FEATURE ARTICLE, SEPTEMBER 2005

TRANSACTION ACTIVITY HOLDING STRONG IN THE NET-LEASE MARKET
An aggressive 1031 market has kept net-lease investment transaction activity high.
Nicole Thompson

Several factors are driving a very strong transaction market for net-leased properties. As prices across many areas of commercial real estate remain strong, many owners are choosing to sell their properties, resulting in an aggressive 1031 exchange market as recent sellers look for a place to park money and defer taxes. Rising interest rates and the potential for further increases in the federal funds rate have also pushed owners to the bargaining table, according to Glen Kunofsky, senior director with Marcus & Millichap’s net-leased properties group.

“Transaction activity is still very strong,” Kunofsky says. “People are trying to get deals closed before rates go up any more, and I would say that we’re probably doing 20 to 25 percent more transactions now than this time last year.”

Kunofsky has also seen transaction trends across property types. 

“I think the general trend of the real estate market as a whole, there are people in other market segments, like multifamily and general retail, that feel the market is at a top, and those people are moving their money to park some of those proceeds in triple-net just because there’s little to no management involved with these properties and they can make a fixed return without having any type of management responsibility,” Kunofsky says. “I think it’s going to keep the market very strong.”

This has been especially true for smaller-scale owners, who are finding it difficult to compete with institutional investors, REITs, and large multifamily developers in a very competitive multifamily market.

“Especially in New York, you’re seeing smaller property owners selling their properties at a premium to large developers that are going to knock them down and build big high-rise buildings and larger-scale projects. It’s hard to compete with the big REITs and the funds and the major developers on the multifamily side, who are buying up whatever they can get for top-dollar, because they have access to cheap money, whereas the mom and pop have been taking that money and moving it into triple-net. It’s an easier market to get into — the underwriting is simpler, the deals are much more simple than multifamily.”

Many of these investors are buying up net-leased properties on the fringes of metro areas in the Northeast where there is a lot of freestanding, smaller retail.

“We’re finding that a lot of these investors want to stay within a 2- or 3-hour drive,” Kunofsky says. “A good example is investors in New York City moving their assets to triple-net properties in Southern Jersey, Pennsylvania and Upstate New York for free-standing, smaller retail properties.”

While the default rate across net-lease property types, even those with non-credit tenants, has been very low, Kunofsky notes that several sectors of net-leased properties are expected to continue to perform well looking forward.

“I think the convenience store market — tenants like Circle K, 7-11 — and the food market are constantly expanding,” Kunofsky says. “Whether it be quick service or fast casual dining, there are so many newer food concepts, and many of the bigger, traditional  food companies have new, boutique concepts. I think the fast food market is going to still remain strong. Burger King has done a tremendous turnaround and it looks like they’re going to start building more stores over the next year as well. I think that you’re still going to see strong growth in the fast casual dining market, mostly in suburban markets where dirt can still be purchased relatively cheap.”

As cap rates on credit-tenant deals allow little room for leverage, sub-investment grade properties are looking more attractive to investors.

“The sub-investment grade net-lease market is growing in popularity tremendously,” Kunofsky says. “Tenants that have 10, 20, 30 units, whether they’re franchisees or smaller concepts — that market is continuing to grow at a huge rate because the returns that they offer are better, and you’re seeing that there’s really no difference in the buildings and the dirt, it’s really just the credit of the tenant.”

As cap rates continue to go down on credit-tenant deals, people are beginning to look more at economics on a smaller level. Instead of asking “What’s the tenant’s balance sheet look like?” investors are beginning to look at how a tenant doing in a particular location. Smaller retailers and franchisees that have good unit economics are able to capitalize on the net-lease market.

“In this market right now, where traditionally the REITs or the institutional investors would not touch a 10- or 20-unit franchisee because of the risk factor, the 1031 market and the private capital market can understand those assets a little bit better, because they know the concept,” says Kunofsky. “A good example is the food sector and the convenience store sector. We’re doing deals with franchisees right now that are smaller franchisees that don’t have a lot of net worth, and their deals are selling in the 8 percent cap range, which basically has a very attractive, positive leverage and the private investor can look at that investment and go to a Burger King or a Taco Bell and say, ‘Wow, this is a very busy location — it’s high-traffic, the real estate has good fundamentals,’ and the investor says, ‘Should I buy a smaller tenant that pays an 8 percent return, or should I buy a credit tenant in an outlying market for 6 percent return?’  A lot of the private investors say that they would rather have positive leverage on their money and go with a less of a credit tenant and a property with better real estate fundamentals instead of credit.”

One factor that Kunofsky notes as driving investors to look more at unit economics and real estate fundamentals is accounting scandals at large companies and a distrust of the level at which the stock market says that a company should be valued.

“What we advise our clients to do is really look into the fundamentals of the real estate and especially the unit economics of the location, if they’re available,” Kunofsky explains. “A good example is, even if you have a small franchisee, but in the particular location that the investor is buying, that tenant is doing phenomenal business, the likelihood of a default in the lease is extremely low. When you look at a tenant, say their average sales are $900,000 overall and you have a location where they’re doing $1.5 million or $1.6 million in sales, the default rate in a location like that is going to be very low. And even through a bankruptcy, that location would survive scrutiny of the bankruptcy court and the tenant is not going to reject a lease on a profitable location.”

Kunofsky also advises clients to look at demographic trends in the area, and not necessarily with high household income as a target. Many net-lease property types perform better in lower-income areas, and investors should also look at population density and demographic shifts across regions.

“A lot of the tenants in the smaller box concepts, whether it be food, retailing, or convenience stores, they’re targeting lower-income demographics—tenants like Dollar General, most of the fast food tenants like KFC and Taco Bell —  which sort of contradicts traditional real estate mentality concerning retail,” Kunofsky adds. “These concepts are growing extremely quickly, and they do extremely well in areas that have low household income. Investors should look at what the concept is, and what’s being sold at the location and who that retailer is targeting.”

As with much of the real estate market, cap rates on net lease deals have been low, and the ease of management has kept cap rate levels in net-lease deals even lower. Kunofsky believes that cap rates will eventually have to rise to reflect rising interest rates, but it will not be an immediate effect, but rather a gradual increase over several years.

“As rates go up on the big box net-lease properties like The Home Depot  or Wal-Mart,” Kunofsky says, “you’re going to find that those properties are more interest rate sensitive just because of their size. When you’re dealing with a $20 to $50 million asset, it’s a lot different than the $1 to $3 million product type.”

Kunofsky also notes that some of the popular segments right now — convenience stores and fast food — are viewed as traditionally more recession-proof than some other retail categories.

The net-lease market has also been seeing a steady amount of foreign investment, as in other real estate sectors. 

“We do see a lot of foreign money coming in, especially over the last year with the weakness in the dollar,” Kunofsky says. “We’ve seen money from Europe, from Australia, and there’s still a lot of Asian money and European funds investing in core assets in real estate because to them, with the weaker dollar, they feel that properties are a bargain, even as American investors feel that the real estate market is so high. Most of the international investors are in the major markets — New York, Boston, Miami, Los Angeles. It’s hard for foreign investors to recognize values in the triple-net market in some of these outlying markets in smaller, suburban areas.”

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