A Perfect Cap Rate Storm: Increased Demand vs. Low Inventory

By Marilyn Kane, CEO, Iridium Capital

As 2013 draws to an end, there is fervor to get final deals consummated and to start lining up deals for 2014.  With that comes a large amount of 1031 Exchange money transitioning from typical owner-managed properties into less management intensive lease structures, such as net-lease.  This transition has created a very one-sided metric where buyers for net-lease properties far outpace new development as well as the willingness of traditional buyers.  Those two factors combined have led to substantial cap rate compression over the past several months.

For most investment-grade net-lease tenants, which have been well priced over the past year, compression has been less dramatic, ranging from, 25-75 basis points for secondary-location properties. Preet Sabharwal, a leading net-lease broker for Marcus and Millichap said, “This supply-constrained market is causing cap rate compression across the board, from high corporate-credit drug stores such as Walgreens and CVS all the way down the spectrum to the challenging balance sheet single unit franchisee restaurants.”   However, as the demand for net lease has increased, concurrent with a lack of inventory, buyers are more willing to accept lower grade, or non-credit, tenants along with less than absolute “net” lease term structures.

More and more, 1031 buyers are turning to sub investment-grade (BBB- or better) tenants as cap rates for investment-grade credit tenants have dipped below 7 percent and in some cases below 6 percent.  These tenants tend to include smaller dollar stores, regional drug chains and supermarkets, as well as well-known lower credit tenants such as Rite-Aid.  In an effort to seek greater yield, investors of net-lease properties have also become more open to modified net-lease structures wherein the landlord is usually responsible for roof and structure.  This lease structure gives minimal exposure to a landlord on new build-to-suit locations; however, with decreasing inventory, investors are having to purchase older assets that have this ongoing liability, which in turn reduces returns.  This increased demand for lower-credit and lower quality net-lease properties has served to strengthen the market even further as high-credit high quality net-lease properties continue to see cap rates drop.

With the current rate of turnover, net-leased properties are expected to be a big market well into 2014 and beyond.  As older investors continue to exchange out of active management, the demand for net lease continues to expand, as well as current net-lease owners wishing to turn over inventory.  With the current environment of readily available financing for net-lease properties, this sector is sure to be at the top for exchange buyers.  This huge growth in investor demand has far out-paced demand, leading to one of the strongest net-lease markets in recent history.  According to Sabharwal, “Brace yourselves for Q4 2013 to be the biggest quarter of closing velocity in net lease that we have seen in many years and possibly in history.”