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Net-Lease Investors Prioritize Assets Occupied by Essential Retailers, Says InterFace Panel

Christian-Brothers-Automotive-Tomball

In September, Dallas-based brokerage firm STRIVE arranged the sale of this retail property in Tomball, Texas, that is net-leased to Christian Brothers Automotive. The automotive space represents a category of essential retail for which investment demand is picking up as the year winds down.

By Taylor Williams

Retail tenants with strong credit, sales and branding have long been the darlings of the net-lease investment market via their ability to unlock value in their underlying real estate. But as the COVID-19 pandemic has battered brick-and-mortar retailers in a plethora of categories, net-lease investors are placing added emphasis on the products and services that tenants offer when targeting new acquisitions.

After nine months of the public health crisis, investors have a better sense of which tenants are flourishing in the net-lease space and which ones are languishing. This more targeted, stable approach to investing is joining forces with the unleashing of pent-up demand from the spring and summer months, when capital sources largely took to the sidelines.

According to a third-quarter report from Avison Young, deal volume in the single-tenant net-lease (STNL) retail space rose by 13.8 percent from the second to third quarters of this year, though the period’s 329 trades fell well short of the first-quarter mark of 416 deals.

As a result of elevated investment demand, cap rates in the market are starting to compress — again with a pronounced difference among retail assets based on their tenancy profiles. Avison Young’s report found that between the second and third quarters of 2020, the compression among average cap rates was strongest in essential categories like medical retail (72 basis points), dollar stores (18 basis points) and quick-service restaurants (11 basis points).

Between this activity and reports that a COVID-19 vaccine may be available to the general population in a matter of months, professionals in the net-lease investment market see reason for optimism in 2021.

These topics and others formed the foundation of the “State of the Industry” panel that kicked off the 11th annual InterFace Net Lease conference on Thursday, Dec. 3. The event, a production of Atlanta-based France Media, was conducted in a virtual format in lieu of the event that is typically hosted in New York City. Glen Kunofsky, executive managing director of investments at Marcus & Millichap, moderated the conference’s introductory panel.

Haves and Have-Nots

After touching on the potential ways in which the incoming Biden administration may alter rules governing 1031 tax-deferred exchanges — a driving force in the net-lease space — as well as capital gains taxes, the panel addressed the broader supply-demand picture.

As capital sources have returned to the market in recent months, the movement in asset pricing and cap rates has been more evident for assets with select tenants, said panelist Gordon Whiting, managing director at alternative investment management firm Angelo Gordon.

“Pricing in general is starting to tighten a little bit and is close to pre-pandemic levels, but it really depends on the asset’s location and tenancy and what the tenant is doing,” he said. “Obviously we’ve had something of a sea change for movie theaters and gyms, but we also see industrial assets doing really well. So it’s really dependent on the industry.”

Later in the discussion, Whiting revisited the importance of tenant product/service in the current market, this time in the context of sale-leaseback transactions. The panel concurred that these types of deals serve as an effective way to monetize real estate for users whose sales have struggled due to COVID-19.

“We’ve continued to target the auto industry, which is also undergoing changes in terms of moving from combustion engines to electric,” he said. “If you want to play in the automotive space, you’ve got to figure out what part of it has staying power. We’ve also done a lot deals in food and agriculture — industries that should continue to do well. Our gyms are still paying rent, and we think those will survive and make strong comebacks too.”

Panelist Gino Sabatini, managing director and head of investments at W.P. Carey, pointed to the relative decline in the attractiveness of office hotel and retail properties as another driver of industrial investment growth. W.P. Carey is a single-tenant net-lease investment firm based in New York City.

“We’ve never been big retail proponents because we believe that relative to Europe, the United States is over-retailed in terms of how much square footage there is per person,” he said. “With regard to office, we will continue to reduce our exposure. We’ll do those deals if the asset has a good tenant in place on a long-term lease, but we believe there will be continued pushes to work from home, and that companies won’t need as much dedicated office space.”

These rationales called attention to the fact that office and industrial investment opportunities do exist within the net-lease space. But overall, these properties are more associated with retail uses. Panelist Joey Agree, president and CEO of Agree Realty Corp., a Michigan-based REIT, spoke to how the fundamentals of investing can best be utilized in the current market. 

“If you look at the vast majority of commercial real estate in the midst of a pandemic, it’s almost uninvestable,” he said. “So, our portfolio is really focused on that 99th percentile of best-in-class users with high-quality underlying real estate.”

“You can’t underwrite a mall or a CBD hotel. Most industrial is overpriced, so you want to have that secure, predictable cash flow that net-lease retail can offer, especially when you can look at the underlying financials of these retailers whose real estate we invest in,” added Agree.

Agree cited retailers such as Walmart, O’Reilly Auto Parts, AutoZone, dominant national and regional grocers like Kroger or [Texas-based] H-E-B and home improvement retailers like Home Depot and Lowe’s as examples of top-tier users. He capped off his insights by pointing out that while the attractiveness of these retailers has traditionally stemmed from their resistance to e-commerce, now it’s all about the success of their omnichannel sales and distribution platforms — the complementing of brick-and-mortar with online delivery.

Panelist Jonathan Hipp, principal and head of Avison Young’s U.S. Net Lease Group, expanded on the types of retail deals that can provide healthy yields for net-lease investors in the current climate. 

“It’s a tale of two cities in retail, especially with regard to essential retail, and this pandemic will decrease the over-retailing we have in this country,” he said. “In terms of food, investment in assets with quick-service restaurants and drive-thrus has been very active, but not for casual and fine dining.”

Hipp added that lenders are also shying away nonessential retail deals, and that some product that was popular pre-pandemic is just not sellable at the moment. But the need to deploy capital remains acute, particularly as the calendar ticks toward the end of a year that has seen depressed deal volumes, and the presence of more buyers targeting the same kinds of properties is causing cap rate declines on those deals.

“For the right tenant, credit and term lease, you’re going to see more cap rate compression,” predicted Hipp, “not only toward the end of this year, but also into 2021 as well.”

Content Partners
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‣ Lee & Associates
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‣ Walker & Dunlop

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