How to Strike a Great Deal in a Stagnant Net Lease Market

Transactions have slowed in just about every category for commercial real estate and net lease is no exception. The reasons are myriad for that but let’s boil them down to two in particular: 

One, sellers do not want to sell their property for less money than it was worth previously.

Two, sellers are taking on more risk and getting the same return.

Sellers, quite understandably, do not like the idea of selling something for less money than it was previously worth. Unfortunately, with many net lease assets having minimal or no rental increases in the base term, a diminishing lease term, and difficulty backfilling the locations at similar rent, values for these asset classes might never return to what they were just a year ago in our professional lifetime. This psychological issue prevents transactions from occurring.  Most net lease owners didn’t realize or wouldn’t acknowledge the bond bubble that propelled property values had ended at some point, and many owners still don’t understand what that means.

The second issue is a real problem. Today’s sellers with existing financing have to take on more risk to get the same return they are currently getting. With interest rates and thus, the debt constant, higher today than yesterday, replacing cash flow means buying at a higher cap than the one they’re selling. Since a cap rate is a measurement of risk compared to alternative investments, they’re taking on more risk to get the same return. Furthermore, their current loan is an asset, and once they sell their property, that asset disappears. For many owners that might normally transact, it simply doesn’t pencil, and they stop transacting.

There is good news for sellers even in this market.  First, for those sellers that are entering into an exchange after the relinquished property, they are able to somewhat time the market.  Typically government regulations prevent sellers from selling “high” in a good market and buying “low” in a bad market.  However, as cap rates continue to rise, sellers are now selling their property at a higher value and purchasing their replacement properties at a lower value.    Furthermore, inflation is everywhere, including CRE rents and construction costs, which means if you have a short-term lease coming due, with every passing day it increases the probability the tenant renews the lease and stays at the location.

The market also presents challenges for buyers of net lease assets.

Cap rates tend to reflect their risk compared to alternative investments, and there is a lag time with real estate values compared to other alternatives. This lag time can be felt in as little as six months, and sometimes it can take more than a year. In this cycle, data suggest that it was closer to a year. Either way, as interest rates rise, they make alternative investments more appealing and real estate less attractive.  For savvier investors that are focused on long-term IRR, purchasing net lease might be off the table entirely as we enter into a market that will perform fundamentally differently than the last 40 years.

Cap rates are moving up, and nobody can predict exactly when they will begin to come down which is causing some buyers to stop purchasing new investments right now. It’s quite simple – they don’t want to buy an asset that will be worth less the day after they close escrow than their contracted price. These investors will wait until cap rates settle and they feel comfortable with current market conditions.

While ample debt still exists for most borrowers and deals, it’s simply too expensive relative to the investment they are making. Either debt has to come down, or cap rates have to move up before they can achieve their ideal results. What will likely occur is both, cap rates will continue to move up, and eventually, debt becomes cheaper again.  This is the catalyst for a market shift.

Owners looking for an upside share the same concerns but might pursue other investment opportunities outside the net lease market. For owners looking for value-add opportunities, many will chase a potential rebound of the stock market rather than the net lease market.

Just because market conditions are not ideal doesn’t mean all transactions stop.  There are investors that are capable of deploying capital into the right investment and there are broader factors that impact an investment regardless of market conditions.

There are always life-changing events that can cause a desire or need to sell, regardless of market conditions. In addition, we see the baby-boomer generation exchanging out of management-intensive properties, causing a strong demand to exchange into passive net lease properties. While their assets have likely performed well with rising rents over the past year, they face similar market conditions, and their motivation is beyond just dollars and cents; it’s personal. These net lease assets give back the most precious commodity we all have, time. In addition, owning net lease can be a stable part of a well-diversified portfolio of holdings.

Regardless of market conditions, many owners will continue to transact because of broader concerns over their current investment.  For example, it might be as simple as an owner trading out of a short-term lease for the peace of mind a longer-term lease would provide or more complex of the likelihood for a rent reduction years from now and how that will impact value.

There are also large companies with a need to recycle capital, which means selling assets in their portfolio. For the most part, this is done strategically with very select properties that do not accomplish their long-term strategies and use that money to deploy into better investments. For those that have to meet Wall Street’s demands which tend to be focused on the shorter term financial performance of these companies rather than the long-term fundamentals of the real estate they own, we’re starting to see some companies trading out of higher quality real estate at lower cap rates to fund riskier investments that provide a higher initial return.

In the short term, we anticipate seeing fewer transactions and declines in pricing this year compared to the previous year.  The larger concern is that market fundamentals for the net lease industry are significantly different than in previous decades.  This will present itself with unique challenges but also incredible opportunities for those in the industry.  

Chad Kurz is executive vice president, net lease retail at Matthews Real Estate Investment Services.