Net lease continues to be a very active segment of the commercial real estate industry as evidenced by the flow of capital and growth of the sector. In 2017, the single-tenant investment market reported $55.4 billion in sales volume, outpacing this decade’s average by approximately 14.0 percent. In fact, demand for net lease product has been so strong that the market has reported sales volumes in excess of $50.0 billion in each of the last four years.
Investor demand for newly constructed properties is particularly high, as these assets typically feature long-term leases, strong credit tenants and high-quality construction. Developers hoping to capitalize on investor demand must have access to capital in order to pursue opportunities, win new projects and fund construction. Net lease developers are faced with navigating the market to determine the optimal capital stack—the proportion and structure of construction equity and debt—for individual projects or their entire opportunity pipeline. In this paper, we have outlined a variety of development capital options available to developers, including those unique to the net lease space.
Historically, the most common source of construction debt financing obtained by developers for new net lease projects is from traditional bank lenders. As recently as two to three years ago, developers were commonly able to secure 85 to 95 percent loan-to-cost ratios for new build-to-suit projects. Today, however, developers are seeing traditional lenders tighten their financing terms and conditions, driven by changes in the regulatory environment coupled with an uptick in interest rates. The result is that many developers today are maxing out at 70 to 80 percent loan-to-cost with traditional lenders, thus increasing the need for external capital partners as it is now more cumbersome for developers to fund their projects exclusively with internal capital.
If a single-tenant development features an investment-grade tenant and a long-term lease—20 or more years, for example—developers may be able to maximize leverage with credit tenant lease (CTL) financing.
But are all external capital partners equal? No—there are numerous profiles for capital partners that may prove to be ideal for specific developers and projects. Investor profiles can be broken down broadly into two categories: private and institutional.
Private vs. institutional investors
The private investor group includes high-net-worth individuals, family offices/trusts and private equity firms. These groups are typically lean and thus quite efficient, flexible and entrepreneurial. They typically are more keenly focused on long-term business relationships that result in multiple partnerships than squeezing the last dollar out of each transaction.
Private investors range drastically in terms of liquidity and sophistication, though. Many developers utilize “friends and family” or “country club” investors initially, but these investors often have liquidity restraints and require significant time and resource investment from the developer to organize and manage multiple investors. An ideal situation for many developers is to transition to larger “ultra” high-net-worth investors or family office equity as their pipeline grows. Larger private investors provide developers with the benefits of entrepreneurial private capital that is liquid enough to fund larger or multiple projects, all from a single capital source.
Institutional investors include REITs, pension funds, insurance companies, endowments, banks and fund managers. These groups typically offer a variety of structured financial solutions to experienced developers, focusing on larger transactions as these entities are extremely well-capitalized.
Which Capital Solution is Best?
Each of these four common capital solutions have unique benefits and variations. The optimal solution can vary based on the specific project and the developer’s goals and objectives. The risk profile associated with a 100 percent leased and fully entitled project fundamentally varies from a multi-tenant strip center development with some lease-up risk. Thus, the appropriate capital solution will likely differ. Additionally, a developer’s risk appetite can determine the solution that strategically makes sense for their objectives.
The funded build-to-suit option allows a developer to avoid market and interest rate risk during construction and effectively lock in their profits on the front end, as they are only responsible for the on-time and on-budget delivery of the project. However, under the joint-venture early stage equity option, the developer has the opportunity to participate in the project upside by achieving aggressive market-level pricing by selling upon completion and rent commencement.
Benefits of finding the right capital partner
Finding a capital partner is a critical component in a developer’s ability to successfully execute on current opportunities and grow their pipeline. A strategic capital partner relationship allows developers to allocate resources to winning additional development projects, rather than dedicate time, effort and energy to sourcing capital for each individual project. Some of the greatest benefits are:
- Removes capital constraints that the sponsor faces while funding development projects and the overall pipeline
- Allows the sponsor to strategically allocate internal capital and balance sheet resources
- Reduces the sponsor’s risk exposure on each project and the overall development pipeline
- Provides the sponsor with a strategic capital partner for multiple transactions, allowing the sponsor to grow and expand the development pipeline exponentially
- The investor’s balance sheet and track record enhance the sponsor’s resume and capabilities during the RFP process
- The investor provides liquidity to be the single source of capital, thus reducing time, energy and resources spent on raising capital, often from multiple sources
Finding the right capital solution that is tailored to meet a developer’s specific goals can be challenging. But in order to reap the benefits, identifying the right solution is vital to a developer’s success and growth. As lending requirements tighten and loan-to-cost ratios decrease, we expect to see continued importance placed on a developer’s ability to source external capital to fund individual projects and potentially their entire pipeline. A strategic partnership with a liquid capital partner can help remove the headache and time investment required to raise capital on each deal from multiple sources, thus allowing developers to bid more opportunities and exponentially expand their pipelines.
Sorting through the available capital solutions and each of the associated players can be difficult. Working with an experienced capital markets advisor can be helpful when comparing each solution and achieving the best execution, the most competitive cost of capital and securing a long-term strategic relationship.