By Carrie Rossenfeld for Real Estate Forum
It’s no secret that the net lease market is attracting many investors, new and veteran, seeking a safe sector for their portfolios. While there’s no sure thing in the investment realm, net lease does have its pluses, including long-term tenants assuring a steady income stream. But with so many players in the market looking for a great deal, how can savvy investors stay ahead of the pack and land the best net lease transactions? Real Estate Forum spoke with several industry experts to get their take on the net lease market and how to make smart choices when making acquisition decisions.
“Things are getting competitive,” says Jason Fox, managing director and co-head of domestic investments with W. P. Carey in New York City. “We have a low-interest rate environment and despite aggressive pricing, it’s inducing a lot of sales. A lot of users are considering sale-leasebacks, and private-equity firms are considering them for their portfolio companies as a way to access capital to finance growth and expansion.”
On the flip side, Fox adds, the market is also competitive for investors. Property yields have been driven down, and pricing that resembles 2007 is emerging. “There are good opportunities, though,” he says, “in a range of asset classes including retail and restaurants, despite the aggressive bidding out there. The good news compared to 2007 is that you’re still able to generate appropriate risk-adjusted rates of return for this type of investment, given the spreads between property yields and lending rates.”
Brandon Duff, director of the Chicago office for Stan Johnson Co., says staying educated about the market is key to remaining ahead of the competition: “Look for both good and bad. It’s also important to understand the debt markets and how they impact pricing.”
Knowing which market you want to be in is part of the education process, and it’s vital for net lease transactions. “You need to be an expert in the market you’re focused on,” says Nicholas Schorsch, chairman and CEO of American Realty Capital in New York City. “For example, if you’re looking for long-term income in net lease space, do you want to buy industrial, retail or office? There are different types of net leases like there are different types of restaurants.”
Schorsch, who also spoke at a recent RealShare Net Lease conference in New York City, believes that building a homogenous portfolio is key. “If all of the assets are in retail, it’s easier to sell it because you create more value,” he explains. “You want to be sector-specific, location-strategic and stay within your discipline. A lot of investors make a huge mistake by buying a variety of asset classes in a lot of different markets and end up with a mediocre portfolio that’s not well diversified. In net leases, it matters when you create aggregation value; you’re creating a mini portfolio.”
On the other hand, United Trust Fund aims to mitigate the risk of uncertain credit by diversifying the spectrum of companies with which it does business. “In the current economic climate, capital is expensive,” another RealShare speaker, Paul Domb,VP of asset management with Miami-based UTF, tells Forum. “This has resulted in a slew of sub-investment grade or dubious credits that do not have access to the capital markets and are now turning to sale-leasebacks. When you have a market where the credit quality has deteriorated, you must take a closer look at the real estate component. Both credit and real estate are the main considerations in a sale leaseback, and where one is lacking, you must look at the other.”
This strategy has worked for UTF: in its 40 years in business, the company has developed many long-term, repeat sale-leaseback clients. “It sounds simple,” comments Domb, “but in a dog-eat-dog market, the message is to keep your existing and prospective clients informed of your capabilities.”
For investors, having an optimal source of financing lined up that will enable them to maximize their yield gives them confidence to push pricing if they’re in a competitive situation, says Guy Ponticiello, Chicago-based managing director of Jones Lang LaSalle and leader of the firm’s corporate finance and net lease team. “Whether that’s five- or 10-year money— whatever the debt structure is that’s in line with the hold objective of the buyer—their ability to take advantage of some very cheap debt will keep them ahead of the pack,” he notes. “Some investors buy with the notion that they’re going to finance the acquisition at some level, but they may not have the structure figured out yet. The more investors can figure out available debt options and partner with a reliable debt source or intermediary mortgage broker, the better off they’ll be.”
Ponticiello is also founder of the new JLL Net Lease Exchange website, which is dedicated to the sale of triple-net leased single-tenant properties on behalf of occupiers, developers and investors. The site connects the sellers to JLL’s global buyer network through an exclusive inventory of properties of all types and sizes, combined with sophisticated transaction tools. JLL’s recognition of the net-lease market’s volatility is what drove the site’s creation.
In such a volatile environment, having a debt strategy is crucial, whether you’re a small “mom and pop” exchanging into net lease investment or a seasoned institutional investor, says Bill Rose, director of Marcus & Millichap’s national retail group in San Diego. “There’s no shortage of capital to finance net lease properties,” he says. “Five-year money can be obtained in the low-4% range. The question is how to reload that debt at that maturity. For other investors who are looking at fully amortizing zero-cash-flow bond financing, Triple-B or better-rated tenants afford free-and-clear ownership of the property upon maturity.” The private investor, while accounting for 80% of transactions of this size, is competing increasingly against institutional investors.
Financing is still the most difficult piece of the capital stack, particularly with more challenged credits or assets in secondary or tertiary markets, Ponticiello adds. “What someone thinks should be a fairly straight- forward transaction to get financed in this market can present a whole host of issues.”
In addition, for well-sought-after single-tenant transactions, many investors are differentiating themselves by putting up non-refundable earnest-money deposits or closing in very quick timeframes. “Given the still-fragile nature of the economy, certainty of closing is right up there with price as the most important criteria on which sellers base their decisions; that will help them bid better than others,” Ponticiello explains. “If I can get five-year money going into a deal, let’s say at 3.5% or 3.75%, and my hold strategy is five years, I can get a low-6% cap. But I can do that only if I feel confident that I can get that debt.”
Actual knowledge about the tenant and a broad view of the sector are key tools, and it’s helpful to have some debt in place. “The debt is clearly a factor on both large and small transactions, and it’s magnified on transactions that are larger than $10 million,” Ponticiello points out.
Some say that taking on more risk is one way to stay in front of the pack, but be sure it is managed risk and not simply outside the box for diversification’s sake. “The net lease market is really an opportunity to stabilize an income stream,” says Al Pontius, managing director of Encino, CA-based Marcus & Millichap’s national office and industrial properties group. “The way to enhance return is to move a little further out on the risk spectrum. I’m not talking about zero credit combined with a tertiary location— I’m talking about managed risk.”
Pontius explains that many active and professional investors buying large volumes of net lease assets on a regular basis believe that the lease term has to be 10 years or greater—even 15 years or more, for some— but this rule doesn’t necessarily apply. “If you want to beat the market and take what many investors would perceive to be a higher degree of risk,” he says, “look at non- major-metro locations, lower credit quality and shorter lease terms. When offered at an attractive cost basis, these investments can minimize the downside risk while allowing for higher going-in yields. And if the lease can be renewed, you can continue to have a great long-term investment, but you didn’t have the 15-year rate up front.”
There are many factors to be aware of with net lease transactions, including understanding that, in the end, these assets are still real estate. “It sounds remedial, but too many times net lease properties are described as bonds, or simply fixed-income assets,” says Duff. “While there’s truth to that, it is still important to understand real estate fundamentals and what to look for when acquiring commercial property.”
Also remember that the value of a real estate asset to an investor is its ability to produce cash flow. “You want to focus on maximizing cash flow on a risk-adjusted basis from individual assets and from your aggregate portfolio,” RealShare speaker Ben Butcher, president and CEO of STAG Industrial in Boston, tells Real Estate Forum. “You have to be cognizant of the things that affect cash flow for a particular asset going forward: a combination of underlying tenant credit and underlying real estate quality and value.”
He also cautions against being overly cautious regarding the risks associated with tenant credit. Viewing the world as black and white and drawing lines in the sand regarding what you’ll invest in can limit you unnecessarily. “The world is shades of gray,” says Butcher. “We substitute analysis for decision rules and look to understand these shades of gray that are the basis for our probability-based under- writing model. A primary market is not ‘good,’ and a secondary market is not ‘bad’—they’re just different.”
Pontius, like many other industry experts, also believes in diversification. “Investors may want to look at how much of the portfolio is comprised of one par- ticular credit, and they may not want to have more than 25% composition. Look for expiration terms that vary. Renewals are likely to happen in a very high percent- age of the assets, and that benefits a diversified portfolio.” The importance of conducting full diligence on every tenant cannot be overem- phasized. “Circuit City was a solid investment 10 years ago, and we saw that change,” says Rose. “You have to like the tenant and have good cash flow, but more importantly, you have to love the real estate. If the tenant goes dark, what am I going to do with the property? You need to go into the deal with eyes wide open and conduct your due diligence before you close.”
Schorsch suggests developing direct relationships with brokers and giving them the exact criteria of what you’re seeking so that they connect you with the right opportuni- ties. “You have to be careful about how broad a fishing net you put out.”
Also, be aware and wary of who is paying you rent for the entire lease term, Domb cautions. “Highly leveraged companies, a pattern of no net income, declining reve- nues, letters of credit tied to the income stream are usually red flags,” he relates. “Corporations today are asking for and obtaining shorter lease terms.”
In the past, investors have been bailed out with a low cap-rate environment such as the current one, given where borrowing costs and underlying treasuries are. “In today’s market, you need to rely on long-term holds and look at the fundamentals,” says Fox. “Are you at the right basis for the property? Is it a good, growing market with deep supply? Is the cost less than replacement cost?”
All of these factors, he points out, will protect investors in maintaining yield on the downside. It won’t do to rely on lower cap rates and asset appreciation anymore; these days, the bulk of the return is based on basic fundamentals and in-place income. ◆