Net lease has long been the bread-and-butter of commercial real estate. It is a business model that covers most asset classes and is notorious for being both recession-resistant and excelling in bull markets as well. "People use net lease for downside protection. It is the bond market for the real estate world," Randy Blankenstein, president of The Boulder Group, a boutique firm specializing in net-lease investments, says. "It doesn't offer large upside or much downside. People want to switch to net lease for stable cash flow and income for the years ahead."

This is still largely true. Last year, for instance, net lease investment volume increased by 10.9% to a record $77.5 billion, according to CBRE.  At the same time, though, current trends in the space and larger commercial real estate environment are offering up both new opportunities and challenges to investors.

For instance, the sector has become crowded, and institutional players have been able to execute large and quicker deals because of their scale and access to resources, edging out small-to-midsize developers in some instances.

Investors are also recalibrating assets for adaptive reuse, figuring out reconfiguration of particular properties. And due to construction and land costs against steady rents, it's become more difficult for investors to price out properties.

To meet these challenges, net lease players have gotten creative, joint venturing, purchasing already developed assets in secondary markets, and thinking about asset classes in new ways.

To cite one example, car washes and lube shops have won investors big gains, according to Glen Kunofsky, specialist in Marcus & Millichap's net lease properties group.

These kinds of properties that are placed in service over 15 years are scheduled for depreciation under the 2017 Tax Cuts & Jobs Act, granting them 100% bonus depreciation for the qualified property acquired. As more investors begin to understand these tax guideline incentives, spreads have tightened.

Cap rates for assets that qualify for bonus depreciation have been driven down by 50 to 75 basis points, according to Kunofsky. The Marcus & Millichap net lease properties group sold 175 gas stations and car washes in 2019 under net leases. Before the legislation, deals on depreciative assets had cap rates that were in the 7% to 7.5% range, whereas now they're in the high 5% or low 6% range, according to Kunofsky. "We're educating buyers on owning other types of net leases," he said.

As another example, experiential real estate like restaurants and fast food have become a consideration because investors expect they'll be around 10 to 20 years from now. Likewise health and fitness, and educational assets like schools. "People see the vision. You have to send your kids to school somewhere," Kunofsky said. "It's very sticky revenue, and once enrolled in school, they stay and enroll multiple kids if they're happy with it. It goes well with long-term net leases."

Private investors and institutional investors along with for-profit education companies are selling assets under a net lease as a part of an expansion, chasing free-standing schools in lower to upper class neighborhoods. "Real estate investors are pulling up to the curb because schools cater to 80% to 90% of a neighborhood, and secure long-term leases," Kunofsky said. "People are turning to these assets and saying this can't be replaced by something online, and schools fall right smack dab in the middle of that."

Also gaining popularity in the market are sale leasebacks, a preferred strategy among small to midsize developers building scale in markets, according to Jeremy Just, president of Blacktide Development, a real estate development and investment company.

Sale-leasebacks with corporate tenants have become a core strategy, according to Just. "We see sale-leaseback transactions happening monthly as tenants continue to seek new capital for expansion and operation and unloading real estate holdings and disposing of new business," he says.  "Our ability to buy sale-leaseback sites in bulk, allows us to get spread-to-market as opposed to buying each site individually."

Even the traditional asset classes—some of which, like retail, come with their own set of troubles—can be a good play for certain investors.

For example, REIT Agree Realty Corp. invested $252.1 million in 74 net lease properties with 81.6% of rent derived from investment grade retailers for the third quarter 2019 results.

Now it is upping its acquisition of net lease properties. "Given our strong year-to-date acquisition activity and improved visibility into the pipeline for the remainder of 2019, we are increasing our full-year acquisition guidance to a range of $650 million to $700 million," said Joey Agree, president and CEO of Agree Realty on a recent investor call.

THE OBSTACLE COURSE

Agree Realty, in fact, is a prime example of institutional investors piling even more into the net lease asset class.

"We have large institutional money coming in and that can move quickly, and that can pay premiums for sale-leasebacks, place money and cost of funds is historically much lower, so it's also about timing," Just said.

Developments for historical built-to-suit uses like restaurant users have become packed, driving up land prices for sites. Higher land pricing coupled with rising construction costs has made it difficult for developers to execute those projects because of the fixed-rent structure. "Tenants will only pay so much of what is forecasted for sales. With increasing land and construction costs as rent maintains stagnancy, it is harder to build," Just said on the earnings call.

Investors could back off and focus more on tertiary markets where there is a lower land basis, but that it is viewed as counterproductive, because users want the best sites and best market, according to Just. However, in order to get the best sites and markets to make the business strategy and plan work, volume is necessary because the margins are tighter on every deal. "You need to have margins to make it work," he said.

While some net lease investors prefer to stay huddled up in specific markets, others are looking elsewhere, pivoting to secondary markets in states like Texas that are business and tax-friendly, says Daniel Herrold, senior director at Stan Johnson Co.

The Texas net lease retail market comes from a position of strength, Herrold said. "Generally speaking, the state of Texas has been very strong when it comes to creating a new net lease product," he said. "Development is robust in all of the major markets, Dallas, Houston, San Antonio and Austin, and the secondary markets are all very healthy as well, with plenty of new projects underway. Thus, the supply of net lease product has remained steady and constant across the state."

And if net lease investors can't find footing in a new market, they're shifting perspectives about existing asset uses. There's been discussion about medical use that is akin to retail-oriented properties.

Property owners are installing urgent care medical centers into their tenant mixes. It's viewed as the same real estate and demands similar rents, but the buildings are more specialized. Due to the recalibration of assets for different uses, landlords are mulling adaptive reuse and non traditional construction materials, according to Just. "About 20 years ago multiple users could find a way to use a similar building, now everyone has specialized prototypes," he said.

MISMATCH INVESTORS JOIN FORCES

To overcome crowding in the net lease sector, joint venturing has become a common strategy. Smaller developers are teaming up with larger institutions because they need to deploy capital. In some instances, institutional investors have been chasing developers instead of sites, so that they have an investment vehicle, according to Just.

It's gotten to a point that many players, whether a high net worth investor, family office or institutional investor have seen so much competition on the triple net market, now money is fighting to deploy capital and is getting very creative to win sponsors who have tenant relationships and can put deals together, he added.

In the case where developers aren't empowered to build and need to main certain return threshold, they've brought existing cash flowing assets, and is why sale leasebacks and the vast majority of net lease properties on the market are trading hands, according to Blankenstein.

THE BUMPY OR SMOOTH ROAD AHEAD?

Net lease investments are expected to remain an attractive investment in the coming years. In 2019, the sector saw record cap rate compression as players jumped in, according to Blankenstein.

Year-over-year cap rates for all of 2019 were down the most significantly for industrial and retail properties, according to The Boulder Group. Cap rates for industrial properties fell for the second straight year, declining 19 basis points. Retail cap rates fell 18 basis points, which was a reversal of 2018 when they increased by 18 basis points.

Investor certainty around interest rates was influential to record cap rates in 2019. "The expectation of the last few years has been interest rates are probably going up so people are waiting to buy because prices will go down," Blankstein said. "But now people think we're in a stable interest rate environment that is probably not changing for a year. So, it's really causing the market to heat up because you can buy with some stability at the moment.

Activity in the sector has no plans on slowing down. If there is a recession like many expect in the market or there will be some sort of downward pressure on rent, investors see now as a good time than ever to get into net lease investments because of the stability of cash-flow.  "That's why the market is still driving prices lower. Cap rates down in the 6's are still favorable compared to the apartment market, treasury bonds and other alternatives if you're a conservative, older investor," Blankenstein said.

Economic growth should stay moderate despite very low interest rates and inflation, and current global conflict may not be as economically threatening as it appears, Barbara Byrne Denham, senior economist at Moody's Analytics, recently told sister publication,GlobeSt.com. "The U.S. economy continues to face risks from global political tensions and uncertainty, but it has weathered these threats for 10 years. As for the commercial real estate market, it should continue to grow in step with the overall economy in 2020 as it has over the past 10 years."

Geopolitical tension may cause exposure for certain aspects of the economy but could even serve net lease well, according to Blankensein. "If anything, it probably has a positive consequence on our market because when those geopolitical events started, the 10-year Treasury actually came down."