Private buyers have taken over the retail net lease market, representing the majority of deals closed in 2014. Private investors accounted for 60 percent of the net lease market last year, a significant increase over the 42 percent in 2013, according to the most recent net lease report from The Boulder Group, a real estate services firm specializing in single tenant net lease properties.
“The net lease industry has been active for all segments—private buyers, 1031 buyers, family offices, institutions, etc.—due to past year’s volatility in the stock market, low interest rate environment, and aging demographic looking for fixed income alternatives,” says Randy Blankstein, president of The Boulder Group. “Investor interest has never been greater.”
Private buyers’ voracious appetite has pushed cap rates to record lows, and the supply-demand imbalance has forced many investors to re-evaluate their risk profile, according to Patrick Nutt, a managing partner with Calkain Cos., which focuses on triple net lease investments. “With a growing economy and a search for yield, many investors are altering their risk profile on at least one of the major criteria (credit, lease term, physical real estate),” he says.
Supply-demand imbalance
It’s a great time to be a seller of net lease retail properties, experts note. Today, there’s far more demand than supply, especially for newly constructed assets.
During the past few years, many retailers have slowed or curtailed their new store openings, points out Julian E. (Jay) Whitehurst, president & COO of National Retail Properties, which is focused solely on single-tenant retail assets. Additionally, very few new shopping centers, power centers or malls have been constructed, which means fewer outparcels are being developed.
National Retail Properties primarily executes closings directly with tenants, either in the form of sale leasebacks of existing stores or development funding for new units. In 2014, the company invested $618 million in 221 retail properties. Of the 54 separate closings the REIT executed in 2014, 34 were for less than $5 million.
“We’ve been very successful in maintaining a stable track record of acquisition volume, but a shortage of new stores coming into the market definitely makes acquisition efforts challenging,” Whitehurst says. “We see that trend starting to turn, as new larger developments are being planned, financed and started. But our primary focus remains on direct relationship business with growing retailers, serving as a capital partner for the retailers’ long-term growth plans.”
Whitehurst says typically there are three to six qualified bidders in those widely marketed portfolio transactions. “One of the reasons we focus solely on retail properties is that the small size of the individual properties discourages many institutions—pension funds, etc.—from participating in our market,” Whitehurst says.
1031 market on fire
Over the past 24 months, real estate prices have recovered to pre-recession levels. This recovery gives investors a chance to exit those properties at attractive price levels they never thought they would see again, which is driving the 1031 activity today.
“The 1031-exchange buyer is clearly the most active and aggressively priced buyer pool in the market right now,” Nutt notes. “The recovery of every major asset class has provided liquidity to other real estate investments, and an aging ownership base generally trends towards net lease for their replacement properties in an effort to simplify their life and lower their overall portfolio risk.”
Many of these large 1031 exchanges are coming from private family offices, Nutt notes, where families have owned multifamily and office assets in New York City and other primary markets.
“There has never been a time in my career I can remember having so many $25 million to $100 million plus 1031 exchanges going on,” Nutt says. “The biggest driver of this seems to be the New York City metro area, where seemingly the entire city is for sale, and being actively bought at cap rates in the 2 percent to 5 percent range. When selling at those sort of numbers, even a 5 percent cap CVS is accretive to your portfolio’s cash flow.”
Continued cap rate compression
Net lease retail cap rates have been at an all-time low for the past three quarters. The Boulder Group recorded the historic low cap rate of 6.5 percent at the end of the fourth quarter.
The cap rate spread between large, national retailers and local or regional operators continues to narrow. For example, in widely marketed transactions involving quick-service restaurants, there may be only a 25 or 50 basis points difference in cap rates between a large franchisor and a local franchisee.
Drug stores have always been the bread and butter of the net lease retail sector. However, in today’s market, investment-grade tenants with long-term leases attract the most demand. Blankstein says restaurants with corporate guarantees are emerging as a favorite for the investors focused on properties priced under $5 million.
National Retail Properties focuses on well-located retail assets, with good access and visibility, leased to high quality operators and with rents which are at or below market, rather than targeting specific uses, according to Whitehurst. However, he adds that the REIT continues to find convenience stores to be very attractive.
“Those properties are typically an acre or more in size, and located at a signalized intersection, which gives the C-store operator the most likely chance to succeed, and which provides NNN with multiple options in the unlikely event the convenience store operator struggles,” he explains. “Within the past two years, a number of our relationship convenience store retailers have been acquired by national and multinational companies. This has improved our already-good tenant credit profile and validated the value of our business model.”
Whitehurst notes that cap rate compression continues, but that it’s slowing. And most experts aren’t forecasting any significant loosening of cap rates, at least until alternative passive investment vehicles offer competing rates of return.
“Cap rates don’t appear to be going in either direction anytime soon,” Nutt says.