Is the Net Lease Market on the Verge of Becoming Frothy?

For all intents, net lease transactions had a banner quarter in the first part of this year, according to CBRE stats. Net-lease investment volume totalled $14.3 billion for the first quarter, a 2.6% year over year drop that prompted CBRE to say the sector was close to its pre-pandemic performance. For commercial real estate as a whole, by comparison, volume was down 18.3% in Q1 2021, according to Real Capital Analytics. 

But those numbers don’t tell the whole story for the asset class. They don’t tell of the difficulty new entrants in the market are having sourcing transactions because it is so competitive. Or that pricing is far tighter than many investors would like. Or the huge amount of money chasing what is ultimately a finite number of deals. Those numbers don’t say what some experts are thinking, namely that the net lease market may be on the verge of entering frothy territory.

“The market is extremely competitive and cap rates are at historic lows right now,” says Josh Lewis, senior vice president of Acquisitions at National Retail Properties and a participant in the GlobeSt. NET LEASE Conference being held this week in New York. “There is more capital chasing deals than at any other time that I can remember. There is just a real frothiness to the market.” 

Gary Chou, partner with Berkeley Capital Advisors and another participant in the NET LEASE Conference, has similar concerns. “In the big picture, yes, there is froth in the market,” he tells GlobeSt.com. “There is a lot of dry powder chasing deals right now.”

For the moment, pricing does not appear to have been too unduly affected by these trends. “It is hard for deals to become overvalued,” Chou says. “There is definitely some degree of froth in the system right now, a lot of which is being driven by stimulus money. But when you look at it from an underwriting perspective you will see that lenders are still being strict.”

This is not to negate the fact that yields for most investments are at historic lows. Navigating this environment takes skill, relationships and a good dose of steady nerves.

“The fundamentals are solid and safe,” Chou continues,  “but when you compare the last six to nine months of activity in the net lease market to even to 2017 or 2018, buyer interest level is more aggressive than it’s ever been.”

Indeed, the high demand for net lease assets is the most common observation among the experts with whom GlobeSt.com has spoken.

“Demand for product right now in this post-pandemic environment is at unprecedented levels,” Jimmy Goodman, partner with The Boulder Group and participant in the NET LEASE Conference, tells GlobeSt.com. Supply is limited because construction was halted during the pandemic and is still constrained because of the cost of building materials right now, he adds. The result of this mismatch between demand and supply? The level of cap rates can be difficult for some investors to get comfortable with based on the threshold rate of return they need to get, he says.

And that’s assuming they can even secure a deal. New-to-the-market investors are finding it difficult to break in because they don’t have the relationships and contacts in place to source transactions. Goodman reports some investors are now trying to get deals done during the construction period, partnering with developers to get the product before it hits the market.

Buyers are aggressive on their terms, Chou notes, by offering all cash or a quick closing or the cap rates they are willing to accept.

Another hallmark of the current market: the spread on the cap rates between a 20-year deal versus a five-year deal is as low as it’s ever been. Traditionally, the spread on these two assets might be 100 basis points, Chou says. Now, they’re trading within 50 basis points.

All that said, investors are not losing their heads in the rush to compete for deals, National Retail Properties’ Lewis says. “I think most folks in our space are trying to be prudent investors and trying to be  good stewards of shareholder capital and get returns appropriate on a risk adjusted basis.” But, he adds, that is getting increasingly harder to do.