Fed Pushes Net Lease Cap Rates to New Lows

While the total number of net lease transactions fell 19% year-over-year in the third quarter, cap rates in the single-tenant net lease retail, office and industrial sectors reached a new all-time low in the third quarter of 2020, according to the 3rd Quarter Net Lease Research Report from The Boulder Group.

In the third quarter of 2019, the net lease sector saw 16,245 transactions trade for a total of $61.1 billion, according to The Boulder Group. In Q3 2020, 13,136 transactions trade for a total of $44 billion.

Compared to the second quarter of 2020, cap rates compressed by 19, 10 and 11 basis points respectively for retail, office and industrial. The retail sector experienced its largest cap rate decrease since 2014 as private and 1031 exchange investors aggressively sought the lower-priced assets this sector provided.

The record low cap rates were partially driven by the Federal Reserve’s announcement that interest rates will remain near zero through at least 2023.

“Everyone thought there was a point where the Fed might close the spigot a little bit,” says Randy Blankstein, president of The Boulder Group. “They’re saying that may happen, but it won’t be soon. So these people understand the current rate environment. More than ever, people need fixed income and bonds aren’t enough for the retirement that people envision. So people need higher-yielding stuff, which fits this [net lease] asset class.”

A flight to quality also powered the low cap rates. Properties with long term leases to investment grade tenants are still in the highest demand.

“Walgreens, Target and Walmart–all these central businesses that are investment grade–are doing well,” Blankstein says. “That is the stuff that trades. If you have a two-unit fitness center, people aren’t even putting it on the market, which is why cap rates are going down.”

That change, caused by COVID, is a departure from just a year ago.

“A year ago, if you have a health club or a movie theater, you would put it on the market and see where it goes,” Blankstein says. “Now, you need to wait until after COVID, or for things to change, before that business is viable enough that people are interested in it. People understand today that stuff just won’t trade.”

As real estate with essential tenants has thrived during the pandemic, owners of assets that have suffered, like theaters, gyms and second-tier casual dining, are not even putting their properties on the market.

“People aren’t selling,” Blankstein says. “This is a conservative market and will pay up for good stuff. It’s not a market that’s looking to put more risk on.”

According to The Boulder Group, the supply of net lease properties declined approximately 9% in the third quarter. Blankstein expects net lease transaction volume for 2020 to be significantly lower than 2019 due to COVID-19’s impact on the sector. While the Q1 2020 was strong, there was a sharp decline in Q2.

“Even though the third quarter rebounded, it didn’t rebound to last year’s level,” Blankstein says. “The fourth quarter is going to be good. But the second quarter was so bad that it’s going to drive the whole year down. Overall for the year, we will be down. There is no question about it.”