SULE AYGOREN: There's been so much increased investor interest in net lease. How has the competitive playing field changed?

GORDON F. DuGAN: A good example of just where the net lease industry is would be to look at a roster of a net lease conference, and see how many attendees there are. I remember wondering if there was even a need for a net lease conference a few years ago, and now it's full of a variety of different players. [For the record, our 2013 RealShare Net Lease Conference greeted roughly 300 attendees.]

PAUL H. McDOWELL: You need to consider that there are two components of investors. There's the public REITs and those we compete against to buy product. That's obviously driving cap rates down; there's competition to buy product. The other component consists of investors who are interested in investing in the public companies. For a long time we faced significant competition to buy assets and a lack of investor interest in our stocks. Now we're facing significant competition to buy assets, but we're also seeing quite a bit of investor interest in our shares, which is helping to expand our multiples and drive our cost of capital lower. It's making public REITs more competitive in the market than we were a couple of years ago.

NICHOLAS S. SCHORSCH: To add a third component, we've also seen much growth in the non-traded REIT space. This expanded interest has grown the industry to an expected $18 billion in non-traded REIT sales this year. Investors that are looking for the income that the public REITs have traditionally provided are now finding more comfort in the non-traded space, where they don't have to deal with the volatility of today's markets. So the industry revolves around providing investors with consistent, durable income in a market where safe, yielding assets are very scarce.

The non-traded REIT is tomorrow's publicly traded REIT. We view non-traded REITs as incubator companies with the ability to be taken public or merge with a public REIT or institutional investor such as a pension fund. The key to this space is that the portfolios must be constructed correctly from the beginning with the exit in mind.

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AYGOREN: Where do you see the cap rates and prices now for the properties that you're going after?

SCHORSCH: Cap rate compression is something that's talked about often, yet misunderstood. As a company, we're focused on building portfolios on a granular level, which gives us our competitive advantage. Most of these deals are being sourced off-market; therefore we don't see much competition. If anything, we've seen a 15% to 20% uptick in the amount of product coming to market, new tenants and new credits as corporations continue to look to reposition their balance sheets, and that creates a great buying opportunity. There may be compression on the ask of a particular deal, but not where the deals are getting bought.

McDOWELL: Cap-rate compression in the REIT sector is a little overblown. Every broker you talk to is going to tell you how the cap rates are compressing very heavily. But our average cap rates over the past few years have been reasonably steady. They've obviously come down in some areas, but the cost of financing is much cheaper. In 2006 and '07, we were buying assets at 7.5% and 8% caps, and the cost of debt was 5.5%. So your net positive spread was 100 to 150 basis points. Now, you can buy that same asset, even at 7.25%, but your financing cost is 3% or 4%. Your net positive spread is very wide.

DuGAN: The flip side of that, though, is what makes the net lease industry almost unique. The business is very scalable and there are more assets available when pricing becomes more attractive. So as valuations have gone up, transaction volumes have also gone up because there are more willing sellers at this point in the cycle. If we go back to '09, there was no capital available, but there were no willing sellers, either, and there was very little sales volume. At this point it's still at an attractive place as an investor. There's a lot of competition, but there are a lot of assets on the market, too.

AYGOREN: What types of sellers are the most active? Are you seeing a lot of sale-leaseback opportunities or other property owners selling their assets?

DuGAN: We see more property owners selling their assets. They bought something, it may have appreciated and certainly, if they're managing institutional money, they have a finite time frame for holding the property. So now is a good time for them to sell. We see a decent amount of activity there. Surprisingly, there's been a low level of sale-leaseback activity the past few years. Pre-crisis, where companies like Spirit bought the big Shopco portfolio, there were quite a few more sale-leaseback opportunities. That could change, though.

RICHARD J. ROUSE: Volume is building, probably because of the lower cap rates. You see companies like Walgreens, which has its headquarters on the sale-leaseback market now. You wouldn't have seen that 12 months ago because of where cap rates were then.

TREVOR P. Bond: Yes, we're seeing a little bit more of that in New York, as some companies are looking to this as a financing technique, a way of getting liquidity on the balance sheet.

AYGOREN: What's the hardest sector to play in right now, as an investor?

DuGAN: Single-tenant standalone retail properties. Not only are there so many investors focused on it that are public or managing non-traded REITs, but you also have individuals that have come back in the marketplace as competitive players.

Bond: It's hard because it's commodity pricing, in a way. All of us need to work harder to move the needle in terms of acquisition volume. So it has those two things going against it. The third thing is that it's rarely mission critical to that particular tenant. So in a downturn, they're going to shed assets. Stores are more likely to do so.

SCHORSCH: I'd have to disagree. The net-lease industry is fragmented. If you can buy single-tenant, freestanding assets with strong investment-grade ratings with corporate guarantees, you're going to mitigate significantly your downside risk of a company shedding assets. Why buy corporate bonds that are trading at historic lows, when you can get the benefits of bricks and mortar with a guaranteed corporate income stream?

DuGAN: I heard a statistic that there are four dollar stores being built daily. I take it to be a good number. How many dollar stores do we need in the country?

AYGOREN: So, then, what sector is offering the greatest deals?

McDOWELL: Well, one of the things that makes retail stand out is lease duration. Retailers want to control a site for long periods of time. And the investor marketplace is rewarding lease duration significantly. Whereas corporate and industrial tenants' needs change over time, they see their assets as more of a commodity so they don't feel like they have to sign a long-term lease. So as investors, we can do better in the office sector, in terms of yields, because the leases are shorter. But you have to be very focused on the real estate, be confident that it's a fungible office building that can be re-leased to somebody else at the same or higher rents that the current tenant is paying.

So a lot of the investment in net-leased retail sector feels to me like asset aggregation. It's not really an investment; you're just trying to buy as many of these individual assets as you possibly can, get as much diversity as you can and as much lease duration as you can get. Whereas when you buy a $40-million or $50-million office building, that's a real investment decision, and it's a combination of tenant credit and lease duration, but a real critical driver is the underlying value of that piece of commercial real estate.

DuGAN: I agree. And if there's one area that concerns me, it's the organizations that have typically been focused on single-tenant net-leased retail spilling over into office and industrial and underwriting things that just don't make any sense. That's because the view on the single-tenant retail side is, nobody looks at the market rent for a Walgreens in Brewton, AL—there is no market rent for a Walgreens in Brewton, AL. But you have a 20-year lease term, so you may not care. If it's up and running and it's profitable, you have site-level coverage of the rent. But if you take that same attitude toward office or industrial, maybe with a 20-year lease you will be okay, but those are few and far between in office and industrial. So the underwriting has to change. It's no longer an asset-aggregation game but something you have to be thoughtfully in underwriting each and every deal. And I've seen a few things that have made me scratch my head.

BOND: Clearly, there's a lot of attention on the net lease sector, but eventually people will come to understand that it's not a one-size-fits-all market, and that it's not just about boiling everything down to the cap rate for the whole net lease sector. It's an unusual sector in real estate insofar as the only common theme is the form of the lease itself. In and of itself, that's very unusual because you have retail, you have industrial, you have all different property types except multifamily represented. So everybody is going to have a different approach to underwriting.

McDOWELL: That's very true. CapLease and Spirit couldn't be two more different companies, but we still call it net lease.

AYGOREN: That's an interesting point. So how do you differentiate yourselves in a market that's so fragmented?

McDOWELL: It's a huge market and public net lease companies have never been the driving force behind that market. So there's plenty of product for us to buy over extended periods of time in our sector. What's interesting is that the public companies are garnering more attention. There used to be less of us, and now there are more of us, which is a double-edged sword. As professional investors with good access to capital, in some ways it's beneficial because if all of our boats rise, the cost of capital goes down so we can compete against the private buyers more effectively. We just have to compete amongst ourselves a little more aggressively. But if you get institutional investor interest, then that helps all of us.

I suspect that we actually don't come head to head with each other that much in terms of overall buying activity. It's a big enough market and there's plenty of corporate-owned real estate out there. And more will be changing hands as sellers start to feel that they won't look stupid anymore for selling. But in terms of differentiating ourselves, we all have a very similar but slightly different focus.

SCHORSCH: As a company, we like to focus ourselves on two things: being an asset aggregator and building credit-quality portfolios. When we're building our portfolios in the non-traded space, we like to think of the vehicle as an incubator. The markets are paying high premiums for larger portfolios, so being an asset aggregator we can buy at cap rates between 7% and 8.5%, and then list, sell or merge the portfolio for an implied sub-six cap rate. Secondly, focusing on credit we can build what's really closer to a bond alternative. We like to look for high-quality companies with strong balance sheets, so in essence you're buying the same corporate guaranteed real estate at a cap rate over 7% while getting the credit of the company's bonds, which may trade at interest rates below 4%.

We've also managed to bring transparency to the industry and align our interests completely with our shareholders by eliminating internalization fees and taking all of our asset management fees in deferred shares. By doing this, we can't collect fees until we return 100% of the investors' capital or meet a stated return hurdle mandated in our prospectus.

BOND: We try to be as diversified as we can. And when we first entered the public space as a REIT, we felt that maybe there would be some resistance to being completely diversified because the REIT-dedicated investors at the time preferred a pure play, and we couldn't say that we were a pure play. That would be style shift. Also at the time, because it was the height of the Euro crisis, we thought there would be some resistance to the fact that we were 30% invested internationally as well. But we found that's just a bigger, broader pool of investments that we can go after.

I think that the Euro crisis eased somewhat so that the Italian bond yield and the Spanish bond yield came down, and the Euro zone itself managed to get everybody past that sense of immediate crisis. And I think that helped to mitigate investor concern. We've all benefited from the lower yield environment.

DuGAN: It wouldn't surprise me if, as net lease companies get larger, some become more focused, others stay more diversified. One size does not fit all. So we're focused on office and industrial, but we'll also buy other things opportunistically. Some of it is to try to appeal a little bit to our niche—we're smaller, less established, so we need to be more understanding.

BOND: But when you see a good investment, you'll underwrite it and buy it. That's all of our jobs, to make more investments.

ROUSE: Lexington is also focused on office and industrial, but we view developers that we do build-to-suits with as our clients. So if one of our clients wants to do a build-to-suit retail store, we'll do it.

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AYGOREN: Is there room in the market for more IPOs?

McDOWELL: I guess we'll find out. A lot of these IPOs are companies that are already public but are just not trading REITs. So the portfolio and the stockholders already exist, they're just not traded on the exchange. So you can make the argument that if we see more of those becoming public, it might not necessarily be a bad thing. As our sector grows, institutional investors are forced to invest in it because it becomes a larger piece of the Russell 2000. There's a view that all these competitors are coming into the market and we'll be fighting them tooth and nail, but for the most part, the competitors that have been coming in already own the portfolios.

SCHORSCH: In the short term, absolutely. The market is starved for yield at the moment, so we're really seeing any high-yield equities trade at significant premiums. In the first quarter of 2013, net lease REITs were trading at earnings multiples between 19x and 21x. So as long as this opportunity exists, I think we'll see more IPOs, especially from the non-traded side, as Paul said. For us, we see listing as a better alternative in these markets. Unless the company has problems that require additional equity to resolve, listing has been a great way to take private companies into the public markets.

BOND: There's certainly room for it. A couple of years ago there were comments made to the effect that among larger REIT-dedicated investors, there was no need for any new equity REITs. But from the investors' point of view, the performance of the big cap REITs last year relative to the small- and medium-cap REITs opened their eyes. It's much harder to move the needle with respect to AFFO growth when you're one of the larger REITs, whereas small or medium-sized REITs are starting below the base, so you get bigger bang for your buck with your investment activity and the accretion you're creating. So from the investors' point of view, there's room, because they're looking for the next new story to invest in.

AYGOREN: So the increased interest has allowed you to be more competitive with private investors, evening out the playing field. Would you elaborate on that?

McDOWELL: This investment class used to utilize a lot of leverage, so before the credit crisis, private investors could often get 95%, 96% leverage. That whole investor class has vanished because that type of leverage isn't available anymore. So you need to put in 30% to 40% of equity if you're a private investor today. The playing field has significantly evened out. Our cost of capital is competitive with the very large investors that are private—the pension funds, life insurance companies or foreign money.

DuGAN: Gramercy's a relatively small, new company, and we've completed over $600 million of investments in the past nine months or so. That's a testament to the fact that we're able to find things that we can be competitive on. Other net lease firms going public—that's not an issue to worry about. But if the highly leveraged transactions come back, that would change my tune.

ROUSE: I completely agree. And our dividend yield, probably for the first time, is well below 5% now. Between that and the relatively mild leverage we usually use, we can be very competitive with anybody.

AYGOREN: There's been a considerable amount of consolidation in the sector. Will we see more?

SCHORSCH: Yes.

DuGAN: It may seem counterintuitive, but I think there will be consolidation but there will also be more public net-lease REITs in five years than there are today.

BOND: Eighteen months ago we were visited by a lot of investment bankers who thought there would be a lot of consolidation. But the implied cap rates have gone down so far that with respect to a public firm merging with another public company, the pricing expectations are too high. It has to be about more than just accretion and financial engineering. So public-to-public is going to be more difficult to pull off now, but we'll probably see more private-to-public.

AYGOREN: So there's a lot of things going on in the sector. Is there anything that's particularly concerning?

SCHORSCH: All eyes are on 2015 at this point. If the Fed holds true and keeps rates low until then, we'll still have an amazing opportunity in this sector. More recently, many people have been concerned that the Fed is going to begin to wean itself off of Treasuries. We're keeping a close eye on inflation indexes over the coming months, but we still see opportunity between interest rate spreads and cap rates.

McDOWELL: The thing that's most concerning is that everything seems fine. All of the people around this table have been in this business many years, and we've seen multiple crashes and contractions. When everything feels good is when you start to worry that one of these days you're going to wake up and look at your Blackberry or iPhone and the headline is going to be that something has blown up and the market pulls back. The market grinds up slowly, but it retreats rapidly.

ROUSE: It's going to be that Black Swan event we can't foresee.

BOND: Right now, the interest-rate cycle is what it is, and it's been a bull market for bonds for more than 30 years. We all know that's going to end eventually, and it's going to be year 32, 33, 34. But you have the two cycles—the interest-rate cycle and the supply/demand cycle. Right now, the supply/demand cycle is what's really keeping a lid on things in a good way. The minute low interest rates result in overbuilding, that'll be concerning. In net lease, though, it's also hard to imagine speculative overbuilding because there's usually going to be a tenant there who wants the building.

DuGAN: It's an unbelievable opportunity today. So the question is, are we maximizing that opportunity every day? Because there will be a point when we'll look back and say, “That was a good time to grow.” The other thing is that the lending markets are rational. I don't see lenders doing dumb things; they're lending to good companies on reasonable terms. I don't see anything really concerning. That gives me another reason to be optimistic about where we are today, and to think that we have many more innings to go.