COVER STORY, MARCH 2011

NNN PROPERTIES IN DEMAND
Credit-tenant deals still drive New York's single-tenant market.
By Alan Pontius and J.D. Parker

Retail sales in the last two quarters of 2010, excluding autos and gas, outperformed industry expectations by rising slightly above their pre-recession peak, signaling growing consumer confidence nationwide. The correction in consumer spending has largely run its course, and the resumption of private-sector job gains, along with the first-time homebuyer tax credit, boosted year-over-year retail spending, especially for big-ticket items. Electronics retailer Best Buy, for instance, reported a 60 percent jump in earnings during the third quarter. With the economy strengthening and payrolls forecast to expand in the coming months, consumer confidence continues to grow, which supported a more substantial uptick in retail spending during the holiday season. Consumers will remain cost conscious, though, until housing market challenges subside. With little improvement expected in suburban housing conditions for a while longer, big box single-tenant retailers Walmart and Target will modify growth strategies by focusing on the urban grocery arena. Dollar stores, meanwhile, will deploy capital obtained during the recession to expand market share, opening in areas where rents previously were too high to pencil out.

Among U.S. investors and New York investors, single-tenant net-leased properties with national-credit retailers will remain the most sought-after deals as high-net-worth individuals and well-funded REITs compete for acquisitions. Unimpressive returns offered by alternative investments and ongoing stock market uncertainty continue to heighten private buyers’ appetite for low-risk, corporate-backed assets. Cap rates for these deals have already compressed 50 basis points this year. Yields will tighten further in 2011 but should stabilize by midyear as returns approach pre-recession levels. Lower cap rates and a shortage of high-quality assets listed will expand acquisition targets for many buyers, and properties leased to well-known franchisees will garner more attention and clear the market faster. Cap rates for these assets will average 50 basis points to 150 basis points above those for best-in-class investment-grade deals, depending on the financial strength of the guarantor.

New York City Outpaces Rest of Nation

Stronger-than-anticipated job growth, increased tourism, solid investor demand and its prime coastal location have boosted New York City’s retail market to one of the top performers in the United States. In addition, a rebound in retail spending will drive improvements in overall retail vacancy and rents. Several trends will develop this year, potentially affecting near- and long-term operating conditions. Among these, weakness in the U.S. dollar will increase tourist volume, providing strong support for many single-tenant net-leased restaurants and retailers in highly visited areas, including Times Square and Fifth Avenue. Bolstered by the influx of foreign visitors, local hotel occupancy surpassed 80 percent last year and could swell to the mid-80 percent range in 2011 due to robust tourism and rising business travel. As foot traffic and spending strengthen during the year, Walmart will renew its push to open stores in New York. The retailer is considering sites in each borough, and its possible entrance into the city would signal greater willingness among local officials to embrace big-box retailers.

Financing for acquisitions of mixed-use properties continues to improve, with loan-to-value ratios generally ranging from 50 percent to 55 percent. Investors remain highly attracted to assets in most of Manhattan, although properties in the Bowery, Lower Eastside and Financial District command especially keen interest. In Brooklyn, transformation of the retail property market paused during the recession but appears to be gaining momentum. The Brooklyn housing market continues to recover, sustaining strong interest from national retailers for spaces along primary retail corridors such as Atlantic Avenue. In addition, more than 3,000 hotel rooms are slated for development in the borough, and demand for retail space to serve and entertain visitors will increase as a result.

Dollar Stores, Quick-Service Segments Lead STNL Market

Two segments of the single-tenant retail market performed well in 2010 and are expected to make strides this year: dollar stores and quick-service restaurants. Cost consciousness will benefit discount retailers even as the economy strengthens, as a significant share of consumers experienced lost jobs, wage cuts or reduced hours through the recession. Both Dollar General and Family Dollar have posted solid same-store sales since mid-2008. As such, leading extreme-value retailers will continue to expand in 2011, and many will broaden their lines of private-label offerings in an attempt to generate higher profit margins. Family Dollar will bolster its new-store openings by 50 percent in fiscal year 2011 to 300 units and overhaul between 600 and 800 existing locations. The company also plans to add 70 private-label food items to capture a share of grocery market sales. Dollar General, meanwhile, had plans to open 600 sites in 2010, a pace of growth the company expects to maintain over the coming years.

Faced with a shortage of other high-quality, single-tenant, net-leased listings, more investors have returned to seeking dollar store assets, driving year-to-date dollar store deals to above the level recorded in 2009. Dollar store cap rates currently average 9.1 percent, though properties in secondary markets or less desirable locations can trade above 9.5 percent. Given the abundance of dollar stores on the market, cap rate compression will be modest at best in 2011 as sellers compete for buyers. The median price for these properties climbed 4 percent through the first three quarters of 2010 to $101 per square foot.

Quick-service restaurants will outperform the food industry as a whole in 2011 as consumers continue to favor bargain-priced eateries. Through the downturn, many chains sustained customer visits by aggressively marketing new products while expanding their value menus and introducing concepts geared toward greater value. Fast-food operators will maintain diverse menus to drive traffic, but competition will center on the morning meal market. During the first half of 2010, quick-service chains offering breakfast items recorded a 2 percent increase in morning traffic from one year earlier. This trend should intensify as job gains help increase morning commuter counts.

Fast-food deal flow has accelerated 15 percent year to date, driven by strong buyer demand for predictable cash flows and lenders’ willingness to finance assets below $2 million. With buyers preferring fast-food chains, cap rates fell 20 basis points to 7.8 percent during the first three quarters, though assets in tertiary areas or those leased to less creditworthy franchisees still trade with initial yields above 8 percent. The median price for fast-food assets climbed 5 percent in deals made so far this year, after falling more than 10 percent in 2009.

Consumers, though hampered by high unemployment and limited credit, will make positive contributions to growth  of the single- and multi-tenant markets this year, but they still lack the wherewithal to propel the economy as they have in previous recoveries. In this cycle, corporations must assume the lead, a trend that will slowly manifest this year as companies gain sufficient confidence to expand capital expenditures and long-term hiring. In the near term, companies will continue to rely on temporary employment to keep expenses low and options open, though easing uncertainty and strengthening demand by midyear will encourage business spending and stronger job creation in the second half.

Alan Pontius is an SVP and managing director of Marcus & Millichap Real Estate Investment Services, and national director of its Net Leased Properties Group. J.D. Parker is regional manager of the Manhattan and Brooklyn offices.

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