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A Crowded Net-Lease Market

Heightened competition in the net-lease arena is prompting investors to dig deeper to uncover viable investment opportunities. Case in point: CB Richard Ellis Investors is applying a little ingenuity in its new $300 million net-lease fund. While single-tenant office, retail and industrial properties are core assets in the booming net-lease market, the CB Richard Ellis fund will take a fresh approach — car dealerships.

With upwards of 20 bidders for every investment-grade deal, it's no wonder that CB Richard Ellis is searching for alternatives. “Car dealerships are a little off the beaten track, so we believe there is an opportunity there,” says Stephen Olsen, managing director of CB Richard Ellis Investors in New York. The fund plans to pitch sale-leasebacks to existing car dealerships, giving the owners a chance to cash in on holdings as a means to finance expansion, or perhaps start on their own personal estate planning, Olsen adds.

CB Richard Ellis is not alone in its attempt to ferret out deals in an increasingly crowded net-lease market. Net-lease properties seem scarce because more bidders and more capital are chasing deals. The deal flow in 2004 is on pace to meet or exceed last year's activity. Through September of this year, $9.9 billion worth of single-tenant properties had traded hands compared with $12.4 billion during the same period in 2003, according to New York-based Real Capital Analytics. In addition, the current volume has surpassed the $9.4 billion worth of transactions that closed in 2002, reports Real Capital Analytics, which tracks single-tenant property deals of $5 million or more.

Blame it on a choppy economy, volatility in the stock market or turmoil in the Middle East, but money continues to flow into real estate, and net-lease investments are attracting a huge share of those dollars. Investors are smitten by two factors: relatively passive ownership and stable returns.

Under the terms of a triple-net lease, the tenant is responsible for maintaining, insuring and paying real estate taxes on the property. “We're in an environment where predictable, stable returns — with property as a kicker if you will — is something people like,” Olsen says. Most net-lease deals are structured with long-term leases — typically 15 to 20 years.

Premium Pricing

That demand continues to escalate the bidding war for net-lease properties. “It is definitely a competitive market. We pass on a lot of deals that we can't be competitive on,” says Anne Coolidge Taylor, a managing director at W.P. Carey. The New York-based firm expects to invest $1 billion in net-lease properties in 2004. W.P. Carey owns about 95 million sq. ft. of commercial and industrial properties, the majority of which are structured as long-term, triple-net leases.

Cap rates have dropped 100 to 150 basis points over the past two years. According to Real Capital Analytics, cap rates for third-quarter deals averaged 7.8%, down from the 8.6% during the same period last year, and 9.3% in the third quarter of 2002. Despite four interest-rate hikes by the Federal Reserve Board this year, cap rates have continued to trend downward due to continued strong demand. “People are paying insanely high prices in situations that just don't make any sense,” says Jay Whitehurst, COO at Orlando-based Commercial Net Lease Realty Inc.

In California, for example, some net-lease properties are trading at cap rates in the 5s and 6s. Nationally, ground-lease transactions for big-box retailers such as Wal-Mart or Home Deport also are trading at cap rates between 5.5% and 6%, while drugstores such as Walgreens and CVS are trading between 6.5% and 7%. “In those instances where the prices have gotten so high, we don't see any upside,” Whitehurst says. Properties under $5 million in particular are getting bid up by individual investors seeking to defer taxes on capital gains via 1031 exchanges.

“We are trying to stay in the range of 8% to 10% cap rates, but you have to turn over a lot of rocks to find good deals,” says Whitehurst. Commercial Net Lease Realty, which owns primarily single-tenant, net-lease retail properties, plans to spend about $125 to $150 million this year on new acquisitions.

The firm has been targeting operators that aren't on the radar screen of most investors such as non-rated, private companies. Currently, Commercial Net Lease is pursuing strong regional operators of various retail concepts that have properties located at high-traffic intersections.

By targeting operators that are not widely pursued by institutional investors, Commercial Net Lease Realty is able to generate returns above 9%, Whitehurst says. “That is a segment that we can apply our expertise in to get the yields that we are looking for with a little less competition.”

A Bellwether Aggressor

The intense competition is driving net-lease investors to work harder to identify and close deals — without sacrificing returns. Atlanta-based Wells Real Estate Funds expects to invest $1.1 billion in real estate in 2004 — about half of which will be allocated to net-lease investments. To achieve that goal, Wells has lowered its investment criteria by 100 basis points. Two years ago, Wells was buying properties at cap rates that averaged 9%, and now cap rates are closer to 8%. And yet the firm is still having a hard time landing office and industrial deals.

“We have had to be much more active and aggressive in finding properties,” says David Steinwedell, chief investment officer at Wells Real Estate Funds in Atlanta. Last year, Wells had a “win ratio” of 17%. In other words, Wells won 17% of all the deals on which it bid. This year that win ratio has dropped to 6%. So, in order to place roughly the same amount of capital as it did last year, the company needs to identify a lot more deals. “That shows that we're being disciplined in how we approach the properties and their pricing,” he says.

In order to land deals in such an intensely competitive market, Wells is relying on a variety of tactical approaches, including the use of a “partial” sale-leaseback. Wells bought a property in Portland, Ore., last year from IBM Corp. that consisted of five buildings and an additional 30 acres. IBM agreed to a net lease on three of the buildings, leaving Wells to find new tenants for the other two buildings.

Wells re-tenanted one building by entering into a long-term, net-lease agreement with Nike, and may raze the fifth building for redevelopment. “With four buildings filled, we have achieved a good return and still have a lot of flexibility,” Steinwedell says. Wells paid $38 million for the land and buildings, which total 364,000 sq. ft.

Investors such as Miami-based United Trust Fund (UTF) are trying to be more flexible in structuring net-lease deals. “It is harder to find transactions. You have to be more competitive,” says Fred Berliner, a senior vice president and director of acquisitions at UTF. “In many respects, you have to alter your criteria.” In its more than 20-year tenure as a net-lease investor, UTF has purchased five or six properties with leases shorter than 15 years, Berliner notes. But this year alone the firm has closed on three properties with leases between 10 and 12 years.

UTF recently acquired a 400,000 sq. ft. building in Charlotte, N.C. for $60 million with a 10-year net lease to General Motors. “Companies today want flexibility,” Berliner notes. In addition, that flexibility in structuring shorter-term net leases can boost returns because companies may be willing to pay more for a shorter-term lease, Berliner says. In the current market, UTF is pursuing net-lease deals that generate unleveraged returns between 7% and 9%.

A Networking Biz

Having a relationship with the seller or bringing a solid reputation to the table can give a buyer an inside track in landing a deal. “Being known by the seller so that they have a comfort zone is key,” says Olsen of CB Richard Ellis Investors.

In fact, a solid reputation can outweigh even a larger bid. “We are working on a deal where we are not the high bid,” Olsen says. But the seller understands how CBRE is structuring the deal and recognizes that CBRE is knowledgeable about the tenant and the property, he says. All of those factors can contribute to a seller's decision because it adds confidence that the deal will close.

“The real secret is to find deals that are off-market transactions that aren't shopped to the world,” says Jay Hooper, managing director of equity for Boston-based CRIC Capital. Not every seller wants a transaction that is broadcast to the market. Instead, some prefer to choose a buyer with cash in hand to ensure a quick closing. “With our relationship with Prudential, we certainly meet that test,” Hooper says. CRIC's co-venture partner is Parsippany, N.J.-based Prudential Real Estate Investors, an affiliate of Prudential Financial Inc. CRIC expects to invest about $400 million in 2004.

Solid relationships also can lead to repeat business. W.P. Carey credits repeat business — particularly among its build-to-suit clientele — for 20% of its transactions. “We have had companies come back three, four and five times with different build-to-suit opportunities,” Taylor says.

The Outlook

Whether the approach is to woo repeat clients or apply flexibility in structuring deals, it is not likely that those creative strategies will be shelved anytime soon. Many investors don't see much of a break in net-lease competition — or sale prices — in the coming months.

Individual investors will continue to be attracted to net-lease deals because those transactions are viewed as safe, income-producing real estate investments, says Commercial Net Lease Realty's Whitehurst. “We think that it is going to stay very competitive for the foreseeable future.”

Beth Mattson-Teig is a Minneapolis-based writer.

Rising Interest Rates Should Help Fuel Volume of Sale-Leasebacks

Net-lease investors are hoping that a shrinking gap between short- and long-term interest rates will bring more deals to the market. The Federal Reserve Board raised the federal funds rate from 1.75% to 2% at its Nov. 10 meeting. “When rates are going down and stable, there is no pressure to do anything. If rates start trending upward, people start coming out of the woodwork,” explains Fred Berliner, senior vice president and director of acquisitions at Miami-based United Trust Fund.

In theory, as the spread between short- and long-term interest rates narrows, it will encourage more companies to lock-in long-term financing. When short-term rates are low there isn't much motivation for companies to enter into a sale-leaseback transaction. Companies — particularly investment-grade firms — can obtain short-term financing at 100 basis points over the London InterBank Offering Rate (LIBOR) compared to a cost of capital of 7%, 8% or 9% in a sale-leaseback, notes Jay Hooper, managing director of equity for Boston-based CRIC Capital.

Many net-lease experts believe that now is the time to pull the trigger on long-term financing such as with a sale-leaseback because short-term rates are beginning to creep higher, while long-term rates are likely at or near bottom. The 3-month LIBOR has increased 116 basis points from January to 2.30% as of mid-November, while the 10-Year Treasury actually dropped 20 basis points to 4.18%.

“What the general trend of the Fed tightening rates has done is make companies focus on the fact that the bottom in the interest-rate cycle has been hit,” Hooper says. “So, even though we might stay along the bottom, now is really the time to start thinking about a sale-leaseback.”

According to Hooper, two additional factors could help tip the scales in favor of long-term financing. First, once the 10-year Treasury hits 5%, it will convince corporate executives that interest rates are clearly trending upward, and prompt them to secure long-term rates. Two, a surge in the economy would fuel a need for expansion capital, adds Hooper. “A big part of the shift is having some need for capital.”
Beth Mattson-Teig

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