Net Lease Makes a Reset

It used to be that when Jonathan Hipp, head of Avison Young’s U.S. Net Lease Group, would get a client requesting a zero cash flow property transaction—meaning the rent the buyer receives is equal to what it will pay on its mortgage—it would be for the bonus depreciation benefits that such a deal would offer.

But more recently he has been seeing a lot of clients sitting across from his desk requesting a zero cash flow deal for another reason: they are giving the keys to a property, usually an office building, back to the lender and want to reduce their tax bill as much as possible. “When a lender takes a property back it is not a forgiveness of the debt,” he explains. “You have a capital gain and have to pay taxes on that gain,” he explains. This is especially significant for owners who’ve had the property for many years or even decades and have refinanced many times.”

As Hipp explains, by performing a 1031 exchange with a zero cash flow deal, the seller can defer the gain they’ve incurred and probably do so with less cash than paying the taxes owed on the foreclosure.

Hipp says he has been working with many clients who are in foreclosure, having been affected by the turmoil in the office sector. It is a rare example of a transaction type that has been rising since last year.

To be sure, like just about every other commercial real estate asset class, net lease has been adversely affected by the Federal Reserve Bank’s multiple interest rate hikes, tightening lending standards and, in some cases, softening fundamentals.

But of all the categories of commercial real estate, net lease is proving to be as resilient as it typically has been during down times. That is not to say that transactions haven’t plummeted in this space—they have—but it does point to the asset class’ ability to pivot, or make a reset when necessary.

PLUMMETING SALES

In the second quarter of 2023, investment sales in the single-tenant net lease sector declined for the sixth consecutive quarter hitting just $9.4 billion, according to a Northmarq report.

Although this represents a “modest decline” from the $10.9 billion sold in the first quarter, it constitutes a 54% slump year-over-year, the report noted, “suggesting more than just a summer slowdown.”

Retail was the worst hit among the single-tenant sectors, which had sales of only $1.9 billion—52% down from the first quarter. By contrast, second-quarter sales rose compared to the previous quarter for the office sector, with $2 billion in deals, and industrial, with $5.5 billion. However, both figures were 50% to 60% lower year-over-year.

To get deals done, brokers have redoubled their efforts to bring capital to market. For example, Andrew Ragsdale, senior managing director at Newmark’s Net Lease Capital Markets, says his group is doing more forward commitments, JV structures and partnerships to get a deal done and ultimately sold. Many deal structures that worked in 2021 because debt was so cheap at the time are unaffordable now, he says, and the group has turned to alternative approaches.

“For example, we are looking for pre-commit dollars much earlier in the development cycle now because it reduces risk while creating a scenario that works for both buyer and seller.”

Ragsdale also tells of a single-tenant retail portfolio that contained roughly $25 million to $30 million of assets that were spread out over four to five states. “We shopped those assets much earlier than we would have otherwise” because of the current environment.

The lending and interest rate environment have caused many deals that otherwise would have penciled a mere few years ago to fall by the wayside today, says Matthews Real Estate Services SVP and Senior Director Josh Bishop. “Cap rates have yet to catch up with the current interest rate environment and people can’t finance these deals. You will need 60-70% down or the numbers don’t work.”

AN INVENTORY IN FLUX

One end result has been an inventory that is in flux. “From 2020 to spring of last year we had the greatest run-up of inventory and developers filled their plates,” Bishop says. “That inventory is coming to market, only there are not enough buyers to meet the supply. In many cases developers made commitments to tenants and as these buildings come online they have to sell.”

Some of these developers are losing money because they need to get out of these deals and pay back inventors, others are barely making money by offering discounts and still others are holding steady, he says.

According to the Boulder Group, in the second quarter the number of properties coming on the market was 20% fewer than in the first quarter. In recent years, owners could sell their properties for more than the purchase price because of cap rate compression, even though the lease term was shorter, the report noted. “This strategy no longer holds true in the current cap rate environment,” it added, leading owners to hold on.

CAP RATE MOVEMENT

Recently cap rates have begun to show some movement. Northmarq reports that in just the last quarter, the overall single-tenant net lease average jumped 21 basis points to end mid-year at 5.95%—the highest in nearly two years. The largest increase—46 basis points—was for the industrial market to reach 5.95%, followed by the office sector—which rose 16 basis points to 6.38%, and retail—up 15 basis points to 5.83%.

“The last three months saw aggressive increases, and there could be some fluctuation before rates settle into a more moderate upward trajectory,” the report said.

The Boulder Group, for its part, spotted a similar trend at least in the single-tenant net lease market where cap rates have risen for all three sectors: retail, office and industrial. “The rise in interest rates, combined with available investment returns in other fixed income investment opportunities, continue to be the primary drivers for the upward pressure on cap rates,” it stated.

The rise in cap rates was especially high for tenants in segments of the net lease market exposed to an “oversaturation” of such tenants. This group included dollar stores, drug stores, and “coffee users,” with dollar stores experiencing some of the highest cap rates in the net lease industry. In the second quarter they rose by 28 basis points, 16 basis points more than the overall net lease sector.

The upshot is that the current interest rate environment and capital market debt costs weed down opportunities that investors will consider, says Newmark’s Ragsdale. “A deal has to be at a cash-on-cash neutral price point.”

Bishop thinks cap rates will eventually catch up to interest rates but that journey will take longer than it normally would. “The optimistic view that most people have is that when we get into 2024 the Fed will slowly start to pull rates down and when they do transactions will increase,” he says.

QUALITY PRODUCTS

Until then the industry must deal with a lack of inventory, which Camille Renshaw, CEO and CoFounder of B+E, says is net lease’s biggest problem right now. “There is a lack of quality assets on the market as owners have held onto properties they don’t have to sell.”

For that reason, when a high-quality net lease asset does come to market, especially for price points under $5 million, it is snapped up right away despite dropping sales volumes, she says. There has been a distinct flight into net lease from other asset classes, in a phenomenon she says underscores the relative strength of the space.

“Cash-flush family offices and private investors still need to trade, making decisions that are tax motivated or involve generational wealth. They want properties that are risk-averse and have characteristics such as long-term leases and strong tenant credit.”

“And it doesn’t matter where interest rates are,” Renshaw continues. “Many investors still need to make buying decisions in today’s market.”

And “right now, if you wanted to place $5 million into something investment grade that has 15 years of term or more, good luck,” she said. “It’s shocking. You’d think there would be assets piling up on the sideline, but it’s not true. We have a supply problem. The demand is there.”

Assets in particularly high demand right now include car washes and gas stations because they get accelerated depreciation, says Bishop. However, because the government has modified the bonus depreciation rules, interest in these assets is likely to taper, he adds. Dollar stores are another popular asset class. “They are accompanied by investment grade credit and a corporate guarantee. Also the rates of return on dollar stores are typically a bit higher than other net lease asset classes.”

Like many other commercial real estate asset classes, though, there is a significant bid-ask gap between buyer and seller, which is also hampering investment sales, says Landan Dory, a senior vice president in Partners Investment Sales Division. “The best thing that could happen for the market is for the seller to come to terms on pricing. Right now sellers are disappointed in the pricing and the opportunistic seller has all but disappeared from the market.”