The net lease sector has seen a year like no other commercial real estate sector. Despite a once-in-a-millennium pandemic, the sector is riding a two-year high on fundamentals that have only strengthened over the past year.
While many sectors in commercial real estate have shown weak rents and lower occupancy levels leading to lower values, many subsectors of single tenant net lease (STNL) retail have seen compressed cap rates post-COVID. Essential retail has been the buzzword of the year, and excepting perhaps healthcare real estate, no other sector has more essential retail users that single tenant net lease. Retailers like drug stores, auto parts, gas stations, fast food/quick-service restaurants, dollar stores and grocery stores all saw strong results as investors quickly shifted their attention to essential retailers.
On the flip side, the single tenant net lease retail sector also contains some tenants who were limited in their ability to make sales or open in 2020, including entertainment concepts, casual and sit-down dining establishments and gyms.
Shopping Center Business spoke to more than a dozen net lease executives for our annual round-up of the single tenant net lease retail space. Here are our findings.
A Year Like No Other
At the beginning of 2020, the net lease industry saw a normal pace and volume as the first quarter progressed. Many expected, because of low interest rates and velocity heading into the first quarter, to have record-breaking years. They weren’t wrong, but how and why it became one of the strongest years will always be remembered. Beginning in March, as the COVID-19 pandemic took hold, deal velocity suddenly hit the brakes.
As the pandemic began to cause closures and shutdowns, many investors hit pause, and many intermediaries quickly had to change their operations to work remotely. While there was a pause lasting a few weeks, many intermediaries say they quickly heard from investors, who had been analyzing the trends that were already taking place in the retail market.
“In the middle of March when the pandemic hit and the U.S. economy began to shut down, we saw an immediate shift of interests from individual and institutional investors who were open to experiential retail — including theaters and gyms — quickly drop off,” says Ken Hedrick, executive managing director, net lease capital markets with Newmark in Tulsa, Oklahoma. “There was a huge shift in all levels of capital — private capital, 1031 exchanges, funds, institutional investors — quickly switching to this newly deemed essential retail category. Pharmacies, convenience stores, grocery stores and dollar stores took over their interest. It created a lot of competition in that space because there was a finite amount of inventory, but a lot of capital chasing that inventory.”
Essential retail quickly became what STNL retail investors sought.
“Tenants started to realize that there was a very fine line between who was essential and who was not,” says Preet Sabharwal, managing director of New York City-based SAB Capital. “Those who were essential really beat their chests and kept moving and opening stores. They picked their heads out of the sand very quickly. There were some unexpected numbers from dollar stores and fast food restaurants in March, April and May.”
Many abandoned long-held investment types to focus on acquiring more essential properties.
“Anyone looking at investing in casual dining quickly changed property types to convenience stores, dollar stores or other more essential properties,” says Anthony Pucciarello, executive vice president with Dallas-based Secure Net Lease.
Hanley Investment Group arranged the sale of a new construction single-tenant Aldi in the Minneapolis metro area, adjacent to the Hazeltine National Golf Club in an off-market transaction. The sale price was just over $3 million for the absolute triple-net ground lease.
In 2020, Pucciarello says approximately 5 percent of what the company sold was casual dining properties; in the past, that figure was closer to 25 percent of properties sold. One such buyer that Secure Net Lease had closed on five 7-Eleven locations by the end of the year, including one that sold at a 3.75 percent cap rate. The company also sold about $60 million worth of QuikTrip convenience store properties in 2020. Overall, Secure Net Lease sold 73 convenience store locations in 2020.
“The sellers who had the essential retailers, such as convenience stores and grocery stores, automotive parts and dollar stores, saw cap rate compression,” says Pucciarello. “We could not keep a Jiffy Lube, 7-Eleven, QuikTrip or Dollar General on the market for longer than a week.”
Essential retail assets have seen cap rates compress throughout the year, with many setting record rates. The extended demand has pressed cap rates lower in many markets (see “Supply” section on page 38 for more details).
“If you take all of the retail net lease investors and put all of their focus on essential retail, it creates a much smaller supply,” says Jeffrey Thomas, founder of Seattle-based The Thomas Company. “That creates a supply/demand imbalance, which is good for net lease sellers.”
“There was a definite flight to quality and security,” says Matthew Mousavi, managing principal of the national net lease group at SRS Real Estate Partners in Newport Beach, California. “There is a need for passive yield and income, which has accelerated with the turmoil you saw politically and economically. Investors are still seeking places where they can put their money for a passive return backed by hard assets and brands that they know.”
By the third quarter, the market had settled back to its routine of doing business, despite many investors and intermediaries still working remotely.
“Q3 was a quarter of recovery when we started to see lending stabilize,” says Sabharwal. “A lot of the lenders who had disappeared during the second quarter had come back alive. The fourth quarter has been one of the lowest interest rate environments I’ve ever seen. Lending is driving this cycle; liquidity in the banking sector is very strong.”
Some supply was created by retailers adjusting their business models, which not only made them attractive and available to consumers, but more appealing to investors.
“Many retailers in net lease products were able to transform and morph quickly so they were essential,” says David Hoppe, executive vice president, capital markets, in the Charlotte, North Carolina, office of Atlantic Capital Partners. “The stores that had a drive-thru and had a business plan in place to have their units open as much as possible thrived. We had restaurant tenants who saw their sales up 40 percent year over year because of how many people were coming through their drive-thrus compared to normal.”
As time progressed to the second and third quarter, investors had even more clarity, as did owners seeking to sell properties.
“What was interesting through that period was that an immense number of investors decided to put their properties on the market,” says Chris Sands, CEO of national brokerage company Sands Investment Group, who saw his company’s listings increase by more than 65 percent during the year. “The appetite for net lease has been unbelievable. We haven’t been able to keep product on the market. There’s a huge appetite for the yield, certainty of income stream from rents and the ease of management to ownership that net lease provides.”
Others also repeated Sands’ notes on performance, despite a rocky road of getting to strong levels.
“Despite the jolt of March, we were able to get out of it and have a record year,” says Mousavi, echoing what many net lease brokers told SCB.
In addition to clarity on property types, the STNL market was also bolstered by the election, as investors tend to fear the repeal of the IRS 1031 exchange rule in every election cycle.
“After Labor Day, the market became flooded with demand and the fourth quarter was one of the busiest in our team’s history,” says Jeff Lefko, executive vice president of Hanley Investment Group in Corona Del Mar, California. “The election definitely played a role in this, but more than anything, it was buyers’ desire to earn a return on their money through real estate investment that had previously been sitting on the sidelines.”
The supply of STNL properties was already constrained heading into 2020. With fewer retailers expanding, there were not as many properties being built as past years. When the pandemic began to impact retail and restaurant businesses in March, many retailers paused groundbreaking plans for later in the year, further constraining supply.
“There was a temporary pause in supply that came from new construction through retailer growth and developers,” says Daniel Taub, senior vice president and national director of retail for Marcus & Millichap. “Those deals that were in the pipeline were temporarily put on hold or completely taken offline. Some took a pause and they’ve come back. The good news is, especially in the active sectors that were actively growing before the pandemic hit, their business models have adapted and made changes that have allowed them to restart.”
“Supply was the lowest it had been in the past few years,” adds Lefko. “A lot of the new construction projects that would have come to market in the third and fourth quarters of 2020 were delayed or put on hold due to COVID. There are certainly more buyers than sellers in the market right now. This has created some cap rate compression for quality real estate. As long as a property is properly priced and exposed to the marketplace, there is a very high probability that it will sell.”
However, many expect supply to continue to be limited over the next 12 months, as fewer stores are being developed in the pandemic era. According to Hanley Investment Group, there were only 94 new construction single-tenant net lease restaurants constructed in 2020 in the U.S. listed for sale in early January 2021. Most of what comes to market is sold very quickly.
“Many of the deals that were out there [in 2020], ended up being sold,” says Hoppe.
Newmark sold this Krispy Kreme location in Concord, North Carolina, near Concord Mills mall. The list price was $5.5 million, representing a cap rate of 5 percent.
“There were not many new deals being built. There is going to be a lack of product available in the market. There is still demand, but retailers and other tenants halted development activity. Some tenants are living in fear and are not currently building new stores; they don’t want to be the last one building stores when everyone else is taking a break.”
One oddity of the past year has been the compression of cap rates on properties that do not have investment grade credit, but that are deemed essential retailers. Thomas Company sold a portfolio of grocery stores that was not investment grade. Some of the cap rates were lower than some investment grade net lease properties, says Thomas.
“I don’t think I’ve ever seen in my career where a non-investment grade offering will trade tighter than an investment grade offering simply because the nature of the tenant’s business. That was new,” says Thomas.
Experts caution that cap rate spreads between credit and non-credit properties are extremely tight.
“Not all single tenant net lease space is created equally,” says Taub. “When you really look at it, the better credit quality properties with long lease term and good real estate fundamentals are seeing cap rate compression. The difference in price is within 100 basis points from one extreme to the next.”
Another factor helping the industry drive activity is the formulaic approach that many investors take in choosing properties. The business itself is very transaction focused, with speed of execution, credit, location, tenant type and lease term setting the stage for most sellers and buyers.
“Over the past 10 years, net lease properties have become more commoditized,” says Sean O’Shea, managing principal with The O’Shea Net Lease Advisory in Rolling Hills Estates, California. “You used to be able to just quote a cap rate. In 2019, we had record low cap rates. That continued in 2020. All of the market intelligence we have now suggest cap rates might go down another 15 to 20 basis points.”
“Net lease, in general, held up very well,” says Robert Horvath, executive vice president with Horvath & Tremblay, based in the Boston area. “There was a lot of capital flowing into smaller net lease deals. On the exchange side, we were concentrated on high quality essential retail businesses. We didn’t take on a lot of fringe product that may not have cleared.”
While the year started out strong in all categories of single tenant net lease, buyers quickly found their way to the sweet spot in the market: essential retail properties, say net lease executives.
“There was a fair amount of capital in the net lease space starting out in 2020,” says Hedrick. “It all converged into the essential retail bucket. All levels of the buyer pool are directed towards essential retailers.”
Taub says that two groups have increased their investment activity in the net lease space since the onset of the pandemic. The first is the individual private investors, who are actively seeking individual acquisitions. The other group is well organized private and institutional equity funds. The funds are traditionally looking to make significant portfolio or equity investment buys in the sector.
“These fund investors are looking to invest directly with retailers or with other owners where they can access the net lease marketplace because of their ability to make investments in scale,” says Taub. Especially active within that are large family offices and large private equity funds who are seeking to create scale within the space.
While investors quickly figured out which retail types and retailers were essential, that didn’t mean they put aside other standard criteria they had for properties. This was especially true for individual investors. Keeping restrictive criteria limited the number of properties they would consider for purchase. Geographic location, for instance, was one criterium that few individual net lease retail buyers were reluctant to change.
“Most individual investors want to buy a property that is either close to where they live or close to where they want to live,” says Matt Bear, founder of Las Vegas-based Bear Real Estate Advisors. “If you are a professional investor, you should care less about where the property is and more about the price you pay, the credit of the tenant and the investment that you are buying. However, there are asset managers that will only buy in gateway markets.”
Intermediaries say there have not been many opportunistic buyers seeking entertainment and casual dining restaurants — those net lease categories that have likely taken the largest hit in value during the pandemic.
“The owners of these assets haven’t lost these assets to the bank or had to sell,” says Mousavi. “The values of these properties are holding firm. A 7 percent cap gym hasn’t gone to a 9 or 10 percent cap rate. Before an owner sells a property at a 10 cap, they are going to hold it for a while or get a new loan. Unlike the Great Recession, we have capital, liquidity and active lenders who are sitting on stockpiles of cash. We went into this crisis very strong.”
Hanley Investment Group saw a lot of activity from buyers who were seeking replacement properties for 1031 exchanges from sales in California. Many of these investors were seeking to convert from multifamily holdings to net lease retail outside the state of California at better yields, says Lefko.
“A lot of activity continued to come from 1031 exchange buyers selling multifamily properties in California,” says Lefko. “Long-time multifamily owners in California became discouraged by certain California laws and mandates that made it difficult for them to achieve their desired returns.”
Lefko reports that Hanley Investment Group saw a number of California multifamily owners choose this route in 2020. The company achieved record cap rates — predominantly from sellers of multifamily in California who were utilizing 1031 exchanges to purchase — on net lease retail in Denver, Seattle, Salt Lake City, Las Vegas, Phoenix and even Bozeman, Montana.
Lefko says he sees that trend continuing as long as capital from California continues to express interest in growing markets.
“Certain Mountain West markets will see major cap rate compression as California capital moves to markets like Boise, Phoenix, Montana, Denver, Las Vegas and Salt Lake City,” he says. “Texas markets such as Austin and Dallas, and Pacific Northwest markets like Portland and Seattle, will continue to see cap rates inching into the 4 percent range for certain properties. The spread between cap rates in these markets versus those in California will hit an all-time low.”
The investment sales market for single tenant net lease retail properties has been tilted in favor of sellers. With supply severely constrained, sellers rely on brokers to price properties accordingly, backing those figures up with research. Investment sales professionals say many properties are going at or above asking prices.
“Very often a buyer will say ‘can’t we negotiate the price?’” says O’Shea. “We have given them the market information for the asset class, the asking price is within the range. The benefit today is that you get the property, not a break on the price. It is just too competitive a market. The key today is to get the property. It is a seller’s market, and will continue to be a seller’s market for the next year.”
In 2020, private owners sold more properties than in previous times, say brokers. Some traded out of fear because they did not know if a property would recover from the pandemic. For opportunistic buyers who had a long-term view, the timing was right.
“There are institutional buyers taking advantage of a situation where there may be some fear by a private seller,” says Hoppe. “Some of them have been able to buy several deals at higher cap rates from private individuals who have owned those properties for years.”
The possibility of acquiring properties that have value potential or are underperforming at the moment has sparked the interest of some in the net lease market.
“We have seen tremendous demand from individuals and corporations who are looking for value-add or higher risk/higher return opportunities,” says Hoppe. “We have not seen owners who are hurting bad enough let their properties go for lower prices. We get several calls a day asking for ‘great deals’ to take advantage of properties that might be distressed during the pandemic. The thing about net lease properties is that most tenants are resilient.”
That resiliency has many in the sector grateful.
“We have had groups call us that bought portfolios of net lease properties years ago, who’ve been sitting on steady returns, thanking us for getting them into this property category because it has been so resilient through this pandemic,” says Hoppe. “Their office and multifamily holdings are seeing rent collection issues, but their McDonald’s, Bojangles, Advance Auto, Auto Zone and 7-Eleven properties are doing well.”
Newmark represents a number of merchant developers who build and sell net lease properties. The company also has a number of institutional clients who seek to prune their portfolios of certain assets every year, says Hedrick.
“Some institutions have done some blend and extend where they had shorter lease terms with extensions, creating value,” he says. “With the compression in cap rates and with essential retail being at the forefront of buyers’ minds, these institutional owners saw an opportunity to make strong profits on these assets by selling them in today’s market.”
“As March and April hit, we thought there might be a lot of distress coming to the market, where people had to sell,” says Andrew Sandquist, vice chairman, sale leaseback and net leased properties for Newmark. “We didn’t see a lot of sales where sellers had to sell. The market, if you were able to get through May, opened back up and pricing was strong.”
Many in the sector expect supply to be the biggest factor at play in 2021. Keeping and developing an inventory of properties is at the top of many intermediaries’ list as the year launches.
“The activity levels are extremely high for buyers and capital looking to get into the single tenant net lease space,” says Hedrick. “With everyone looking for the same property types and the same tenants in the retail space, there might be some constraints on available product.”
Because of the tightness in supply, some sellers are in a quandary. Never has it been more important to have a good investment sales professional on your team.
“Now that we are in a very competitive market with fewer properties and more buyers, we have to pick and choose on behalf of our sellers who to do business with,” says O’Shea. “It is not a popularity contest; it is the result of being trusted by sellers over many years.”
Despite the concern around supply and lower cap rates, those in the industry are bullish about its long-term prospects, as well as the return of some property types as the industry moves through 2021.
“The fundamentals are still very strong for the net lease sector,” says Mousavi. “We have low interest rates, a lot of capital, a lot of liquidity and a lot of lenders.”
As always, post-election, there is a concern around the possible repeal of the 1031 exchange provision in the tax code. The provision is something the real estate industry as a whole agrees is essential to continued transactions.
“As long as the tax law remains relatively unchanged, we will likely see a continuation of what we see in 2020, which is a laser focus on essential retail and durable cashflow, which could lead to more cap rate compression,” says Thomas.
With a vaccine rollout underway, and the new Presidential administration’s promise to get millions vaccinated over the next three months, investors are cautiously optimistic about even better times ahead.
“As we continue to move through 2021, the macroeconomic conditions should match and allow for the momentum to continue from the third and fourth quarters of 2020 for single tenant net lease,” says Taub. “You are going to have more development come back online that was paused. The market and momentum — volume and pricing — should see continuing improvement as we move through 2021.”
One bright sign is that more development is planned ahead as well, particularly for essential retailers. That may also allow other retail types to resume expansion as the nation’s pandemic — and economic — recovery becomes clearer.
“Development is still trending upwards,” says Pucciarello. “We’re not seeing a decline in single tenant retail development for essential product types. We have a list of more than 50 properties coming to market soon. Depending on the rollout of the vaccine, the market for casual dining properties could correct itself this year.”
Those in the industry have hopes that rising employment levels and consumer spending bolstered by further government stimulus will improve the outlook for many retailers active in the net lease sector.
“Our expectation is clearer skies ahead for 2021,” says Sabharwal. “We think it will be a year of recovery and extreme consumer confidence as we see, hopefully, a new stimulus plan that gets dollars in the hands of Americans who can funnel that cash to retailers. We think it will be a better year for employment than 2020 was. If you connect all those dots, consumer spending should bolster retailer earnings and those retailers can hire at a faster pace. That should lead to retail expansion as well.”