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The net lease sector remains one of the most desired types of investment in commercial real estate. Many investors are drawn to the asset class because of its promise of low or nonexistent management demands on them, particularly in triple-net scenarios—so much so that the scarcity of net lease properties available to purchase has been well publicized. However, such a highly sought-after asset class inevitably leads to lower cap rates and lower yields for investors.

Some of the latest trends in the net lease sector are what one might expect: more of the same. But the sector continues to grow and morph as new investors enter the fold. "The increased competition in the net lease space and the demand for current yield continues to put pressure on cap rates as well as the length of the average lease term," Gino Sabatini, managing director and head of net lease investments for W. P. Carey, tells Real Estate Forum. "In addition to traditional net lease investors, we have seen an increase of participants in the sector, including foreign players as well as private real estate investment funds with cash that needs to be invested within a designated timeframe. Some of these newer investors have a shorter investment and liquidation timeframe. However, they are at greater risk as shorter-term market fundamentals change because their analysis does not focus as much on the residual analysis in terms of both the real estate fundamentals and the creditworthiness of the tenant. But their potential success is based on a favorable early exit."

Ed Hanley, president of Hanley Investment Group Real Estate Advisors, tells Forum as supply remains scarce and yields for single-tenant and net lease properties in primary markets continue to compress, an increasing number of investors are seeking opportunities in secondary or tertiary markets across the country to meet their requirements. "Those investors willing to purchase well-located net-leased properties in small to mid-size markets are able to take advantage of slightly-above-market returns compared to the premium values being demanded in primary markets."

Lifestyle is the trend in net lease these days, Matthew Mousavi, senior managing director of Faris Lee Investments, tells Forum. "New fast-casual and healthy-dining and entertainment concepts are growing at a rapid pace. Younger consumers, particularly the Millennials, enjoy dining out and having a wide array of options. Health and fitness uses, particularly the specialized and smaller-format concepts, are gaining in popularity—yoga, Pilates, barre, boot camps and other class formats are taking more free-standing and in-line space within neighborhood and lifestyle-oriented centers."

Mousavi says as retailers within this lifestyle segment expand, developers are meeting the demand by constructing free-standing properties featuring long-term net leases. "Net-leased restaurant properties are highly popular with investors of all types, public and private. These properties include traditional quick service, fast food and drive-thru, as well as new fast-casual and casual-dining concepts. Net-leased gym and fitness uses are also well received by the marketplace. Properties leased to necessity-based users such as grocery stores and pharmacies continue to transact with high velocity, as are discount retailers such as dollar and convenience stores."

On the other hand, Mousavi says properties net leased to retailers specializing in electronics, clothing, soft goods and housewares are in less demand as these retailers struggle financially with competition from e-commerce giants like Amazon. "Many of these retailers are downsizing, closing stores and shifting their business models to attempt to synergize their brick-and-mortar locations with their online businesses."

But overall, investor demand for net lease properties continues its momentum across the majority of markets throughout the country, says Mousavi. "New construction leased to investment-grade and strong-credit tenants is trading at ultra-low cap rates and is in highest demand. For example, we have transacted and continue to transact several new corporate ground-leased and build-to-suit investments within the top 20 MSAs in the low- to mid-3% cap-rate range. As investors continue to seek passive and predictable income, coupled with the choppy equity markets and sluggish—and, in some cases declining—economies globally, namely China and Europe, demand for net lease properties continues to increase."

While demand continues from private investors, REITs and institutional buyers, the sale-leaseback sector of net lease has increased tremendously in velocity, Chris Sands, founder of Sands Investment Group, tells Forum. "Operators, franchisees and corporations that own and occupy their real estate are recognizing the current market opportunity and are choosing to structure long-term leases and sell their underlying real estate. In particular, the long-term leases are highly desirable in today's market due to certainty of occupancy and yield for the investor. Overall, the liquidity of these events allows companies to infuse capital back into their business, acquire smaller companies or expand into new locations."

The tremendous deal velocity is also partially fueled by historic IRC 1031 transactions in which sellers are, appropriately, exploiting the compressed-cap-rate environment before rates change, Sean O'Shea, managing director for the O'Shea Net Lease Advisory, a BRC Advisors Co., tells Forum. "The very same sellers then become buyers, and securing an acceptable replacement is the real challenge in the current NNN marketplace. Net-leased assets that have historically traded in the mid-8% cap range are now being executed at 6%-cap pricing. Inventories are improving, but with the crush of capital chasing net lease deals, buyers/investors are being asked to recast their yield expectations on a daily basis."

New Financing Strategies

Some changes are occurring in the strategies that buyers are using to finance net lease purchases. Sabatini says for his firm, the financing strategies it uses depend on which of its entities is acquiring an individual asset. "In the case of our publicly traded REIT portfolio, we finance our acquisitions with a combination of balance-sheet debt and equity. For our non-traded REITs, which have a finite life, we typically use non-recourse, property-specific mortgage debt in combination with equity raised through our non-traded REIT offerings. We have never been a highly leveraged buyer. As a result we have been successful at securing attractively priced non-recourse debt, and our track record of closing acquisitions on a timely and efficient basis has been a differentiating factor for us through our 40-plus-year history in the net lease investment space. In addition, our ability to craft more complex deal structures and evaluate privately owned as well as publicly owned corporate tenants allows us to secure opportunities that other investors are not equipped to evaluate, structure and negotiate."

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Hanley says competition has increased as more lenders have entered the market trying to keep pace with new purchases and refinancings at historical low interest rates. "Borrowers are paying closer attention to future exit strategies, including potential pre-payment penalties and assumption fees. Interest-only components within the initial portion of a fixed-rate loan are very prevalent, again offering borrowers increased cash flow at the beginning of their loan period."

Investors Faris Lee places into net lease properties are increasingly utilizing smaller, local banks and credit unions to finance their purchases, says Mousavi. "Traditionally, larger, more-recognized banks, life insurance companies and institutions were tapped for financing net lease properties, and small and local banks focused on relationship borrowers and local lending. Today we are seeing a high number of smaller, local and regional banks aggressively pursuing loans collateralized by net lease properties on a national basis. The investor, bank and net lease property are all located in different states in many of our transactions. This is a new 'national lending' dynamic we are witnessing and is a major positive for investors. Larger and institutionalized banks are having to compete with local banks and credit unions, thereby increasing competition within the lending space and reducing the cost of capital to investors."

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Sands says while the majority of the new acquisitions are either cash purchases or conventional financing (given the attractive interest rates that are benefitting borrowers), his firm is now seeing an increase in seller financing. "Sellers don't want to miss an opportunity to take advantage of the values they are getting for their real estate, but they are also concerned about whether there will be another investment of equal or greater value available into which they can exchange their capital gains. The installment-sale approach to selling is allowing buyers to acquire properties without having to perform an appraisal. For sellers, they can benefit from both the possibility that their property would not have appraised equal to the incredible values they are selling for, and they are also getting reoccurring cash flow that is collateralized by the property they owned. While this is not frequent, it is a strategy that we are seeing to avoid the appraisal process and to continue the reoccurring cash flow that benefits the seller, without having to acquire a new property."

O'Shea's firm appreciates that due to the compressed cap rates, buyers and their lenders are structuring many deals with "IO" debt. "While understandable in crafting a short-term yield solution, this type of debt is subject to lease term and possible lease escalations that could be accretive, and the loan-to-value leverage is very important. We are counseling the lowest LTV to secure best coupon rates, and only tenants with a minimum of 10 years remaining on their lease are the best candidates. In our best judgment, too much debt and not enough term, combined with real estate intrinsic, could yield a short-term solution and a long-term refinancing problem that could endanger NNN assets' residual value. This is a serious issue that not everybody is taking seriously enough.  We are apparently 'old school' in terms of locking in fixed longest-term debt to ride out the next six to eight years. Accepting lower-than-hoped-for yield may be tough, but it's a sound strategy."

Institutional Investors' Yield-Capturing Strategies 

Institutional investors have their own unique underwriting criteria for any type of real estate transaction, and that goes for the net lease sector as well. What is this sector doing in an attempt to capture necessary yield?

Hanley says institutional investors are trying to purchase in bulk (i.e. portfolios) in order to get a higher yield. "Due to increased cap-rate compression of core tenants such as Walgreens, CVS, O'Reilly Auto Parts and AutoZone, many institutional investors are now willing to consider non-investment-grade tenant net lease properties in proven locations in primary markets. They're looking at second and third-tier credit tenants, which opens them up to double or triple the amount of opportunities." Still, he adds, this is driving down cap rates as the competition gets more heated. It also pushes private investors into the secondary and tertiary markets in search of higher yields.

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According to Mousavi, the number of private investors within the net lease space has increased dramatically. "At the same time, public REITs and institutions targeting net lease properties have also grown exponentially as capital flows through the equity markets, private equity funds and other capital sources into net lease REITs and institutions. In order to compete with the private market and to secure a higher yield and deploy capital, institutional investors are targeting larger-price-point acquisitions ($50 million to $100 million-plus), portfolio acquisitions and other higher-price-point transactions where competition from the private market is dramatically reduced. There's also been a considerable amount of multi-billion-dollar corporate mergers, acquisitions, and overall consolidation within the institutional net lease sector as another method of growing assets, engineering a higher yield and increasing operating efficiencies."

Sands says there are two prevalent strategies that institutional investors are using to capture yield. "The first is they are acquiring short-term lease opportunities at a better yield and then restructuring the lease with the tenant in order to create the term that they typically desire when acquiring. The second is they are doing build-to-suit development for tenants that are looking to expand. In this scenario, they can control and manipulate multiple variables such as construction costs, rent that tenant will pay, tenant improvements and more." In turn, they can create a better yield for a new building with a long-term tenant that they would otherwise have to pay a market cap rate for if they were to acquire it from another developer."

Sabatini says his firm's approach and evaluation of any new investment remains consistent. "We look at the creditworthiness of the tenant, the strength of the real estate fundamentals as well as the fungibility of the asset and the structure of the transaction. The way we capture yield is over the long term, so we not only evaluate initial yields but also look at contractual escalations over the life of the lease. A large part of that consideration is how current rent compares with current market rents and what potential upside we have on renewals or releasing of the asset at the end of the initial term of the lease." 

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A large part of W. P. Carey's strategy is its global presence and capabilities, Sabatini adds. "Our on-the-ground team in Europe, where cap rates and lending rates compare favorably with the US, has been able to underwrite and secure significant accretive opportunities for both our owned portfolio as well as our managed REITs. For longer-term institutional investors such as ourselves, the analysis is somewhat comparable. However, some of today's shorter-term investors often maximize their yield by securing shorter-term, lower-rate debt with the idea that they will be selling the asset before they need to refinance. That is a much riskier proposition and one into which we do not buy." 

Other factors for W. P. Carey in achieving attractive yields are its relationships and history with tenants, lenders, brokers and other intermediaries. "We often get the best yield when we are not the initial successful bidder on a particular acquisition," says Sabatini. "In cases where the initial winner of the bid fails to close on a timely basis on the agreed upon terms, the seller or their representatives will often turn to us because of the certainty of close that we have historically delivered."

O'Shea says the biggest issue is underwriting the residual valuations and crafting a really efficient exit strategy for these assets. "Lower leverage and best-deal economics. There are real estate cycles, and they have their own historical context and deal dynamics. We are living in unprecedented times, and it's worth noting the Black Swans that are appearing more frequently in our practice."