Net Lease: Challenges or a Bubble?

 

Eli Randel, director of business development at CREXi.

VENICE, CA— CREXi  has experienced a volume explosion of quality single-tenant net lease deals from top brokerages mirroring a macro surge in recent quarters (and years) due to compressed cap rates creating yield starved investors, demographic trends, and a shift away from Wall Street investment products. In two recent client meetings, he says Eli Randel, director of business development, says that “very sophisticated investors” have asked if there was a bubble forming in the segment. His answer is “no” as he explains in the exclusive commentary below. The views expressed below are the author’s own. NET LEASE Net lease investments are a tenancy structure in which the property owner has one tenant paying rent to the landlord and also paying all property related expenses including taxes, insurance, and structure. Therefore, the rent payment is the same as the NOI or net income amount to the landlord. The structure results in an investment similar to a bond as rent payment becomes the coupon or “fixed” income which is secured by the asset in the event of default. In recent years, yields have ranged from 4.5%-7.5% depending on the credit of the tenant, the terms of the lease, and the projected future value of the real estate. Modest returns are exchanged for low risk profiles, passive ownership, and usually income and/or wealth preservation strategies. IRRs can be further enhanced with debt, at reversion, or as NOIs increase via rental rate “bumps” during the term of the lease or at exercise of option(s). BUBBLE SPECULATION (THE BEAR) Oversupply & Inefficiency Low cap rates have resulted in ideal sale pricing which has created an oversupply of properties resulting in a small decrease in sales velocity and liquidity as supply is exceeding demand of late. “Credit” has also become an oft abused term recently signifying any “national company” when meant to indicate a company whose debt is credit/investment grade rated reflecting an ability for the tenant to honor their lease. In an efficient market, cap rates should vary based on the credit of the tenant and therefore the surety of the income stream. In recent years we’ve seen homogenous cap rate pricing for different risk scenarios. Lease terms should also be priced into the yield based on term remaining yet sometimes aren’t. Institutional investors typically require lease terms of 12 years or greater (but will often accept ten year terms). Any lease term less than ten years should generally have a cap rate premium associated with the price. Pricing homogeny has created risk-reward disconnects which has made the market segment less efficient than designed to be. Peak Value Another condition concerning to many is a likelihood of increasing cap rates resulting in immediately decreased asset values. During the last few years as investors are starving for income they have been accepting historically low yields resulting in high asset values. However, many sense a loosening of cap rates which would result in lower asset values. Some feel as if buying net lease assets at current cap rates is a purchase at peak value with depreciation soon to follow. WHY THERE IS NO BUBBLE (THE BULL) Increased Demand and Efficiency Restoration The supply and demand curve will correct itself as sellers slightly adjust pricing expectations coupled with demand increases from a surge of retirees looking for fixed income investments offering yields greater than other low-risk passive alternatives. International investors in countries with negative interest rates and riddled with economic risks, continue to be attracted to the net lease segment and wealth management advisors specializing in passive real estate continue to emerge daily. Buyer underwriting will become more efficient as technology brings access to analytics, credit ratings, and lease auditing and buyers become more selective. The result will be a supply balance and a more efficient marketplace Peak Concerns Net lease buyers should generally not be “traders” and should employ a cash flow strategy whereas they are long-term holders and generally don’t need to liquidate their investment in a down market. Though cap rates may expand, they will eventually compress again and an investment that achieves the buyer’s wealth preservation and cash flow strategies with low-risk during the entirety of the cycle is a powerful vehicle that can be hard to replicate. Additionally, with rent “bumps” during term and resets at option exercise, NOI increases will boost appreciation or offset depreciation. In other words, paper value fluctuations should be ignored. Alternatives With interest rates remaining low (at least in the near future), there are few yield alternatives for investors. CDs, savings accounts, and low-risk bonds offer negligible yields and remain less palatable to investors disillusioned by banks and Wall Street investment products. Net lease ownership offers singular fee simple ownership with no fees or intermediary layers of control with base IRRs in the mid to high single digits, enhancement opportunities, and usually very low risk profiles. Low Barrier to Entry Because access to net lease deals is relatively easy with brokers marketing deals nationally and to a more general audience, net lease deals offer investors access and exposure to markets they typically would not be able to find opportunities in without a local presence. This allows investors to enter new markets and geographically diversify their portfolio with a low-risk entry investment. Technology (The CREXi Story)  We believe net lease assets are a stepping stone to better bringing commercial real estate online. Assets are typically highly liquid, can be acquired by a national or international audience, and can be transacted on efficiently. The challenge? Yields are sensitive to fees. Platforms charging high fees can drag yields outside of a tradable level however, our platform is 100% free and we are dedicated to ensuring that our technology increases efficiency and lowers friction costs as opposed to contributing to them.