Investors Ride Down the Credit Curve

Investors Ride Down the Credit Curve

Searching for a single-tenant, net-lease property with a strong investment-grade rating is like trying to find a needle in a haystack. Net-lease or sale-leaseback transactions were fewer and farther between in 2003 compared with previous years. In fact, the number of total available net-leased properties by the end of 2003 reached a 10-year low, according to estimates from The Boulder Group, a Northbrook, Ill.-based investment real estate firm.

“Many net-lease investors think that the inventory is at least two years away from catching up with the demand,” notes Jeff Rothbart, Boulder's research director. His firm, which just began compiling national data this year, is currently tracking the pricing of 3,198 net-lease properties nationwide.

Investors were faced with a key decision in 2003 — wait out the shortage of transactions, partake in excessively high-priced offerings or venture down the credit curve.

Many chose the first option. Kevin Shields, managing principal at Griffin Capital, a Manhattan Beach, Calif.-based financial services firm, says the feeding frenzy among buyers for deals that did come to market forced him to sit on the sidelines for most of 2003. “People were way too aggressive given the credit dynamics of the tenants.”

Bobby Fitzpatrick, a principal at Cardinal Capital Partners Inc., says the market was so tough in 2003 that he wasn't able to buy new large portfolios. His Dallas-based real estate investment firm closed on $500 million in net-lease transactions in 2003, down from $592 million in 2002. Clients ranged from Wal-Mart to PETCO Animal Supplies. That's a far cry from the volume Fitzpatrick had expected and much lower than the $1 billion he anticipates in 2004. For 2003, at least, supply and demand were out of whack since there was more buyer demand than there were properties for sale, he says.

What's likely to be different in 2004? For one thing, supply. The net-lease deals that came to market in 2003 were predominantly non-investment grade. Investment-grade tenants had plenty of cash and/or borrowing leverage — the main benchmark for borrowing, the 10-year Treasury, was at 40-year lows and yields approached 4%. This year, an almost certain hike in interest rates will likely benefit the supply-starved sector, particularly as more investment-grade tenants utilize the net-lease market rather than borrow capital.

“With higher rates, we believe there will be more product available since more corporations will look to raise capital via sale-leaseback transactions,” says Scott Tracy, a founding principal at Los Angeles-based Corporate Partners Capital Group, a real estate investment firm specializing in net lease.

Increased supply will level the playing field between buyers and sellers of net-lease properties. A typical non-investment grade net-lease offering likely will offer wider pricing, or spreads of 50 to 70 basis points, over investment-grade transactions. This is an added cost to buyers, but also offers higher yields. The average cash-on-cash returns for non-investment-grade, net-lease transactions hover between 7% and 8%, whereas cash-on-cash returns for investment grade are between 6% and 7%.

Richard Ader, chairman of U.S. Realty Advisors, says his firm has resisted the temptation to overpay for net-lease properties. It purchased only a few net-lease properties for client GE Capital last year. The Manhattan-based financial services firm, which specializes in net-lease real estate investment, typically purchases investment-grade and non-investment-grade properties totaling between $300 million and $400 million for GE Capital each year. “Investors have gotten so competitive. The pricing is so bad,” Ader explains. “It's difficult for buyers looking for returns.”

The amount of capital flooding the net-lease sector has led some investors to overpay for deals, most notably tenant-in-common (TIC) investors, says Chuck Klein, head of the net-lease group for BRE Commercial, a full-service real estate brokerage services firm in San Diego. In a TIC deal, individual equity investors combine to purchase a property larger than what they could buy on their own.

“TIC buyers are typically motivated by both the tax-deferral and flexible equity requirement features that these ownership structures provide and are thus willing to accept lower cash-on-cash yields,” says Klein. Net-lease financing affords these investors the chance to acquire a fractional ownership interest in an investment-grade property.

In recent years, cash-on-cash returns for net-lease investments began to decrease along with capitalization rates, the initial rate of return on an investment based on the purchase price. For example, cap rates for Walgreens — which has a high investment-grade credit (Aa3/A+) — range from 6.5% to 7%, down from 8% at the end of 2002.

“Investors were able to obtain positive leverage (between cap rates and mortgage debt), but with cap rates for Walgreens now between 6.5% and 7%, the days of positive leverage on even 10-year fixed money is a thing of the past,” says Klein. Now negative arbitrage, or debt financing that is higher than cap rates, is quite common.

New Entrants

A lack of attractive alternative investment products, coupled with a volatile stock market — most notably in 2002 and early 2003 — helped draw more investors into the net-lease market. The net effect was to drive cap rates to new lows. “A number of new investors including fund investors and retail investors have penetrated this market,” says Shields of Griffin Capital.

One such non-typical net-lease player is making more than a little splash into the global net-lease market. Blackstone Real Estate Partners, an affiliate of The Blackstone Group, will be closing this quarter on the largest equity position the firm has taken in any real estate transaction — net lease or otherwise. The $1.2 billion sale-leaseback transaction with Deutsche Bank AG consisted of 51 multiple net-leased office buildings in nine countries.

A year ago, Blackstone would not have been in the net-lease market, says Ader of U.S. Realty Advisors. The company prefers shorter-term leases than are typically available via net-lease investments. The transaction with Deutsche Bank does include some non-traditional features with the shortest net lease having a duration of six months and the longest of 10 years, according to a Blackstone spokesperson.

Real estate investment trusts (REITs), in particular, have fueled some of the growth in sub-investment grade net-lease deals. Natasha Roberts, vice president of Lexington Corporate Properties Trust, a New York-based REIT, is one such investor.

But when a long-term, investment-grade opportunity comes along she jumps at the chance. In December, Lexington acquired single-tenant office properties in Kansas and Missouri from top-rated (Aa2/A+) Employee Reinsurance Corp. for $79.3 million. The properties are leased for 15 years.

“As REITs, private investors and brokers struggle to find places to invest and obtain acceptable yields, more and more they are turning toward direct sale-leaseback transactions with sub-investment-grade tenants. The underlying intrinsic value of the real estate and/or strong comfort levels with the company's outlook compensate for lack of a strong credit rating,” says Klein of BRE Commercial.

Loosening of Credit Criteria

Some net-lease investors who concentrate exclusively on investment-grade properties — those rated anywhere from BBB- to AAA — have now ventured into the BB or single B properties. As a group, investors in B-rated net-lease transactions are willing to take on more risk in search of extra yield.

With less pieces of the net-lease pie available, decisions on whether to lend purely based on credit no longer are commonplace. Take for example, a recent net-lease transaction involving a 150,000 sq. ft. property in Southern California occupied by Wal-Mart. The newly opened retail store had completed only two years of its 10-year lease term. The store had opened to only $75 million in annual sales, which by Wal-Mart standards was on the light side, and annual rent of $900,000.

A lot of lenders reasoned that although Wal-Mart is a strong credit tenant, the probability it would move out after the eighth year is high, according to Gary Mozer, CEO of George Smith Partners, a commercial mortgage brokerage firm in Los Angeles. But Mozer, viewing a potential rise in store sales despite the slow start, arranged the financing. “It's all about supply and demand and actual risk versus perceived risk,” he says.

Ethan Nessen, principal of CRIC Capital in Boston, says there has always been a balancing act between real estate fundamentals and credit quality, but with the downturn in supply there's more of a meshing between the two. “From an overall underwriting perspective, as much as real estate and location are important, there's been a loosening up of credit,” he says.

Some underwriters also are making deals that might not typically come to market, if supply were more plentiful. “There are not enough deals. Lenders are trying to be creative. They are structuring single-tenant, non-investment-grade deals that used to have no bid,” says Mozer. Now, lenders say if a borrower pays them for such a deal in terms resulting in a higher premium in spread, the deal will get done, he says.

Life insurance companies, as opposed to conduits, are particularly lax in underwriting transactions, according to Ader of U.S. Realty. If life companies are comfortable with a tenant, they are generally willing to take on an obligation, as opposed to conduits that are more concerned solely over the tenant's credit rating determined by the rating agencies, he explains.

While some underwriters have been known to be more stringent, Sheldon Abrams, senior vice president of The Boulder Group, says the tide has shifted over the past few months. “You still see lenders using more stringent standards, but I have seen lenders relaxing those requirements.”

Kathleen Fitzpatrick Hoffelder is a New York-based writer.

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