Bell.

Buyers are also scouring the market for distressed properties that could be potential bargains. “We think there are going to be some great opportunities later in the year. But the ability to take advantage of those opportunities is going to be tougher than what people think, because it is going to be harder to raise capital,” says Jon McClure, principal at Chesapeake Cos., a Minnetonka, Minn.–based developer of net lease properties.

Franchise leased properties are examples of properties that are very difficult to underwrite in the present market. “We could do about as many franchise deals as we wanted right now, because there is a lot of demand from franchise operators, says McClure. “The ultimate question is—are they bankable?”

The biggest and best franchise groups with a great track record and solid brand, such as McDonald’s, will continue to find financing. It is the smaller, less established franchise groups and individual franchisees that are struggling to get deals done in the current market environment.

Caution is one thing all net lease investors have in common. In the past, net lease buyers would commit to deals based largely on the credit quality of the tenant. That is not the case anymore. Buyers are scrutinizing the real estate fundamentals, property and market conditions and neighboring vacancies, not to mention the surrounding tenant mix and demographic patterns.
Developers, in particular, are careful in their underwriting of deals. For example, Chesapeake is working on a 24,000-square-foot development in Waterford, Conn., that is 94 percent pre-leased. The short list of prospective tenants are best-in-class, national brand operators. In the past, Chesapeake has done deals with names such as Darden Restaurants, Buffalo Wild Wings and Jared the Galleria of Jewelry. “We have to be cautious to make sure we are picking someone that is going to be there at the end of this froth,” says McClure. “There are not going to be a lot of deals that make sense.”

Opportunities in the market will continue to emerge as cap rates rise. The question remains whether those opportunities will be enough to bolster sluggish sales. A recovery in both the economy and capital markets may be the only key to restoring investor confidence, and many industry experts don’t expect an improvement this year.

“I think 2009 is going to be very similar to the second half of 2008 in that transaction volume is going to remain depressed,” Blankstein says. “The impetus that we really need to see is the debt market turn, and I don’t see a clear way out of the debt market issue this year.”

Retail Properties

Cap Rate Bracket
Average Price
Average Cost per sq. ft.
Percent of Deals







0.00%–6.99%
$3,079,686.39
$395.29
28.84%
7.00–7.99
3,063,336.47
316.27
31.84
8.00–8.99
2,271,331.86
228.76
22.11
9.00–9.99
1,670,835.52
190.07
8.1
10.00–10.99
1,215,464.73
175.56
5.71
11.00+
1,322,389.99
193.32
3.41

Source: Boulder Net Lease Funds LLC