End of an Era?

Are Cap Rates as Low as They Can Go for Net-Lease Transactions?

By Keat Foong, Finance Editor

The demand for net-lease properties remains intense, but there is very little new product coming online. Based on the law of supply and demand, that should cause cap rates for net-leased properties to continue falling next year, right?
Wrong.

On the contrary, the era of cap rate compression for net-leased properties is likely to end in 2014. “We do not see cap rates compressing. If anything, they will tick up a little,” said Jonathan Hipp, president & CEO of Calkain Cos.

“We think there will be a flat to slight increase in cap rates in 2014,” agreed Ken Hendrick, senior director of Stan Johnson Co. He predicted their remaining flat in the early part of 2014, then increasing slightly through the rest of the year.

Research by The Boulder Group shows that cap rates may have already shown marginal upward movement. For the first time in nearly two years, single-tenant retail and office properties inched up slightly during the third quarter (see table on opposite page). That increase could be attributed in part to the rise in interest rates this year, as Treasury rates moved from the low to the high 2 percent range from May to August.

Experts agree that whether the rates for net-leased property will increase going into 2014 hinges mostly on interest rates. And it is widely believed that interest rates will rise by the latter part of next year—and with them, cap rates for the single-tenant sector. For the time being, many players believe net lease valuations will stay stable at least through the first portion of 2014.

Randy Blankstein, president of The Boulder Group, projected any increase will not be seen for the next six to nine months. “We think there will be a sustainable plateau (in prices) through at least the middle of next year.”

Further budgetary disruptions on the domestic front also have the potential to impact cap rates by shaking confidence. Congress has only “delayed the issue of a government shutdown,” pointed out Hipp. “If that happens again, there will be uncertainty in the market, and when there is uncertainty, there will be risks of interest rates rising.” That is influencing his own anticipation of a cap rate increase. “After the first quarter, we are not so confident because there are a lot of issues in Washington, D.C.”

Make no mistake, demand for net lease investments is very strong, and projected to remain that way. That has made Hendrick bullish, especially going into 2013. “We believe there is still a lot of capital that wants to get into the sector and be placed into single-tenant net lease properties,” he affirmed.

Also, availability of capital—both debt and equity—is driving the triple-net single-tenant market—and expected to continue to grease the wheels of net least next year, barring disruptive events. Gary Tenzer, principal & managing director at finance company George Smith Partners, reported that debt capital is currently plentiful for net lease properties, whether investment or non-investment grade. Borrowers can even obtain financing of as much as 99 or 100 percent if they structure the deal correctly, he noted.

Tenzer projects that debt capital will become even more plentiful next year as lenders grow more active. “There will be more lenders chasing deals. … There are new capital sources every day. There is no reason that will change next year, unless there is another shutdown or the U.S. defaults. Then all bets are off,” he said.

Varied Popularity
The reasons net lease properties are extremely popular as investments are multifarious. Of late, it is also becoming a more mainstream investment. “Net lease used to be a niche investment,” said Hipp. “Now there are more investors, whether REITs or high-net-worth individuals, who want a portion of their portfolio to be placed into net lease.”

Also driving investors to the net lease sector are the low yields alternative investments currently produce. Holding net lease property is similar to holding an investment-grade bond that has “real estate backup,” said Hipp. “It boils down to the need for predictability of income, and the yields are better than those of fixed-income investments out there.”

Net lease investment is “very attractive to a lot of investors,” added Tenzer. “The single-tenant assets allow investors to hold real estate without being in the real estate business. … It is a low-brain-damage investment.”

Other factors increasing the demand for net lease include heating markets resulting in reduced returns in other asset sectors and 1031 investors seeking to shift into low-maintenance real estate. Some of these pressures will not likely let up next year, driving continued interest in the net lease sector.
For example, Blankstein expects the same, if not higher, levels of 1031 exchanges in 2014. Higher real estate prices encourage property owners to enter the market to sell. He explained these sales will generate a large gain for many investors, which they will seek to reinvest in net lease properties through 1031 exchanges.

Further heightening the market imbalance is a limited supply of property, a situation Blankstein anticipates continuing next year. That will also apply to build-to-suits, since low-cost financing will be more attractive to corporations than the more-expensive sale-leaseback process as a means to fund business expansion. “Low interest rates do not encourage (companies) to engage in sale-leasebacks,” he noted.

While Hendrick also sees the sector as supply constrained, he has noted some signs of life in the retail and industrial development markets around the country. “While it is not where we want it to be, supply is starting to increase,” he said. For example, Walgreens and Whole Foods may be looking to expand via single-tenant leases, and Hendrick also sees FedEx expanding. “We see a pickup in growth. This will continue at the beginning of 2014 (and) through 2014,” he asserted.

New supply is also expected from investment firms as they sell off assets. One big case in point is American Realty Capital Properties, which in the past year of merger-and-acquisition activity has amassed a huge amount of property and is expected to unload some of it.
Hendrick also believes a major source of new net lease investment supply next year will be second-generation leases. New leases will be signed for vacated single-tenant buildings, which will be offered for sale to investors. Or leases restructured with lower rents and longer terms will be placed on the market. “We see a lot of such (transactions taking place), because the sellers can create much value.”

These improvements in supply notwithstanding, the overall level of supply will remain significantly less than desired. For that reason, “it will take a substantial increase in interest rates to move the cap rate much,” said Blankstein.
Given that cap rates are likely to move up in the near future, if not continue to plateau, Hendrick offers some advice.

“We are close to historical lows on the cap rate,” he said. “The cap rates have gotten off of the bottom and are slowly increasing. And because interest rates are artificially low now, we think cap rates will increase over time. So now is a really good time to sell.”

This story appeared in the December 2013 issue of Commercial Property Executive magazine.