CRE's Most Unassuming Asset Class

Griffin Capital’s purchase of a Toshiba subsidiary’s Durham, NC headquarters was one of the biggest net lease transactions in Q1.

  This is an HTML version of an article that ran in Real Estate Forum. To see the story in its original format, click here. Net lease transactions in the first quarter of 2016 totaled $8.8 billion, a throat-gulping year-over-year drop of 44.1%, according to JLL’s first quarter Net Lease Investment Sales outlook. Let’s set that aside for a moment, though, to consider two notable transactions that did occur in the quarter. One was the $354-million trade of Cira Square in Philadelphia. Radnor, PA-based Brandywine Realty Trust sold this redeveloped CBD asset leased by the Internal Revenue Service to South Korea-based Korea Investment Management. Another was by El Segundo, CA-based Griffin Capital Corp., which purchased the 200,846-square-foot Toshiba Global Commerce Solutions Corporate headquarters in Durham, NC for $35.8 million. Now let’s ponder these deals for a moment. The Cira Square deal was one of the largest net lease transactions for the quarter, acquired by a foreign investor. Yes, we all know—foreign investors are placing capital in US commercial real estate at record volumes. But according to the industry’s storyline, they are interested only in assets they can easily explain to their investors. That usually translates into trophy office in gateway cities. Not the pedestrian category of net lease and not in a second-tier city such as Philly. And then there is the purchase by Griffin Capital, a non-traded REIT. The bare-bones rendition of this deal doesn’t convey it, but Griffin Capital worked hard to get this particular property, fighting off competing buyers for it. It was worth it as, president David Rupert says, the company is not a buyer of commodity assets. Something, in short, is happening in the net lease space that is not immediately, or at all, apparent from the Q1 sales figures but can be seen so clearly from these individual deals. Because not only did net lease investment sales drop during the quarter, but so did many other related metrics, according to the JLL report. Sale leaseback transactions declined by 56.1%. Fundraising by non-traded REITs, such as Griffin Capital, decreased 57.1% year over year, causing non-traded REIT acquisitions to decline by 48.9%. And while we are at it, foreign net lease investments decreased 69.9% in the quarter. These dismal numbers followed a peak year of activity in 2015. As is often the case, that “something” is due to multiple reasons. The intense competition for assets has pushed this once unassuming, steady, income-delivering asset class into the global spotlight. Of course, foreign capital has been participating in the US net lease asset class for decades, but these buyers have only been interested in certain cities. As one net lease REIT CEO tells Real Estate Forum , “we have watched them overpay for the same type of asset in the same type of CBD for years.” Now, though, they are getting smarter, perhaps because a younger generation of foreign investment asset managers and buyers are coming to the market. They went to schools in the US outside of the Ivy League and are more familiar with such cities as Denver or Atlanta. They feel comfortable buying in these markets and explaining them to investors back home, the CEO explains.

“There was a great deal of uncertainty in the market in Q1, which caused a lot of institutions to sit back and watch as the net lease market slowed down.”—April Ronchetti Little, Spirit Realty Capital

But it’s not just foreign investors that are snapping up assets. Domestic buyers—both institutional and individuals via 1031 exchanges—are eager to invest their money as well. Why? For the very familiar and ubiquitous explanation that investors are searching everywhere for a respectable yield. They are finding it in the net lease asset class. “In a very low-yield environment people are looking for alternatives to provide stable income,” says New York City-based Broadstone Real Estate president and CEO Chris Czarnecki. This has been the catalyst for the growth of the industry for the last five years, giving rise to public and private REITs devoted to net lease assets. Then, finally, there is the elephant in the room: the effect that one of the biggest buyers of these assets in memory, American Realty Capital’s family of net lease property trusts, has had on the market. It is effectively a non-buyer now, leaving in its wake a realigned market. But what to make of Q1? Reasons attributed to the drop include the general volatility in the US equity and capital markets, global economic uncertainty and political uncertainty in the US. Another theory behind Q1′s sad performance is that the net lease cycle, like that of some of the other CRE assets such as hotels, is maturing.  This is true: the cycle is very mature for net lease right now, which can make it dangerous for plays that stretch to get yield. But few believe that the cycle is over. For the most part, the industry believes that sales will pick up for the remainder of the year to turn in a respectable performance for 2016. JLL, in its report for example, makes that prediction. This is not to understand the current market. “The fact of the matter is the market was soft in the first quarter of 2016 and continues to be sluggish into the second quarter as well,” says Daniel Herrold, senior director of Stan Johnson Co. But the year should end well, he concludes, with deals picking up in the third and fourth quarters. “Most of the net lease institutional buyers have been net sellers thus far this year, but they’ll have to pick up the pace on acquisitions to keep up or catch up with their targets. Furthermore, the 1031 market remains healthy. So overall, I think volumes will increase over the course of the year.” There are other reasons for optimism about net lease investment sales performance for the year. There is a strong pipeline of build-to-suits, with an additional 13 million square feet expected to deliver over the next nine months, according to JLL. For example, April Ronchetti Little, vice president of Investments for Scottsdale, AZ-based Spirit Realty Capital, says Spirit Realty has “a very robust pipeline for the second half of the year and we are working through the transactions. We do not give guidance but I will say there is a lot of activity in the market today and we should have a strong finish to the year.” She too, though, acknowledges the unnerving start to 2016. “There was a great deal of uncertainty in the market in Q1 of 2016, which caused a lot of institutions to sit back and watch as the net lease market slowed down.”

In April, W. P. Carey entered into a sale-leaseback transaction with Nord Anglia to acquire this Windermere, FL property and two other preparatory schools.

Other developments expected to drive deals for the remainder of the year include rising investor demand, a buyer base that is broadening (see the Cira Square deal) and the increasing willingness of institutional buyers to pick up single-tenant assets, again in the unquenchable desire for yield. These latter transactions increased by 9% in Q1 year over year, JLL reports, due to “the ongoing focus on diversification and yield in the latter stages of the cycle.” JLL concluded that the impact of these buyers relative to overall activity has increased 58.2% year over year. All that said, JLL in its report says it believes that net lease investment sales for the year will decline compared to 2015, which came close to reaching $50 billion. One reason for that may be that it’s sinking in that interest rates will remain very low, barring the occasional increase here and there. “With the current general expectation that we will continue to operate in a low interest rate environment for the foreseeable future, sellers may not feel the same urgency to jump into the market to capture the higher pricing driven by lower cap rates as they did in 2015,” says Jason Fox, president and head of global investments for the global net lease REIT, New York City-based W. P. Carey. Don’t take that to the bank though, so to speak, he adds. “As we all know, that outlook can be impacted by a range of political and economic events, so we will have to see how the rest of the year plays out on that front.” Fox’s take on the market for the moment, though, is largely optimistic. “Net lease in the US continues to be competitive, although from what we are observing cap rates appear to be reaching a bottom,” he says. “Widely marketed deals continue to attract aggressive bidding while less marketed, relationship-based deals offer better opportunities, which is where we continue to focus our efforts.” As for whether transaction volume will improve, that will be largely driven by the supply of attractive net lease assets.” It’s an interesting environment for net lease—and one that buyers must navigate very carefully. It also helps to have an edge of some kind. In Griffin Capital’s case, that “edge” was a willingness to hold off on placing its capital until the seller was ready to pull the trigger. The four-story, 200,846-square-foot Toshiba Global Commerce Solutions Corporate headquarters that it acquired in February 2016 is leased to Toshiba TEC Corp. through April 2028. Its subsidiary, Toshiba Global Commerce Solutions, is occupying the property. Toshiba Global Commerce was created when Toshiba TEC acquired IBM’s Retail Store Solutions business for $850 million in 2012. IBM remained the owner of the property. Now, the Toshiba property checked off a lot of boxes for Griffin. It (1) benefited from the strong market fundamentals in the Research Triangle Park area in Raleigh, (2) had undergone extensive building renovation, (3) had a name brand tenancy and (4) that tenant was paying below-market rent. It checked off a lot of boxes for competing buyers, too. Griffin Capital first got wind of the asset and its potential because its acquisition team had an existing relationship with the investment sales team from CBRE, according to Rupert. It went on to win the deal by being creative in structuring the deal to meet IBM’s needs. IBM wanted flexibility in the closing date for tax purposes, Rupert said, with a “preferred closing window” that was more than six months in the future. That accommodation took competitors that needed to put their capital to work right away out of the running. Griffin used its financial flexibility to maximum leverage, in other words—a concept that Spirit Realty takes and really runs with. It views itself as a partner to its SLB and net-leased tenants, there to help nurture their growth, Little says. The makeup of its portfolio allows it to assume this role: Spirit has 2,600 properties in the portfolio but those properties are leased to 470 tenants. “Recently Spirit acquired a $60 million grocery store portfolio in the Midwest,” says Little. “Spirit was able to partner with the company to monetize their real estate to free up capital to improve the company’s balance sheet. The properties are high quality real estate assets that improve the quality and diversity of Spirit’s portfolio through sustainable cash flows.” But Spirit is likely an exception in the net lease investment space. Most of the institutional buyers navigate the market’s ups and downs by being very savvy. For example, a common tactic Griffin Capital also uses to source the best deals is to arrange a transaction on the front end with a developer who has a credit-worthy tenant before construction even begins. Griffin Capital is using this strategy to buy into the industrial asset class right now, Rupert says. Developers are flocking to build new warehouses close to cities to accommodate the demand of online sellers to be close to their customers, Rupert explains. What they typically do is build the warehouse or distribution center and then sell it to a buyer when it delivers. At that point there are no unknowns left: the risk is no longer priced into the valuation, the competition is higher and the price is about 75 to 100 basis points more. “We skip that entire step and arrange our purchase before the building is developed,” says Rupert. This MO also allows Griffin Capital to avoid the cardinal sin of stretching for yield in a very mature cycle by having a less-than-investment grade tenant or a building that is not brand new. Pricing, especially for shorter-term buyers, has become a concern due to the influx of demand, Broadstone Real Estate’s Czarnecki says. “There are plenty of wealthy individuals buying properties, but they always have been in this space,” he says. But as the economy continues its recovery, these people are finding themselves up against tight deadlines to get dollars deployed or face taxable gains. “Those folks are the most aggressive acquirers, driving up prices on the individual side.”

“The true winners will be those buyers that are prepared to hold and are not over-levered. A 20-year deal, if that asset is leased up, will generate escalating revenue.”—Shelby Pruett, Capri EGM

Meanwhile, portfolio buyers are less active as, ahem, one of the most prolific has left the field. A portfolio discount for buyers has emerged but it is a subtle one, Czarnecki says. “Changes we have seen include provisions that now favor the landlord, such as with insurance, and longer lease terms.” For example, he says most restaurant and retail assets have returned to the 20-year range, compared to 15 years not long ago. Medical and industrial lease terms, for their part, are back in the 15-year range, compared to 12 years. The truth is, no one knows where the cycle is right now, other than it is “mature,” says Shelby Pruett, founder of the Chicago-headquartered Equity Global Management, a private equity real estate investment firm that invests in net lease, sale leaseback and build-to-suit assets. He now oversees the business activities of Capri EGM, Capri’s joint venture specializing in net lease investments in major US property markets. At this point, the investors that have been thinking about jumping into the net lease market for quick gains better be prepared for the long haul. “The true winners will be those buyers that are prepared to hold and are not over-levered,” Pruett says. “A 20-year deal, if that asset is leased up, will generate escalating revenue. A buyer can hold onto that asset through a downturn and wait for the upturn.” To be sure, such a scenario sounds like a dream to many investors, which is why cap rates have compressed so dramatically in recent years, says Pruett. “The gateway markets have become very expensive. In some cases yields are so low deals have become a preservation of capital move for investors, especially foreign investors. They will accept a four cap in a gateway market.” The spread between gateway and non-gateway markets for office and industrial buildings now is about 200 to 300 bps, Pruett says. His strategy is to look at markets that are surrounding the gateway markets. These enclaves are becoming viable live-work-play hubs and are generating significant employment growth and lending activity. “Right now we are looking at an asset in a transit-oriented suburb to a gateway market on the East Coast.” WPC’s Fox also looks to the long-term when calculating yield. That means not only evaluating initial yields but also looking at contractual escalations over the life of the lease, he says. “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.”  But perhaps the most important ingredient in WPC’s secret sauce is its ability to underwrite property types that are not typically thought of as sale-leaseback properties. At the start of April, WPC entered into an SLB transaction with Nord Anglia, a global educational organization, to acquire a private preparatory school campus in Florida along with agreements to acquire two additional school campuses by the end of Q2 in Florida and Texas. Both the existing and build-to-suit facilities are subject to 25-year leases with uncapped CPI base rent escalation. The purchase price for all three properties totaled $176 million and WPC agreed to provide up to an additional $128 million in build-to-suit financing over the next four years to fund the expansion of existing facilities. “These are prestigious private schools with long histories of profitability and success,” Fox says. “Individually, they have strong rent coverage with income sourced from private paid tuition fees and further supported by a guarantee from Nord Anglia.” Fox adds that WPC’s ability to underwrite this deal—private tuition substituted as rent and all—is what will allow it to continue to be competitive in the net lease market. And indeed, one has a difficult time envisioning a foreign investor, no matter how savvy about the US markets, willing to explain the nuances of our school system to the folks back home.