Taking A Direct Hit

Buyers of commercial real estate properties with net leases in place have long considered these assets to be a safe haven because of their bond-like ability to generate steady income streams. Yet for an increasing number of investors, not even the incentive of a fixed return over a period of 15 to 25 years is enough to offset the ill effects of the current credit crunch.

Sales of net lease properties, or those leased entirely to a single tenant, are down as much as 50% compared with a year ago, according to some industry estimates. The biggest impediment to sales is the bid-ask gap between buyers and sellers, a problem that has been exacerbated by higher borrowing costs stemming from debt market volatility.

Sellers are waiting for the credit crisis to end so prices will rebound. Buyers are waiting for bigger discounts on pricing as the cost of capital rises along with perceptions of increased risk, says Randy Blankstein, president of Boulder Net Lease Funds in Northbrook, Ill. Boulder is a sponsor of private equity real estate funds focused exclusively on net lease properties. “I think people can only wait so long, and I think in the third or fourth quarter [of 2008] we will have a good sense of where the market really is,” says Blankstein.

One reason for that optimism is that companies continue to need capital, and net lease finance in the form of sale-leasebacks is gaining acceptance as an attractive capital source. The financing vehicle allows companies to pull 100% of capital out of real estate assets, while still retaining use of those properties. Such deals are typically structured with a long-term net lease that gives the tenant control of the property for upward of 15 years.

At the same time, investors are drawn to the stable income streams and minimal direct management responsibilities that often come with net-lease properties. Most net lease transactions are structured with a triple net lease, which requires little direct management because the tenant pays all taxes, insurance and maintenance costs.

The pricing bubble

Sale prices are dropping across the board in Class A, B and C deals. “To me it's not so much a pricing shift as it is a return to normalcy,” says Blankstein. Historically, there has been a big pricing gap between Class-A deals and lesser quality B and C properties. During the frenzied investment market of 2005-2007, that gap compressed but is now widening again.

One of the most dramatic examples of the pricing disconnect is Walgreen's. The $35 billion, A+ rated company has typically been the gold standard in the single-tenant net lease world. In recent years, investors were willing to pay a premium for net lease Walgreen's stores. Buyers valued the stellar credit, as well as the trademark 20- to 25-year lease terms and phenomenal locations.

But that demand has stalled. Currently, there are upward of 50 Walgreen's net lease properties on the market offered either as single transactions or multi-property packages. “I have never seen so many Walgreen's deals on the market,” says Michael Houge, a principal at Minneapolis-based Upland Real Estate Group.

Why are Walgreen's properties sitting on the shelf? Buyers are not enthusiastic about market cap rates, explains Blankstein. Cap rates on Walgreen's have moved little in the wake of the credit crisis and average 6.25% to 6.75%. Many buyers believe that those cap rates are 25 to 75 basis points too low — especially for properties in second- and third-tier markets.

Dissecting the market

The net lease and sale-leaseback market can be split into several different niches and specialties, such as restaurants or portfolio deals. But to simplify, the market can be divided into two sections based on deal size. Buyers who seek replacement properties for 1031 tax-deferred exchanges generally drive deals priced less than $5 million. REITs and other institutional buyers acquiring either single assets or portfolios fuel deals upward of $5 million.

“The velocity of transactions has slowed down significantly at all levels, and especially on large deals over $20 million,” says Mike Syers, a partner in charge of Ernst & Young's Transaction Real Estate Practice in New York. The cost of capital has sidelined some buyers, while cooling sale prices have prompted some sellers to delay offerings. “Some of those sellers are taking their deals off the table,” Syers notes. “They are focusing on becoming longer-term holders on those properties versus having to sell them.”

The most significant decline in transaction volume is occurring on deals less than $5 million. The amount of completed transactions in that niche has fallen by 30% to 50% compared with the same period a year ago, according to Boulder Net Lease Funds. Although the supply of available deals remains healthy, demand from 1031 buyers has floundered along with the slumping housing market. In recent years, skyrocketing residential values spurred sales, which subsequently led to a spike in 1031 activity.

Boulder Net Lease Funds estimates that property sales priced above $5 million are down 20% to 25%. However, other industry sources indicate that decline could be even larger. The amount of sales of single-tenant transactions greater than $5 million fell by more than 50% with 25.1 million sq. ft. of office, industrial and retail properties selling for a combined $3.1 billion in the first quarter, according to Real Capital Analytics (RCA).

During the same period in 2007, 62.8 million sq. ft. of single-tenant properties sold for $7.1 billion. Although RCA does not specifically track net lease properties, a majority of single-tenant transactions are structured as net lease deals.

Even though investor appetite in net lease properties valued under $5 million is waning, demand for properties valued above $5 million remains strong. “A lot of people who raised equity funds in 2005, 2006 and 2007 still have money to invest. So there is still demand, but there has been a decline in the supply,” Blankstein says. The $5 million-plus segment has slowed largely because sellers are holding onto properties, hoping that pricing may rebound once capital markets recover.

Pricing continues to shift

Much like the broader commercial real estate investment market, the credit crisis has triggered widespread re-pricing among net lease properties. “I think there is good equity capital available in the net lease sector, but the bid-ask spread is very different,” says Michael Rotchford, an executive vice president in charge of the investment banking group at Cushman & Wakefield in New York.

Clearly the pricing gap between Class A, B and C properties that had shrunk during the recent frenzied investment cycle is now returning. Cap rates generally have increased between 50 and 150 basis points depending on the property, credit quality and lease terms.

In the retail arena, for example, the biggest decline in price has occurred among Class B and C properties, but even A properties have experienced a price drop. Class-A properties have seen cap rates increase by 25 to 75 basis points, while B and C properties have climbed between 50 and 150 basis points.

Because of that pricing shift, a number of retailers have put deals on hold. “There is great demand to do deals, but retailers are not seeing the pricing they could have gotten a year ago, and they are rethinking whether they want to go forward at current pricing or wait for things to get better,” says Julian E. Whitehurst, president and COO of Orlando-based National Retail Properties Inc. (NYSE: NNN). The publicly traded REIT has an 11 million sq. ft. portfolio of single-tenant, net leased retail properties.

Although most industry experts agree a price shift is under way, the reality is that prices on deals getting done are all over the board. It is difficult to make general statements on values because buyers are underwriting deals case by case.

Some niche markets are even seeing cap rates decline. A 66,070 sq. ft. retail property in Burbank, Calif. recently sold for $28.75 million. The property is occupied by a Ralphs and CVS Pharmacy. The deal drew 11 offers from 1031 buyers, and sold for the full asking price, which generated an extremely low 5.58% cap rate. The average cap rate was 6.99% for net lease retail properties priced greater than $10 million sold during the first quarter, according to Boulder Net Lease Funds.

Los Angeles-based AMC Associates LLC purchased the property from Univest Development Group in Scottsdale, Ariz. The bidders were willing to pay top dollar for high-credit tenants and realize the added bonus of deferring capital gains taxes by rolling proceeds from another real estate sale into the acquisition.

Some observers question if low bid numbers are realistic in today's market. Some aggressively priced deals are getting signed, but then get re-priced or don't close because the bidder underestimated the cost of financing. “It's frustrating because if you know the marketplace you know what's viable and what's not viable,” says Ethan Nessen, a managing partner at CRIC Capital.

CRIC, which is backed by Prudential Real Estate Investors, buys and sells more than $500 million annually of single-tenant, net leased real estate including office, industrial, large retail, and portfolios of smaller retail properties and franchises. “You lose to a deal that can't get done, and it mucks up the market,” says Nessen.

Buyers find opportunities

Well-capitalized buyers are finding that it's a great time to pick up triple-net lease properties from solid operators. “Once you've got those leases, you've got a long-term income stream that is really valuable,” Whitehurst says.

NNN posted a phenomenal year of transaction activity in 2007 with $900 million in acquisitions and $300 million in sales. Although that pace has slowed slightly this year, NNN remains an active buyer with $173.4 million in acquisitions during the first quarter. “We have been able to successfully reload our capital structure, so we have gone into 2008 with a strong balance sheet and the ability to do deals without having to access the debt markets,” Whitehurst says.

But in order to realize those opportunities, buyers must beware of significant pitfalls — namely by underwriting deals carefully to avoid any missteps in an economy that appears to be going from bad to worse. Credit concerns about the market and stability of some businesses only reinforce the point that every deal should be underwritten individually.

The current climate in the net lease market is all about the dynamics of each deal. “The one trend that I see in the marketplace is that there is no trend at all,” Nessen says. “What I mean by that is that every deal, every category of product becomes so specific in terms of the credit, location, marketplace and perception.”

The tenant's credit rating is still an extremely important measure, but the bigger question is assessing a deal in its entirety. A company with an A-credit rating with a 10-year lease in a mediocre location that is pricing its deal at a 6.5% cap rate is “insane,” Nessen notes. The same deal with a 15- to 20-year lease becomes a lot more attractive, he adds. “You have to underwrite carefully and specifically and understand what you're dealing with,” he adds.

CRIC completed a $33.6 million sale-leaseback deal in March with Arlington Heights-based Amcol International Corp. The building is a new 72,000 sq. ft. headquarters for Amcol in Hoffman Estates. Amcol has signed a 20-year lease on the building, which is under construction and slated for fall completion.

Rosier outlook ahead?

Although net lease has taken a hit with the drop in sales activity, it may be one of the few bright spots in a dismal commercial real estate investment market. “The net lease sector is doing slightly better than the broader commercial real estate investment market as a whole because, on the longer-term type leases, the credit crisis causes a flight to quality and flight to safety,” Blankstein says.

A year ago, for example, single-tenant office transactions accounted for 10% to 12% of all office sales. Now single-tenant office buys make up 17% to 18% of all office transactions, reports RCA.

Many investors look at net leases as a safe haven, especially during volatile periods when capital tends to flow to conservative investments. “If properly underwritten, you have a steady, safe long-term rental income stream from these properties,” Whitehurst says. “We do think those are still valuable to investors.”

And deal flow is expected to pick up during the latter half of the year as the pricing gridlock between buyers and sellers starts to loosen. “There can only be a disconnect between buyers and sellers for so long,” Blankstein says. “Both of them, to a certain degree, need to be in the market and making transactions.”

Beth Mattson-Teig lives in Minneapolis.

Excess retail space adds to net lease woes

Retail properties are bearing the brunt of the blow from the sharp drop in net lease investment activity. Retail has traditionally dominated the net lease market, representing about half of all net lease offerings.

At the end of the first quarter, retail accounted for 10,918 separate offerings valued at $27.3 billion, according to market data from Boulder Net Lease Funds, a sponsor of private equity real estate funds that focuses exclusively on net lease properties. In comparison, there were 6,462 net lease office deals on the market valued at $20.7 billion, and 3,586 industrial deals valued at $12.6 billion.

The sheer size of the retail segment has translated into a glut of available properties on the for-sale block as sales activity has dropped by as much as 50%. “From our perspective, we're seeing twice as much product on the market and it will take a while for that inventory to burn off,” says Michael Houge, a principal at Minneapolis-based Upland Real Estate Group, a commercial real estate firm that specializes in net lease investments.

Part of the problem is that retailers and restaurants often use net lease sales to fuel expansion. So even though the credit crunch slammed the brakes on buying activity, there were still a number of projects in the development pipeline. Those developments that had previously been snapped up quickly are now adding to the excess supply.

Net lease retail properties, which had been a hot commodity in recent years, are facing a reality check in terms of declining demand and rising prices. “I think retail is having the hardest time year-to-date,” says Randy Blankstein, president of Boulder Net Lease Funds in Northbrook, Ill. “There are a lot of negative factors related to the drop in consumer spending and some of the challenges for growth in that market due to the economic and housing downturn.”

The decline in 1031 exchange activity also has hit the retail sector hard because it has sidelined a core investor group. Net lease retail and restaurant properties have traditionally attracted 1031 buyers. Not only are net lease properties appealing to buyers because they are less management intensive, but investors also can acquire a store, such as a Dollar Tree or 7-Eleven, for less than $1.5 million.

In addition, demand for retail has been so hot that the property sector has been priced at a premium some 25 to 50 basis points over office and industrial, Blankstein notes. “There are a lot of people that don't feel that premium is justified anymore, so people are reluctant with the cap rates in retail.”
— Beth Mattson-Teig

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