1031 Exchange buyers and private investors looking for yield drive demand, but stabilizing cap rates suggest this cycle is nearing the top.
Hunger for yield and still-low interest rates — the dynamics that have fueled a robust net lease investment market for retail properties over the past few years — remain in place so far in 2016, but emerging signs suggest that prices are nearing their peak as recession worries continue to mount.
Institutional, high net-worth and foreign investors make up a good chunk of net lease buyers, who are plowing money into Family Dollar stores, Walgreens properties, quick-service restaurants, convenience stores and similar retail properties that are geared to provide steady income from stable long-term tenants. But 1031 Exchange buyers, who roll the proceeds from a property sale into a similar property for tax benefits, have increased their appetite for net lease properties over the last six to nine months to become some of the most active buyers in the market.
“The market is red hot; there’s a tremendous amount of money wanting to get into net lease real estate,” says Ralph Cram, president of Northbrook, Illinois- based Envoy Net Lease Partners, a private lender focused on ground lease, construction and bridge loans for net lease properties. “Investors want stable cash flows and non-volatile assets.”
David Sobelman, an executive vice president and managing partner with Herndon, Virginia-based net lease brokerage Calkain Companies, says that his firm has generally served two categories of buyers over the last several months: 1031 Exchange buyers and institutional investors “starved for a passive, stable and above-market” yield for the long term as an alternative to bonds. In turn, feisty demand is maintaining low capitalization rates, states Sobelman, who operates in Calkain’s Tampa, Florida, office.
Well-located properties housing credit tenants like Walgreens and McDonald’s in major markets with longer lease terms are commanding typical cap rates from 4.5 percent to 5 percent, he says. For example, in January, Calkain brokers oversaw the sale of a newly constructed Taco Bell with a 20-year lease in Pompano Beach, Florida, at a cap rate of 4 percent. Meanwhile, assets with more risk — those leased by non-credit tenants, those that have shorter lease terms or those in secondary and tertiary locations — are generally trading some 100 to 250 basis points higher, Sobelman says.
“Until there is an investment, real estate or otherwise, that offers the stability, growth, passivity and/or yield that today’s net lease properties provide, then cap rates will stay in the lower ranges,” Sobelman says.
Higher cap rates typically found in the Heartland have also stimulated the appetite of buyers, says Randy Blankstein, president of net lease brokerage Boulder Group. In early 2016, the Northbrook, Illinois-based firm arranged the sales of a Walgreens in suburban Kansas City, Missouri, for $6 million and an LA Fitness in Chicago for $9.5 million. The deals featured cap rates of 5.86 percent and 5.63 percent, respectively. The LA Fitness sale was to a 1031 Exchange buyer.
“Investor demand in the Midwest is strong, as it has historically been a market with higher cap rates than that of the coasts for similar assets,” Blankstein says.
In some cases, however, sellers are pricing net lease retail assets too aggressively and have begun to encounter resistance, especially for properties in less-than-premier locations, with lease terms of fewer than 15 years, or that lack reasonable rent bumps, observers acknowledge. By way of example, a Walgreens landlord may hear that a Walgreens property in the area traded for a cap rate of around 5 percent, and so he decides to test the waters and seek the same cap rate, reports Joey Odom, a director with Stan Johnson Co. in Atlanta.
“But those properties they’re trying to sell may have only five years left on the lease, and not 20 years like the one that sold at the five cap,” says Odom, whose team recently handled the sale of 25 Dollar General stores in the Midwest at a cap rate of less than 7 percent. “People are bringing properties to the market with unrealistic pricing, and I don’t think they’re trading.”
Some investors worried about a possible recession and tightening credit have in general become more cautious, adds Ian Schroeder, a senior vice president specializing in net lease properties with CBRE in Newport Beach, California. Last year it was common to put assets up for sale at prices higher than market to take advantage of demand. Early this year the philosophy shifted to asking for a price closer to market to create a bidding war, ideally between five to six parties, he says.
“I believe right now we’re in the middle of an adjustment on aggressive capitalization rates. I’m getting a lot of email blasts about price reductions that we just haven’t seen in the last four years,” explains Schroeder, whose team closed 65 transactions valued at $200 million in 2015. “There’s a feeling that the market is going to correct, and nobody wants to be the guy that paid too high a price just before the correction.”
EXCHANGE TRADE FRENZY
Boulder Group research indicates that cap rates for net lease properties continue to compress, but more stubbornly than in previous quarters. Median asking retail net lease cap rates dropped 25 basis points to 6.25 percent in the first half of 2015 and then remained at that level in the second half of the year. In the first quarter of 2016, asking cap rates ticked down seven basis points to 6.18 percent, the brokerage said.
The slight drop in cap rates in the first quarter occurred despite the Federal Reserve Board’s decision in December to raise the target range for the federal funds interest rate to 0.5 percent from 0.25 percent, and net lease professionals expect 1031 Exchange activity in particular to keep cap rates in their current neighborhood. The 1031 Exchange program allows sellers of a property to defer paying capital gains taxes if they funnel proceeds into a similar or “like-kind” asset. To qualify, the exchanger must complete the purchase of the new property 180 days after the initial sale.
“If a 1031 buyer really likes a deal, they don’t care so much about the cap rate on the last trade (of a similar property), they just care about fulfilling their trade,” Odom says. “So they’re willing to pay a little higher price.”
Schroeder adds that many 1031 Exchange buyers are second- or third-generation owners of apartments rotating out of the management-intensive properties and into more “hands-free” net lease real estate. As long as investment interest keeps cap rates compressed in the multifamily sector, he predicts, demand for net lease assets will stay strong.
Similarly, retirees are also seeking net lease properties, whether they are 1031 Exchange investors getting out of hands on properties or more conventional investors frightened by stock market volatility and low-yielding bonds, says Parker Carroll, a managing director in the net lease investment group with Coldwell Banker Commercial in Austin, Texas.
“Right now we’re seeing a big trend of people preparing for retirement, and they’re using net lease properties to replace bonds in their portfolios,” Carroll explains. “We’re seeing that on a bigger scale than we’ve probably ever seen before.”
Carroll’s team began marketing seven renovated Dairy Queen restaurants operated by a major franchisee in small Texas markets in February, and three were sold or under contract to separate investors within roughly a month. The buyers accepted cap rates of around 6 percent for the properties, which feature 19 years left on the leases and annual rent increases of 1.5 percent. Each of the seven properties listed for around $1 million, and the remaining properties were generating high interest, he says.
“We believe that’s a pretty aggressive cap rate for those markets,” Carroll says. “But I think the assets served as a price point where a lot of buyers could go in and buy for cash.”
Demand for net lease retail properties continues to outstrip available product, which should also keep downward pressure on cap rates. The supply of net lease retail assets for sale plunged 12.5 percent in the fourth quarter of 2015 from the third quarter, according to Boulder Group. It dropped an additional 1 percent in the first quarter of this year.
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