For more and more high-net-worth (HNW) real estate investors, dollar stores and drugstores make for a winning combination, although these assets can turn into losers if the sole tenant leaves.
Office and hotels still draw a lot of attention—and dollars—from HNW investors. But a rising number of them are betting on single-tenant net lease properties such as dollar stores, drugstores and fast-food restaurants to help round out their portfolios.
By and large, net lease properties are magnets for HNW investors because they’re viewed as safe, recession-proof assets that preserve cash flow and yield.
A single-tenant net lease investment is like “a bond wrapped in real estate. It’s the closest thing to cash that sits inside real estate,” says Rick Chichester, president and CEO of Faris Lee Investments Corp., an Irvine, Calif.-based investment advisory firm specializing in retail real estate.
Thanks to rent hikes built into many net lease deals, an investor can enjoy positive cash flow and a hedge against inflation, Chichester says. On top of that, there’s the residual value of the asset once the lease expires. But while the investment risk of a net lease property is minimized, growth of the equity investment will hit a ceiling, he says.
The movement of HNW investors into the space underscores the legitimacy of net lease as an investment alternative, Chichester says. In recent years, the single-tenant net lease market has evolved from a niche to a core investment option, he notes.
HNW investors are especially attracted to single-tenant net lease deals in the retail sector. Private and 1031 exchange buyers—many of them HNW investors—accounted for about two-thirds of single-tenant retail deals in 2017, according to data compiled by The Boulder Group, a Northbrook, Ill.-based commercial real estate firm specializing in net lease properties.
In the case of 1031 investors, many are switching to single-tenant net lease properties as a “truly passive” investment after having had more active ownership in properties like apartment complexes and shopping centers, according to John Feeney, vice president of The Boulder Group.
Dan Hoogesteger, West Coast managing director at Sands Investment Group Inc., a commercial real estate brokerage firm specializing in net lease properties, says HNW investors are increasingly pursuing single-tenant net lease deals because of a lack of investment alternatives for passive money. Furthermore, they’re drawn to the long-term stability of the leases, the likelihood of rent increases, the possibility of the properties appreciating in value, the potential of tax write-offs for depreciation and the largely hands-off nature of managing the properties.
In addition, Hoogesteger says, a HNW investor who’s not overly familiar with commercial real estate can easily grasp the net lease concept.
“Especially over the last several years, we’ve seen a shift from high-net-worth investors and family offices turning more toward yield than just [focusing on] trophy locations,” Hoogesteger says.
Some of that shift is being driven by the ease of passing along a single-tenant net lease asset to the next generation compared with a more complicated multi-tenant property, according to Chichester.
In the net lease sphere, HNW investors are leaning toward segments like quick service restaurants, casual dining, medical and industrial, Hoogesteger says. Geographically, net lease assets in major markets—particularly those in states with no income tax—are generating the most demand from these investors, according to Feeney.
Depending on the location, the tenant’s creditworthiness and the length of the lease, cap rates for single-tenant net lease properties with long-term leases generally range from 5 percent to 7 percent, Hoogesteger says. In California, however, cap rates for the same kind of asset average 4 percent or below, he says.
For a HNW investor pondering single-tenant net lease assets, Chichester recommends setting clear expectations for investment yields and weighing the risk tolerance associated with those yields. He also emphasizes considering the quality of the real estate, the creditworthiness of the tenant and the term of the lease.
“That lease term is particularly important because you’re buying cash flow,” Chichester says. “Obviously, a shorter term lease means you’re buying a shorter term of cash flow, and there’s risk for you if you can’t replace that cash flow.”
Chichester offers this cautionary note about a single-tenant net lease asset: The property will either be fully occupied or fully vacant. Even a highly-coveted net lease tenant like McDonald’s closes locations, he points out.
“It’s still a real estate-centric investment, so the fundamentals of real estate still need to be underwritten,” Chichester says. “You clearly have to understand the scenario planning in the event that a tenant were to vacate. Who’s the replacement tenant? What would their credit be? What would the lease term be?”