Despite Inflation, Investors Are Still Flocking to Net Lease

The net lease sector has been somewhat resistant to the Fed’s rate hikes so far, but according to Gary Chou of Berkeley Capital Advisors in Orange County, Calif., “it’s a matter of when, and not if, cap rates will start moving.” 

Chou, who will be sharing his insights on the net lease investment market at this year’s GlobeSt Net Lease conference in Los Angeles in October, says he’s observing a broader upward pressure on cap rates across the board in the net lease space. In the early part of 2022, he says, that pressure was more localized around specific types or grade of properties.

“Throughout the year we started seeing little pockets of net lease start to shift,” he says. “We’ve seen increased spreads on cap rates for deals that have varying degrees of quality. When COVID hit, everyone wanted Class A deals. They were scared of Class C and D deals. Last year in the frenzy, everything started compressing again and we started seeing five-year deals trading very similarly to 20-year deals. That normally doesn’t make sense – and it’s reasonable to expect that would start to change, regardless of whether the Fed hiked rates.”

In Chou’s experience, the deals that are transacting at cap rates similar to last year’s are those that don’t require debt, which tend to be in the $5 million and below tranche. He also notes an increase in funds coming into the net lease space that are focusing on medical and industrial spaces as well as retail.

“The cost of financing and lending has gone up, and so as of the latest hike, rates were roughly in the 5 to 5.25% range,” he says. “We’ll see if they continue to go up. A lot was priced in already, but that’s our baseline right now.”

And Chou says that because the loan-to-value ratio for deals are going down, “lenders are requiring more equity. A lot of the lenders are trying to ensure they maintain their debt service coverage ratio and at the end of the day, that’s what’s pushing buyers to see if they want to buy a deal.”

Heading into 2023, Chou says he’ll be keeping a close eye on supply and demand to help predict where investors will go moving forward.

“Five years back, people were not as active in medical and industrial net lease, and it’s a trend we’ve pushed into and followed as a demand from clients,” he says. “Every year there are new trends and products that come back or fade for certain reasons, and on the supply side that’s something that will be interesting to really observe.”

And M&A activity, which is often a source of net lease product, has cooled a bit since last year, “so that will cause a potential supply constraint if people aren’t selling as much,” he notes. As for the development market, “the 1031 markets are robust right now, and product is coming out,” he says. “But the market has been cooling to some extent, and we’ll see less product coming online over the next 12 to 24 months. And that could be the right timing if the market starts to cool from an interest rate perspective – less product may help the net lease space values stay robust.”

Check back soon for more insights from Gary Chou and other panelists and speakers at this year’s GlobeSt net lease conference.