It’s still a bit early to see the effect of the Federal Reserve’s recent rate decrease in the dynamics of the market. What we do know, however, is that further cuts will keep potential buyers and sellers looking for deals.
Q2 2019 Overview | Real Estate Fundamentals Drive Q2 Activity
Until then, the market is holding steady with activity from the first quarter market, with some interesting changes. We see a robust number of transactions taking place, as in Q1 and, other than the typical summer doldrums, there are no signs of any slowing down.
But as the upcycle continues to lengthen, investors want to ensure long-term income, and for that, they’re taking a hard look at the real estate fundamentals behind every deal. If a property is occupied by a reliable tenant with brand recognition in a prime location, with high visibility to passing customers and ease of access, it is likely to trade at a premium.
Overall, it does appear that cap rates are down this quarter by some 11 basis points (bps). This quarter was shaped predominantly by three of the largest sectors: Dollar Store, big-box and automotive. This second category drove the largest change with a positive 73.5 bps change. Other sectors where we see significant change are dollar stores at a -35 bps swing and banks at -32.4 bps.
The above-mentioned long-view expectation of buyers is at work here. With a longer lease term remaining, the new property owner will collect rent for a longer period of time and cash in on built-in rent escalations.
Turning to the Big Box sector, we see a jump in stores sold in the premium markets of California and Florida, which can explain why we see this sector’s cap rate rise from quarter to quarter. The stores sold were also occupied by solid tenants, a positive for buyers since they don’t have to worry about the tenant not being able to complete their term and replacing that rental rate.
Even though deals in the Automotive sector were marked by longer terms remaining, there was an average cap rate drop of 26 bps to 6.32% in Q2. This could be attributed to more stores sold in premium markets.
Big Box stores were up from quarter to quarter by 73.5 bps, due likely to the average lease term rising from 8.5 years to 10.2. The opposite holds true for the Educational sector where the average cap rate dropped 26.7 bps but terms increased from 7.3 years all the way up to 11.9.
Lease terms in QSR were also up, this time to 14 years. But this time with only a relatively minimal drop, by 5.8 bps. But this didn’t hold true on longer-term deals, where cap rates increased from Q1 to Q2.
Markets in Depth: Dollar Stores
Dollar Stores see themselves having a major drop in average cap rate, decreasing by 35 bps down to 7.08%. While we do see decreased sales, the drop in cap rate could be accounted to the fact that more sales are taking place in prime locations closer to metropolitan markets, as opposed to smaller more rural communities. Within the sector, we can also see the average years remaining rise, meaning owners are building up new properties then turning around and putting them on market.
Markets in Depth: Casual Dining
Overall, the sector is up 17.9 bps, with the average term remaining pretty static overall. Chili’s and Red Lobster witnessed the largest changes of the sector, with both seeing their average cap rate climb by around half a percent. In terms of deals that had at least 10 years remaining, Applebee’s saw a half percent increase as well on its cap, averaging a 7.01% in Q2 versus its 6.57% in Q1, making for a stable investment over the long term.
Markets in Depth: QSR
The QSR sector had a small Q2 drop in the average cap rate, from 5.63% to 5.57%, or -5.8 bps. McDonald’s sales are certainly a factor in these low rates with its overall average drop from 4.36% in Q1 to 4.30% in Q2. Contrary to that, other name-tenant numbers increased, such as Popeyes, from 33 bps to 6.05%, and Burger King increasing 8 bps.
Brand-By-Brand: Average Cap Rate Changes
7-Eleven: The average lease term went up, however the average cap rate went down by 7 bps.
Burger King: We saw an increase in Burger Kings sold in this quarter, as well as the average lease term increasing. These longer terms allowed the cap rate to increase 8 bps.
Chili’s: Chili’s numbers remained relatively static, with its average lease term decreasing to 14 years from 14.75 and the average cap rate increasing 2 bps.
Dollar General: Q2 saw an influx of properties being listed for sale, which caused a significant drop in the average cap rate from 7.04% to 6.65%, or 39 bps.
Pizza Hut: A decrease in average years remaining led to an increase in the average cap rate to 6.28%, a change of 28 bps.
Taco Bell: An 92 bps drop in the average cap rate was caused by significantly more years remaining on terms, which rose to 19.88 years.
Wawa: In Q2 there was a slight decrease in the number of properties sold in premium markets and a slight uptick in the average term remaining, causing a quarter-over-quarter change of -7 bps in average cap rate.
STNL Cap Rates vs. 10 Year Treasury Rates
This is the fourth straight quarter in which we have seen the 10-year Treasury Rate decrease, along with the spread increasing. This despite the STNL rate decreasing. It is in fact the lowest 10-year rate we have seen since Q3 2016, and the spread continues to be in excess of 4%.
Investors are looking behind the names to analyze the local market and real estate fundamentals to gauge their level of risk–as they should. What happens as we move into the third quarter of the year will largely be determined by how the Fed views the economic outlook, although the general wisdom indicates continued rate cuts through 2019. Just like everyone else industry-wide, we’re watching.