Paula Hess is a freelance writer for REALTOR® Magazine.
Triple Net Lease Market: Near Perfect
Tight supply and investor appetite for premium NNN assets compress cap rates to historic lows.
October 28, 2015
Although two game-changing scenarios—an interest rate hike and tax reform targeting 1031 like-kind exchanges—are visible on the triple-net lease horizon, commercial real estate practitioners are thrilled with the market’s here-and-now fundamentals. “We are in a really good market,” says Will Pike, senior vice president for corporate capital markets at CBRE. “The 10-year Treasury is at 2.2 percent. U.S. real estate investing has gone up across all product types. The net lease demand is still greater than supply. Cap rates are still historically low. Pricing exceeds prerecession levels. There is a limited pipeline of quality assets.”
A Good Problem
If the NNN market is dogged by anything, it’s lack of supply, as evidenced by compressed cap rates that are dipping to the low 4s or 5s for McDonald’s or JP Morgan Chase leases, according to Jonathan Hipp, founder, president, and CEO of Calkain Cos., a commercial brokerage and consulting business, and coauthor of The Little Book of Triple Net Lease Investing.
This propitious supply-side dynamic will not be eased by new construction, says Sam Chandan, Ph.D., founder and chief economist of Chandan Economics. “We’ve seen an increase in the volume of new development activity, and the pipeline is growing, but at a modest pace. Compared to previous expansions, the recovery in development activity, for net lease and other commercial real estate types, has been fairly subdued.” The reason is simple: “Banks are still significantly risk-averse in their commercial lending activities,” notes Chandan, adding that a new regulatory framework creates a disincentive to make construction loans unless significant preleasing (30–40 percent) is secured. “We don’t see lending available for speculative -development in the net-lease sector.”
Gregg Thompson, CCIM, general manager with Ratcliff Development, agrees. “As the economy heats up,” he says, “a lot of people are starting to put capital to work for them, but they are not warming up to the idea of speculative building.” His firm recently codeveloped a 100-acre industrial park that represents an $85 billion expansion of the liquefied natural gas industry in Louisiana. “As far as the volume of projects, we are busier than we were a year ago, but a lot of that work was in the pipeline a year or two ago.”
CBRE’s Pike, who corepresented the seller in a recent $81.6 million sale of four freestanding, single-tenant Lowe’s Home Improvement stores, notes an uptick in construction. “It’s a function of the economy and retailers,” he says. Similarly, Calkain Cos.’ Hipp notes that many retailers have backed off on new-store construction, most notably Walgreens. “A lot of retailers are spending their budgets on revamping and renewing existing stores.
Tax Reform Cometh?
One factor that real estate practitioners cannot predict is Congress, which has targeted the 1031 like-kind exchange as a possible source of tax revenue. According to Mary Cunningham, president of Federation of Exchange Accommodators, a national trade association that represents professionals who conduct like-kind exchanges, “It is absolutely realistic that section 1031 [of the Internal Revenue Code] could be repealed or restricted as part of tax reform legislation. Three separate proposals have been introduced in the last 18 months that would do just that, driven by the ‘revenue’ that section 1031 supposedly raises through the deferral mechanism,” says Cunningham. The Obama administration’s 2016 fiscal year budget proposed limiting real property exchanges to $1 million annual gain deferral.
Opponents of such reforms, including the National Association of REALTORS® and FEA, say repeal of the tax deferment would hurt commercial real estate and the economy by locking up capital and discouraging investing; the initial hit could be $8.1 billion in lost GDP, according to a study commissioned by FEA and produced by Ernst & Young LLP.
Other 1031 challenges over the past decade have gotten little traction, though, so commercial brokers aren’t losing any sleep. Indeed, two proposals in the last Congress to repeal like-kind exchanges have since expired. “The consensus seems to be that the chances of eliminating 1031 exchanges in the near future are extremely small,” says Ben Cook, associate with the National Retail Group at Marcus & Millichap in Roseville, Calif. “However, if 1031 exchanges were eliminated, it would be extremely detrimental to my business and the market as a whole.”
Sale-leasebacks and Foreign Investors Heat Up Market
If Congress remains mute on 1031s, NNNs will continue to attract investors with their security, passivity, and “mailbox money,” as Ratcliff Development’s Thompson describes the fixed-income stream. It’s those qualities that appeal to foreign investors, who are now aggressively seeking and competing with institutional buyers for NNNs. Hipp, Cook, and Pike notice an increase in these buyers, with Hipp noting increased interest from Latin American and German investors. “They will pay top dollar for trophy real estate,” says Hipp. Tenant and location drive these deals, says Hipp, noting that cap rates can be as low as 3 or 4 percent for investment grade properties in a prime trophy location. “They have the mentality that they keep real estate forever. If they see something and they like it, they don’t mind leaning in to get it.”
Pike reports that his firm has seen a “tremendous amount of equity going into NNNs from Asian, South American, and European investors. U.S. real estate is a safe haven, and when you peel back the onion more and look at real estate, the safest asset is net lease real estate.”
The high demand for NNNs presents an opportunity for businesses seeking capital for expansion. A sale-leaseback can be an attractive financing tool, says Cook. “A sale-leaseback gives companies the opportunity to pull 100 percent of their equity out of the property,” he explains, noting that fast food and restaurant tenants represent the largest portion of sale-leaseback opportunities for investors. Hipp agrees, saying his firm has seen a 10–15 percent increase in sale-leasebacks in the past year. “The increase mainly reflects that businesses can get very aggressive cap rates from investors hungry to buy real estate,” he says. Hipp cites a recent listing of two daycare centers in which the owner-builder is selling the properties in order to build two new schools. “He knows that’s the most efficient way for a noncredit company to fuel its growth.”
Though the NNN market appears to be humming along, economist Chandan is concerned that interest rate hikes will nibble at the returns offered by bonds and NNNs. He notes that brokers and investors should be mindful to include adjustments in the lease terms: “If there are step-ups in the lease payments tied to inflation or the interest rates, those assets will hold their value. If they do not include these step-ups, these assets will come under a lot pressure as interest rates rise,” he cautions.
Chandan is also tracking how technology and changing space-use patterns may affect the value of retail and office properties. For instance, bank branches traditionally get strong valuations, but Chandan counters, “The number of bank branches is declining, as are the reasons we have for going into a bank branch. When we are looking at banks that are expanding versus those that have signaled they are retrenching, we should observe risk pricing, but we don’t.”
E-commerce, telecommuting, and the desire for open and collaborative workspaces are squeezing the office space sector given that square footage per office employee is diminishing. Chandan cites the example of a law firm in Lower Manhattan that was able to reduce its square footage after its lease expired because it had digitized the firm’s library holdings. Commercial practitioners should be factoring in changing space-use requirements going forward in NNN negotiations, he adds.
While interest rate hikes will inevitably affect cap rates and increase investors’ mortgage debt and operating income, Calkain Cos.’ Hipp believes investors will adjust to the hikes—and even possible longer-term changes—and continue to covet the NNN for its predictable, stable income stream. As Chandan notes, NNNs can play a stabilizing influence over the course of a business cycle and beyond.