New Dynamics in a Stable Asset Class

Adam Scherr, an advisor with Sands Investment Group, says his firm is seeing numerous 1031 exchange buyers looking for long-term net-lease deals across the country.  Read more below.

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When the Tax Cuts and Jobs Act passed at the end of 2017, no group within the CRE community could have been more pleased with the shape it had taken than the net lease sector. Earlier versions of the tax bill had proposed gutting the sector’s supporting infrastructure—the 1031 exchange—but the final legislation not only preserved it, but also strengthened an already strong economic case for a net lease investment.  As it happened, when the bill passed the net lease industry—typically among the most stable of all CRE asset classes—was navigating a few new trends in investor preference. With the tax bill now a few months old, the net lease industry finds itself in a sweet spot of enthusiasm generated by the tax bill’s passage that is coupled with new investor appetite for its changing fundamentals.  To be sure, some of this recent activity began before the end of the year and the passage of the tax act. Like in other asset classes, net lease investment activity slowed in 2017. But net lease was among the first to begin to pick up again.

“We’ve seen an increase in velocity of the number of transactions completed over the past six months as that tentativeness to act has gone away,” says Kyle Gulock, senior managing director for Charles Dunn Co. Inc. “Investors are now seeing more of a runway to this cycle.” Another factor in the net lease sector’s favor—indeed all of CRE’s favor—is the recent volatility in the stock market and the promise of further fluctuations. This could prompt investors to pull money out of the stocks and into real estate, says John Read, first VP of CBRE’s National Retail Partners-West team. But the most dynamic of the trends affecting net lease right now is the changing preferences of investors in the type of properties they are seeking. Many investors are gravitating toward assets with Internet-resistant tenants in categories such as quick-service restaurants, discount stores and daily needs retailers, says Jeff Conover, senior managing director of Faris Lee Investments.

Another asset type of interest is health-care services, particularly drugstores, which is currently undergoing radical change—change that could realign how net lease investors view this category, depending on how developments unfold. Specifically, two major deals—Walgreens’ $4.3-billion purchase of 1,932 stores, three distribution centers and inventory from Rite Aid, and CVS’ acquisition of Aetna for $69 billion—are poised to remake the drugstore category. Neither of these deals are finalized yet. The CVS-Aetna transaction is still pending before regulators despite CVS’ recent $40-billion offering of new debt, which will be used to finance the transaction. This deal has the potential to transform its store base into community health hubs, with potential for nurses, healthcare providers and lab technicians to locate in its stores, which could change the way healthcare is delivered to a wide range of the population, according to Matthew Mousavi, managing principal of SRS Real Estate Group’s National Net Lease Group.

Walgreens’ acquisition of Rite Aid, for its part, has been an ongoing story with numerous stores in the process of being transferred while about 600 others are being closed. It has been an unsurprisingly messy procedure as city councils get involved to transfer certain licenses and Rite Aid customers are notified of the change. It is expected to take about three years for all of the stores to be completely integrated into Walgreens. Then, in February Albertsons announced plans to acquire the remaining Rite Aid stores in a cash and stock deal—part of the grocery store chain’s efforts to broaden its offerings. Walgreens’ acquisition, by contrast, is more of a real estate play but there are other developments in this space that could have a transformative effect on drug-stores—with more will likely come.

In short, healthcare costs continue to soar and companies are trying out various strategies to tamp down these increases. The most significant—and one that sent the healthcare sector roiling—is the decision announced this year by Amazon, Warren Buffett and JPMorgan Chase to create a company to provide their employees with high-quality, affordable care. Few details have been provided and whether it will have an effect on net lease real estate is unclear. It does seem, based on the broad outline of the endeavor, that real estate will play some role in providing this service. Finally, Amazon is expected to be a factor for the pharmacy space as it continues to add products to its e-commerce empire.

“We expect that 2018 will be more active in this category with more clarity among the three big pharmacy brands,” Conover says. Amidst these trends sits a new tax code that is expected to promote more activity from real estate investors who had previously been on the sidelines, says Bill Asher, EVP of Hanley Investment Group Real Estate Advisors. In particular, single-tenant net-lease properties could attract a disproportionate share of the investment generated by the tax law’s passing, according to a report from Marcus & Millichap. Net-lease assets, which are often occupied by high-credit tenants on long leases, afford passive investors compelling yields that could be structured to benefit from the new pass-through tax rules, the report said.  Indeed, many see the tax overhaul as a positive in the net lease sector, according to Patrick Luther, managing principal of SRS Real Estate Group’s National Net Lease Group. Brick-and-mortar retailers in particular stand to benefit from the lower corporate tax rate, and any increase in house-hold incomes through tax savings could result in higher consumer spending. The preservation of the 1031-exchange code should continue to drive retail and medical net-lease transactions, attracting investors from other sectors, he adds. Also, the reduction of the corporate tax rate from 35% to 21% will help net-lease tenants to fulfill their rental obligations and increase renewal probability for leases with less term remaining, adds Conover.

Already investors seem to be responding to this confluence in trends. Indeed, even with the recent spike in interest rates and anticipation of more hikes to come this year, investor demand for new, well-located single-tenant triple-net investments leased to credit retailers remains strong, Asher says. “Buyers will continue to pay premiums for these properties, seeking long-term stable cash flow with relatively low risk and little to no maintenance.” Investors are also showing increased willingness to seek out new markets in secondary or tertiary markets, Asher says, as yields of high-quality, stabilized, Internet-resistant single-and multi-tenant retail in primary markets remain compressed.

Adam Scherr, an advisor with Sands Investment Group, says his firm is seeing numerous exchange buyers looking for long-term net-lease deals across the country, although right now, California has extremely low cap rates in comparison to other markets. He adds that there are shifts in the amount of for net lease product in some tertiary markets, but not in the stronger major metropolitan cities. “Bottom line: investors still want access to long-term passive income and to avoid capital gains through 1031 exchanges,” he says. It should be noted that like other CRE asset classes, net lease investments experienced a pause in 2017 due to a variety of reasons including uncertainty in the new administration and its policy direction. It has recovered admirably but signs of that cooling-off period are still apartment. Sellers once accustomed to fielding a high number of offers may need to adjust their expectations to two or three buyers who can execute with the intention of closing, Scherr says. “Rather than seeing multiple offers—especially in tertiary markets—you see one solid buyer who will close.”

Another factor affecting the CRE market that’s also made its impact felt in net lease: banks are now underwriting more conservatively. This, too, is slowing down the cycle somewhat, but deals are still closing. “While there may be more time between listing and selling, people are still looking for a deal, so if you price it right, it will sell.” At the same, some net lease assets are performing poorly because of changing fundamentals. Interest in big-box properties has clearly cooled, for example. According to the Boulder Group, big-box properties saw a 25-basis-point increase in cap rates from Q4 2016 to Q4 2017, while big-box properties are priced at a 68-basis-point discount when compared to the broader net-lease retail market. Investment-grade big-boxes are faring slightly better than non-investment-grade ones, though, with the former being priced at a 33-basis-point premium over the latter. HIG’s Asher says larger, non-grocery-anchored shopping centers have been negatively affected the most in the past year.

Anything with a flat rental-rate lease has seen a rise in cap rates as interest rates move up and buyers become more sensitive to the lack of growth, says Matthew Gorman, an investment properties SVP with CBRE’s Net Lease Property Group. However, other segments of the market, such as strong-credit convenience-store gas stations like Wawa, Sheetz and Royal Farms, have not seen a significant rise in cap rates and generate a good deal of interest from the marketplace, he adds. “Tenants with a flood of available inventory—Dollar General, Family Dollar, Starbucks—are seeing upward movement on cap rates since buyers have lots to choose from, and yield is one of the only ways to set yourself apart from the crowd,” Gorman says. Despite these changes, the type of buyer interested in net lease has essentially remained the same. While over the past year REITs have increased their net lease holdings, private players continue to dominate the buyer pool. Of those, says Conover, “cross-border capital from Asia has picked up, including investors from South Korea and China,” he says. A significant portion of private buyers are motivated by 1031 exchanges, which continue to be the net-lease sector’s driving force in terms of activity and pricing, says Read. Private investors traditionally claim the largest share of activity, accounting for 37% of volume in the first half of 2017—on par with the five-year average. “The trend of what seems to be a never-ending supply of 1031-exchange buyers—including those making cross-property-type purchases into more passive, less management-intensive net-lease assets—should continue,” he says.

But these investors do have their concerns. There are the rising interest rates, as well as more store closures and consolidation expected. Also, the shakeout in the retail space will continue for some time. “Retailers will continue to adapt to an ever-changing new normal,” Asher says. Gorman characterizes the net lease market as being in flux as the divide between buyers and sellers continues to widen as interest rates move up, putting pressure on the low cap rates that are generally associated with long-term net-lease properties. “That said, it’s still the safe harbor of choice for most people in 1031 exchanges, and even though velocity is off of its peak in 2016, deals are still getting done.”