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Net Lease Investors Are Realists About Potential Changes in the Market, Say InterFace Panelists

InterFace Net Lease conference, March 1, Omni Los Angeles Hotel

Attendees listen intently to speakers at the InterFace Net Lease conference, held March 1 at the Omni Los Angeles Hotel.

LOS ANGELES — The net lease market has, by and large, enjoyed a steady run post-recession. But many investors are entering 2016 with a sentiment that an uncertain future may lie ahead, according to panelists at InterFace Conference Group’s Net Lease West conference, held March 1 at the Omni Los Angeles Hotel.

This sobering reality was inspired by a few factors, including a likely hike in interest rates, a bulk of CMBS loans coming due, a discrepancy in pricing between buyers and sellers, rising cap rates, the possible dissolution of 1031 exchange transactions and a bull market that has lasted longer than average.

 

CMBS Wall Creates Opportunities for Buyers

Gordon Whiting, managing director at Angelo, Gordon & Co. and a “State of the Industry and 2016 Outlook” panelist, believes now is a good time for buyers to begin infiltrating the market due to the girth of CMBS loans coming due. More than $300 billion is set to mature between 2015 and 2017, according to the Mortgage Bankers Association. Rather than refinancing, panelists noted some borrowers were choosing to sell ahead of maturity.

“I have clients who have chosen to put their properties on the market because the debt is coming due,” said Maurice Nieman, senior vice president at CBRE and the “State of the Industry” moderator. “The last peak was 2006 to 2007, so all that debt is now on the table.”

This glut of inventory could theoretically create a buying bonanza for the right investors — if there were a meeting of the minds between buyers and sellers. Instead, panelists noted many sellers held unrealistic expectations of what their assets were worth. This disconnect was heightened when market factors like an inevitable hike in interest rates and rising cap rates were considered.

“I’ve stopped debating what real estate is worth to sellers,” said Sean O’Shea, managing director of BRC Advisors/The O’Shea Net Lease Advisory and “State of the Industry” panelist. “The last half a dozen years has been madness with valuations. I accept we’re in a low-return era and the debt piece of the puzzle kind of informed me of that.”

Panelists generally cited retail and multifamily as the two asset classes they’re most heavily selling in this current market, at an average rate of 6 cap. A few admitted their disposition decisions are partially due to a fear of overbuilding and oversaturation, especially among “hot” sectors like drugstores, dollar stores and restaurants of all service levels.

“We like restaurants, but we have too many, so we’re selling,” said Mark Selman, portfolio manager for VEREIT and a 2016 Investment Market panelist. “We’re selling many non-core assets as well. There are many investors out there pruning their portfolios and shortening term leases. They’re disposing of assets they don’t want to hold five years from now.”

 

1031 Exchanges Drive Market

It’s not just borrowers with maturing debt and investors anticipating changes to the near future that are bolstering net lease market activity. The bulk of this activity, panelists believed, was coming from the 1031 exchange market. Many witnessed exchange investors tying up multiple net lease properties at a time, then choosing their favorite once their existing asset traded.

“There’s still a tremendous amount of exchange sellers and buyers,” Selman said. “About 75 percent of sellers are doing 1031 exchanges. The market is flooding with trade buyers. The flip side is yields and interest rates are adversely affecting the cap rates in the bigger deals.”

Selman said this was especially true for apartment sellers, who are now trading into single-tenant net leases. Though it’s clear the net lease market is active, the larger question is whether that activity is actually producing any results. Coffee is, after all, for closers.

“I’m seeing lots of deals get re-traded because they’re not closing,” said Daniel Hoogesteger, senior managing director at Sands Investment Group. “They’re going through two to three escrows, people are tying up multiple deals, and then they’re just not performing. If the trade buyers remain in the market, it will drive prices.”

Selman believed it was ultimately up to the seller to complete the due diligence necessary to appreciate both the larger buyer population in this current market, as well as the specific buyers competing for the asset.

“When you have properties selling two and three times before they close in some markets, it’s not a cap rate problem,” he said. “It’s that you have to really understand who the buyer is, especially in secondary and tertiary markets. They have a lot more choices.”

 

Is 1031 Going Extinct?

Perhaps the biggest threat hanging over the net lease market is the possibility that new tax reform may mean the end of 1031 exchanges.

“One to two years ago, when people talked about the elimination of the 1031, most people thought it would never, ever happen,” said Dino Champagne, division manager at Asset Preservation and a “1031 Market Update” panelist. “Now, people have a more somber outlook.”

Washington estimated its loss of tax revenue from 1031 exchanges to be about $40 billion over a 10-year period, Champagne cited. She also referred to an Ernst & Young study that suggested the elimination of 1031 would lead to an overall U.S. GDP reduction between $61 billion and $131 billion over that same period.

The study went onto say investors would likely face a higher cost of capital, increased holding periods, increased reliance on debt financing and, ultimately, a reduction in sales velocity. Many sellers would be disincentivized to sell if they had to pay capital gains taxes.

“There is an importance associated with 1031, but regrettably, Washington has an opinion that 1031 is for the 1 percent and that no one else benefits from it,” said Champagne. “In the 1031 world, I work with all types of investors, from mom-and-pops to REITs. It’s mom-and-pops that will be affected the most.”

“It won’t impact only investors, but business owners as well,” Champagne continued. “When they realize what their taxes will be, my comment will be ‘welcome to the 1 percent.’”

Andrew Van Tuyle, chief acquisitions officer for BH Properties and a “2016 Investment Market” panelist, agreed with the assertions of Champagne and Ernst & Young.

“We’re doing our best to reshuffle our portfolio,” he said. “We feel very confident 1031 exchanges are going to go away this year. There’s a ton of velocity out there right now. I have to believe a lot of that money is 1031.”

A study recently completed by the National Association of Realtors (NAR) noted that 40 percent of realtors surveyed said they had been involved in a transaction that wouldn’t have closed if it weren’t for the 1031 exchange platform. Another 56 percent said they had been involved in projects that would have been much smaller without 1031.

The sobering reality that 1031 may not exist in the future has caused some investors to take a different look at their assets, strategies and future growth potential as they realize all good times — and good markets — must come to an end.

“What we’re seeing now in the marketplace is that people aren’t looking for promises,” said Selman. “They’re looking for reality.”

Whiting concurred that while this legislation, if passed, will not benefit the industry as a whole, it has caused some to perhaps take a much-needed pause as they reprioritize.

“If 1031 goes away, it will cause people to make rational decisions and actually look at the real estate,” he said. “It’s going to be a very interesting year. Things are going to change.”

— Nellie Day

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