Amid a slump in investment sales volume, investors eagerly welcomed the Federal Reserve’s interest rate cut in September. The half-percentage point decrease was more than what many in the industry had anticipated, but Fed Chairman Jerome Powell recently indicated that additional rate cuts this year will likely not be as aggressive.
The move by the Fed came after a spike in the federal funds rate from near zero in March 2022 to a range of 5.25 to 5.5 percent in July 2023 — a period during which the central bank raised the federal funds rate 11 times.
Ultimately, the higher interest rate environment has led to a major slowdown in the sales volume of net lease properties this year, says Randy Blankstein, president of The Boulder Group based in Wilmette, Illinois. “Transaction volume is down approximately 60 percent from 2022 levels,” he says.
In a net lease transaction, the tenant pays a portion or all of the taxes, insurance fees and maintenance costs for a property in addition to rent. For the 12-month period that ended in June, net lease investment volume across property types decreased by 34 percent from the same period a year ago to $35.4 billion, according to CBRE.
The Boulder Group recently released its Net Lease Market Report for the third quarter. In it, the brokerage firm notes that cap rates in the single-tenant net lease sector increased for the 10th consecutive quarter across retail, office and industrial property types. The retail sector recorded the smallest cap rate increase of three basis points to 6.5 percent.
A cap rate is the rate of return on a real estate investment property based on the income the property is generating. A lower cap rate corresponds to better valuation and a better prospect of returns.
“The persistent upward trend in cap rates can be primarily attributed to sustained high interest rates,” states the report.
“Additionally, there is a stagnant supply of net lease properties on the market resulting from limited transaction activity from both private and institutional buyers.”
While history shows that there is a positive correlation between changes in interest rates and cap rates, the process takes time to play out, say industry experts.
“We hope that the interest rate decrease is a sign of positive momentum, but it will take some time for market fundamentals to improve,” says Dan Elliot, a senior vice president with SRS Real Estate Partners in Chicago. “The cost of capital, combined with the cost of construction, has created a bottleneck.”
Jeff Lefko, executive vice president with Corona del Mar, California-based Hanley Investment Group Real Estate Advisors, says he expects to see cap rates compress gradually over the next 18 months.
“While buyer activity is expected to increase due to more affordable debt, cap rates don’t move one-to-one with interest rates as it takes time for all of the excess supply to be consumed,” he explains.
Lefko says the net lease retail sales market has been dominated by 1031 exchange buyers thus far in 2024, but opportunistic buyers are starting to enter the mix.
“Seeing non-1031 exchange buyers coming back into the market is typically a sign that cap rates have hit their high point,” Lefko asserts. In other words, prices have likely bottomed out.
The U.S. average cap rate on single-tenant net lease retail assets that traded during the 12-month period that ended in June was 6.3 percent, up approximately 40 basis points from the year prior, according to Ashish Vakhariya, senior vice president of investments with Marcus & Millichap in Southfield, Michigan.
“While single-tenant net lease transaction activity across the country has slowed since the peak velocity observed in 2021, trading is still above the historical average,” emphasizes Vakhariya.
He says the total number of transactions of single-tenant net lease retail properties $1 million and higher that changed hands for across the U.S. for the 12-month period that ended in June was down about 5 percent from the prior year, while exceeding the 2014-2019 annual average by over 10 percent.
What buyers want
There are two major trendlines unfolding in the net lease retail market, according to Blankstein: (1) investors are focused on smaller transactions that do not require debt; and (2) buyers have placed a larger focus on residual real estate valuations, whereas historically they were more concerned with tenant credit and remaining lease term.
“Deals under $2.5 million are trading with much more frequency than larger price points solely because they don’t require debt as much as larger deals do,” echoes Elliot. “Anything that incorporates debt immediately makes the deal more complex.”
Elliot also states that buyers are more astute when evaluating assets in today’s market. They look for solid real estate fundamentals across the board, including tenant credit strength, location, lease structure, rent in relation to market rent, and cost per square foot.
“If an asset doesn’t check all the boxes, there is likely a similar deal out there that does,” says Elliot. “This is contrary to years past where inventory was low, and demand was very high.”
Today’s buyers are less concerned about the creditworthiness of the tenant and more concerned about the quality of the real estate, emphasizes Lefko.
He says key considerations include whether a property is located at a hard corner or a signalized intersection with high traffic counts and strong demographics. (A hard corner means a property shares a boundary line with two intersecting roads.)
“If the tenant vacates, can the property be easily re-tenanted? Does it feature a drive-thru? There is no shortage of demand for high-quality properties,” says Lefko.
One bright spot for investors has been the net lease retail strip center, according to Lefko. He says it is one of the few product types with cap rates high enough to offset the impact of higher interest rates.
In one example, Lefko’s firm generated multiple offers for a 37,259-square-foot pad site, otherwise known as an outparcel, located at Lakeport Commons shopping center in Sioux City, Iowa. The high quality of the real estate attracted investors, despite the majority of tenants having only a few years or less remaining on their initial leases, says Lefko, adding that Lakeport Commons is the most visited shopping center in Iowa.
“There is significant demand for unanchored strip centers in secondary markets or shadow-anchored strip centers (properties in close proximity to a large, well-known retailer), but supply remains limited,” says Lefko. “This steady demand has helped cap rates stay relatively stable. Even with lower interest rates in the past, the cap rates for this product type were in the high 7 to low 8 percent range and continue to hover in this range.”
Who’s active?
The types of buyers most active in today’s net lease retail investment market include high-net-worth individuals, family offices and 1031 exchange buyers, according to Blankstein.
His firm recently brokered the $2.3 million sale of a single-tenant property net leased to Chipotle in Lansing, Illinois, a southern suburb of Chicago. The newly constructed building features a 15-year lease. A 1031 exchange buyer purchased the asset from a Midwest-based developer.
In addition to 1031 exchange investors, the other types of active acquirers in the market include bonus depreciation buyers, institutional capital and opportunistic buyers, according to Lefko.
Bonus depreciation enables buyers to reduce their taxable income by writing off a portion of the cost of eligible assets in their first year. Bonus depreciation buyers aim to take advantage of the current bonus depreciation rate before it decreases in 2025, explains Lefko. The bonus depreciation rate is set to drop from 60 percent in 2024 to 40 percent in 2025 and 20 percent in 2026.
In January, the U.S. House of Representatives passed the American Families and Workers Act of 2024, which includes provisions to restore the 100 percent bonus depreciation. The Senate still needs to pass the bill, but it failed to garner the required 60 votes for passage in August.
While some institutional investors pressed pause on buying assets over the past few years, three or four are now active again, states Lefko. They have returned to the market particularly in pursuit of multi-tenant pad sites and strip centers but are less interested in big box centers.
In one example, Hanley Investment Group, in association with ParaSell Inc., generated multiple offers for a newly constructed pad site with three tenants at Independence Center Mall in the Kansas City suburb of Independence. As of press time, the property was in escrow with a publicly traded investment company as the buyer.
Opportunistic buyers are always active in the market, seeking distressed assets or properties with value-add potential. However, there are fewer value-add opportunities available in today’s market due to occupancy levels being at or near full stabilization in the primary and secondary markets in the Midwest, says Lefko.
Historically low vacancy amid modest construction and a resilient consumer base draws investor attention to the single-tenant net lease sector, says Vakhariya. Additionally, high-credit tenants with long-term leases provide potential stability during economic cycles, while the triple net lease structure minimizes the management responsibilities of the owner.
“Private buyers seeking assets under $5 million were the most common so far this year, with both private individuals and large organizations pursuing deals,” he states. “Elevated borrowing costs may have prompted buyers to focus on lower sales prices, potentially leveraging proceeds from a previous investment to sidestep financing hurdles.”
A glimpse into the future
Industry professionals assert that there is still a disconnect between buyers and sellers today. According to Blankstein, the bid-ask spread was 21 basis points in 2022, and is currently at 34 basis points.
“The gap between buyers’ and sellers’ expectations has widened over the past two years, due in no small part to higher interest rates imposed by the Fed. This misalignment has inhibited deals from closing while dry-powder capital accumulates on the sidelines, waiting for the right opportunity,” says Vakhariya. “There are signs, however, that this expectations gap is starting to narrow.”
In many cases, investors bought assets when prices were higher, or developers broke ground on projects when debt costs were lower, according to Elliot.
“They are now at, or nearing, their construction debt expiration and facing the possibility of negative leverage upon refinancing,” he says. “While many sellers are wanting to sell at elevated pricing, buyers are willing to pay what the overall market dictates and what the cost of capital allows.”
Buyers seem to be holding firmly to their pricing with minimal flexibility, echoes Lefko. “We are approaching a point where the disconnect between buyers and sellers is narrowing as [interest] rates decrease, but we are not quite there yet,” he says. “Now is a good opportunity for buyers to lock in higher-than-average cap rates, knowing that rates will continue to decrease in the near future.”
Another opportunity for buyers, according to Lefko, is to purchase existing retail spaces with “replaceable rent.” The market can support rent increases at these older properties.
“Due to high construction costs and the lack of new development, tenants may be forced to lease second-generation spaces,” explains Lefko. “These properties can be purchased far below replacement cost and at significantly better cap rates than new construction.”
Lefko also notes a surge in expansion plans by quick-service restaurants, grocers, convenience stores, car washes and auto repair tenants as a nod to the stability of the retail market.
As for consumers, they have shown “remarkable durability” despite a prolonged period of elevated inflation, says Vakhariya. “While recent spending behavior indicates a focus on discounts and affordable options, the overall consumer landscape has generally held up well amid strong headwinds.”
— Kristin Harlow
This article originally appeared in the October 2024 issue of Heartland Real Estate Business magazine.