The Federal Reserve’s decision to reverse its monetary policy and lower short-term interest rates has fueled demand for single-tenant, net-leased retail assets with regard to both deal volume and the entrance of new buyers into the space, although cap rate movement has been slow to reflect this growth.
The nation’s central bank has implemented three 25-basis-point cuts this year, creating a lower cost of capital for prospective buyers in the net-lease market and generating positive impacts on the cash flows of owners marketing their properties for sale. Consequently, both sides are showing a willingness to both bid on and ask for more aggressive price points.
Traditionally, lower interest rates translate to more investment demand, leading to higher prices, thus lower cap rates. The new monetary policy, which has only been in effect since this summer, has not yet impacted cap rates in the net-lease retail sector. However, that will likely change in early 2020, says Jonathan Hipp, president and CEO of Calkain Cos., a Virginia-based net-lease brokerage and advisory firm.
“Cap rates rose slightly in the middle of the year, but with interest rate cuts, they’ve come down,” he says. “Cap rates should demonstrate more compression when we do a 2019 review in the first quarter of 2020, because whatever deals have closed or been put under contract in the last 30 to 60 days aren’t reflected in current cap rates.”
According to Calkain’s research, cap rates for single-tenant, net-leased retail assets across the country rose slightly from 6.41 to 6.57 percent between the second and third quarters. Properties leased to banks and drugstores showed some of the highest cap rate elevation between those periods, with categories like quick-service restaurants and casual dining seeing their price levels hold steady.
Randy Blankstein, president of The Boulder Group, an Illinois-based investment brokerage firm specializing in net-leased properties, concurs with the notion that interest rate cuts have thus far had little impact on cap rates. It’s the uptick in deal volume, he says, that really illustrates how rate cuts have stimulated the market.
“At the beginning of 2019, many investors expected continued rate increases,” says Blankstein. “Now that we’re in a compressed interest rate environment, net-lease investment activity has continued to garner strong demand. In 2018, transaction volume in the national net-lease retail sector totaled more than $22 billion across more than 12,000 transactions, and 2019’s deal volume is expected to surpass that.”
A capital-rich market has also contributed to cap rate movement — or lack thereof — during this cycle. The strong volume of capital chasing yields and targeting alternative asset classes as hedging mechanisms against a potential recession worked to keep demand strong and pricing high when the Fed was raising interest rates in 2018. But the still-high degree of liquidity in the market should further help with cap rate compression.
“There’s a ton of liquidity in the market right now based on where the economy is,” says Hipp. “And when you look at what net-lease is — a long-term contract with a predictable income stream tied to a piece of real estate — there’s not really a group of investors that this asset class doesn’t work for. Plus, real estate like this works as an inflation hedge due to the ability to have rent increases within the lease.”
Hipp also says that the net-lease space receives strong attention from investors that want to stay within the real estate vertical, but prefer a more stable cash flow scenario at this late point in the economic cycle. So long as interest rates stay low, he says, the market should continue with its current level of momentum, and even potentially see some acceleration in deal volume from fund allocations that must be deployed before year’s end.
An Example: The Texas Scene
Blankstein says that investors have also shown a willingness to pay a premium for single-tenant, net-leased retail assets in Texas over other states — though once again, the cap rate movement doesn’t tell the full story. According to his firm’s data, in the third quarter, the overall cap rate for these properties in Texas was 6.1 percent, about 11 basis points higher than the national average.
“Private investors are targeting Texas because it has no income tax and boasts a growing demographic profile,” he says. “Accordingly, there are fewer advantages for REITs, which remain focused on stable cash flows and higher-yielding properties, due to the low cap rates.”
Reed Hudson, associate director in the Dallas office of net-leased brokerage firm Stan Johnson Co., notes that interest rate cuts have also bolstered demand in terms of how investors look to acquire these assets.
“We’ve seen numerous situations wherein previously, an investor would only have considered a deal by acquiring it with all cash,” says Hudson. “Now, with rate cuts, buyers are looking to leverage their investments with attractive financing.”
Hudson also says that in Texas, where deal volume matched its 2018 total of about $1.5 billion in the first three quarters of this year alone, cap rate movement has been very subtle. However, the buyer pool continues to display a diverse composition, with 1031 exchange investors and high-net-worth individuals tending to make more aggressive pushes into the space.
“While overall we see a tremendous amount of capital coming in from out-of-state and from coastal markets, Texas-based buyers are competing for net-leased assets more so than in years past,” says Hudson. “A large portion of them are 1031 investors that are taking advantage of the demand by selling their properties at premium prices and exchanging into another investment in Texas due to their familiarity and confidence in the market.”
Data from The Boulder Group supports this position. The firm’s research found that in 2018, approximately 67 percent of buyers for single-tenant, net-leased retail properties in Texas were private investors, while 25 percent of the pool was institutional capital. Thus far in 2019, 73 percent of the pool has been private and 23 percent has been institutional.
The Bottom Line
The net-lease retail space is somewhat insulated from the effects an economic downturn, as these properties tend to be leased to exceptionally creditworthy tenants that have the financial backing to guarantee the lease. In addition, these single-tenant assets are often leased to users that offer services or other
internet-resistant products, like food, medicine and automobile service.
Some industries that are heavily associated with the net-lease space have seen major merger and consolidation activity within their industries of late. The primary culprits of this activity are the banking (i.e. — SunTrust’s acquisition of BB&T) and pharmaceutical (i.e. — Walgreens shuttering Rite Aid stores
Sources concede that investors are taking harder looks at cash flows and same-store sales of properties that are leased to companies that have been impacted by buyouts, mergers or consolidations. But by and large, this activity has not been a major impediment to deal volume or pricing, save for situations wherein the buyer has a higher- or better-use tenant to bring into the space.
— By Taylor Williams. This article first appeared in the December 2019 issue of Texas Real Estate Business magazine.