CREJ - Retail Properties Quarterly - November 18, 2015
How aggressive is pricing for net-lease investments right now? Very aggressive based on what is observable in recent transactions. Net-lease investment properties have become a popular investment vehicle for smaller investors seeking a fixed return with few responsibilities for a landlord. Retail net-lease assets typically are single-tenant properties that are leased for long-term to a well-established or widely recognized retail or service concept. Common examples include banks, restaurants, drug stores, coffee shops, gas stations, automotive parts stores, discount stores, learning centers and specialized facilities, such as day care facilities or automotive service stations. Here are some common terms that typically are found in a lease that is structured for a net-lease investment sale: • Single tenant (often a regional or national branded concept) • Long-term lease (10 to 20 years) • Fixed lease rate with structured increases • Tenant is responsible for taxes, insurance and all maintenance (triple-net lease) Do these terms remind you of another type of investment? Perhaps a corporate bond? These types of investments do have a lot in common – aside from relative liquidity – and market returns for both options tend to exhibit a similar risk-and-reward relationship. Let’s consider two hypothetical retail assets that are located in the same shopping center. The first asset is a conventional retail building that is leased for a 10-year term to a coffee chain that is operated by a $10 billion company with an investment-grade credit rating and a brand that is recognized around the globe. The second asset is also a freestanding retail building that is leased for a 10-year term; however, the lessee has made some questionable financial decisions over the past several years and he now has a higher-risk credit rating. The building also features several unique design elements and an unconventional layout. In the event that the tenant vacates, it is probably going to be a difficult property to re-lease. Obviously, investors will need a much higher return on investment for the second asset, which has a higher-risk profile. To gauge current market pricing, this article will examine and summarize investment activity over the past 12 months along with a few current listings for good measure. To peg current investor demand, we will examine implied capitalization rates from these transactions. As a reminder, a capitalization rate is the ratio between net income and the sales price or market value of an asset. To avoid skewing the results of this survey, the market data set is limited to stabilized performing assets where confirmation of transaction details could be attained. To get a more specific set of market pricing indicators we will split the sales data into two categories. The two categories will be based on the credit rating of the lessee. Category one will be limited to assets with tenants that are rated as investment-grade status by one of the major credit ratings agencies. Category two is limited to assets with tenants that have credit ratings below the investment-grade tier or tenants that are not rated, including local or regional business concepts. With the asset categories clearly established, Chart 1 shows the implied capitalization rates for the investment-grade asset category along with some key characteristics. Note that the following characteristics were identified with lower implied capitalization rates: • Higher-quality credit rating • Conventional retail box that would appeal to many potential users • 10 years or more of remaining lease term • Located within a well-established shopping center • Evidence of strong tenant sales activity Chart 2 shows the implied capitalization rates for the non-investment-grade asset category. In looking at this set of transactions we found that the key characteristics identified with lower implied capitalization rates were identical to those identified in the investment-grade data set. We compared results from the Denver market to sales occurring nationwide and found rates of return to be highly similar. Broker feedback and market transaction data suggest that demand remains exceptionally strong; however, there is some evidence that capitalization rates are stabilizing. Investors remain concerned about interest rates, and they are watching trends; however, near-term demand is not impacted by investor concerns for rate movement at this time. There simply aren’t enough alternative investment options available for investor demand, especially for investors who may have time constraints resulting from a 1031 exchange.