Cap Rate Needle Shows Little Movement in Q4
Q4 2018 Overview
In many respects, the closing quarter of 2018 could almost be a replay of Q3. Almost. Cap rates demonstrated a slight uptick of three basis points (bps) quarter over quarter, and the remaining average lease term rose by only 0.7 years. What was noticeable in the last three months of 2018 was, as there always is at that time of year, speculation about interest-rate hikes, which tend to put upward pressure on cap rates through the financial markets.
In terms of sectors, those considered “safe bets,” such as quick-service restaurants (QSR) and pharmacies, saw their cap rates compress while sectors facing challenges, such as big-box and casual dining, have traded at higher cap rates from quarter to quarter.
Sectors in Brief
While the overall national cap rate remained virtually flat, there are trends in specific sectors that require highlighting:
Both the automotive and casual dining sectors logged decreases in sales from Q3 to Q4, but with notable differences. For automotive, the decrease was primarily in the number of double net (NN) deals, resulting in a lower average cap rate (from 6.83% to 6.55%), the largest single-sector compression for the quarter. In the casual dining sector, the sales decrease in premium markets had the reverse effect, causing the cap rate average to expand from 6.34% to 6.64%, even though the average remaining lease term rose.
In another sector, convenience stores, (C-stores), saw a decrease in premium market sales with a cap rate expansion of 23.6 bps from 5.63% in Q3.
In the QSR sector, average cap rates moved in different directions, depending on the details of the lease, whether ground (GL) or triple-net (NNN). Ultimately, an increase in the number of GLs resulted in a slight quarter-over-quarter compression (from 5.88% to 5.65%). That trend was further fueled by an increase in average lease years remaining.
Markets in Depth: Dollar Stores
Taken as a whole, the dollar store space is driven by the profile of the sellers and how motivated they are to move product or to maximize proceeds on any given deal. For many smaller developers, every dollar counts, so they tend to be more patient and will hold out to maximize profit. Meanwhile, larger developers are interested in moving inventory and show more leniency with cap rates.
The sector ended Q4 with a five bps expansion in cap rates while Family Dollar and Dollar General went in two different directions. The former ticking down a bit (7 bps) and the latter, with the largest market share, moving up 10 bps.
That dynamic changes a bit when we look at assets with 10 or more lease years remaining. Then we see Family Dollar experiencing a 40 bps uptick and Dollar General remaining virtually flat, with a slight compression from 6.77% to 6.73% from quarter to quarter. Family Dollar’s uptick is largely accounted for by the changing location of sales from Q3 to Q4, from a higher percentage of sales in premium markets to a more normal distribution.
Markets in Depth: Pharmacy
Sector-wide, pharmacies logged a compression of 25.1 bps from Q3 to Q4, with both CVS and Walgreens trending down, CVS by 12 bps and Walgreens by 15 bps. While a distant third in market share, Rite Aid’s large compression in cap rates contributed to the sector’s movement.
Looking only at assets with 10 years or more remaining on their leases, CVS turned in a virtually no cap rate change (5.66% to 5.63% quarter to quarter). Walgreens’ compression was a bit more noticeable (6.33% to 6.09%) owing to more sales in premium markets.
We are also watching a certain disruption in this space as consumers look for their most convenient option. Front end store sales at pharmacies have been observed to suffer when convenience stores, such as Wawa, provide consumers with a closer or easier option. This poses a possible drain on pharmacy store profits.
Brand-By-Brand: Average Cap Rate Changes
- 7-Eleven: The number of lease years remaining rose from 12.7 in Q3 to 16.5 in Q4, resulting in a drop in cap rates from 5.31% to 5.02%.
- Arby’s: The inverse occured with lease years remaining, drop from Q3 to Q4, from 15.6 to 12.8. The result was a 34.5 bps expansion of cap rates.
- Jiffy Lube: The high cap rates set in Q3 (7.69%) were due to a low number of lease years remaining and no sales in premium markets. The large 200-plus-bp compression in Q4 is a revision towards the mean.
- KFC: Q4 was marked by properties with new leases selling in premium markets, putting significant downward pressure on cap rates.
- McDonald’s: A falling number (by two and a half years) of average lease years remaining caused the 46.3-bp increase in average cap rates from quarter to quarter.
- Starbucks: After a quarter-to-quarter increase in NN deals versus ground leases, we see an upward trend in cap rates of 155.4 bps, the largest expansion of the brands tracked. Q3 also featured a majority of sales in high-value markets as opposed to Q4.
- Taco Bell: The increasing number of ground leases caused a compression in cap rates from Q3 to Q4, from 5.37% to 5.07%.
STNL Cap Rates vs. 10 Year Treasury Rates
The count is now up to five . . . five consecutive quarters of expansion for single tenant net lease (STNL) cap rates. This is set against the lowest quarter end 10 Year Treasury rate since the close of 2017. The 10 Year rate was driven down in Q4 by uncertainty in equities markets.
While spreads have expanded from the third quarter, they still remain below 4%, as they have for the past nine quarters. Meanwhile, the Federal Open Market Committee raised the fed funds rate four times in 2018, and the Chair of the Federal Reserve, Jerome Powell, has indicated the committee would remain flexible on future rate hikes in 2019.
Cap rates remain flat as we swing into 2019, and as the above chart shows, they were the least volatile of the three measures. So, we expect it shall remain, at least for the short-to-mid term. Ditto the fed funds rate, which according to published reports, will remain at or below where it is at the start of the new year. The marching order for now clearly is: Steady as she goes.