Western Real Estate Business magazine covers the multifamily, retail, office, healthcare, industrial and hospitality sectors in the Western United States.
Issue link: https://westernrealestatebusiness.epubxp.com/i/818922
www.REBusinessOnline.com Western Real Estate Business • May 2017 • 65 IT'S A NNNEW MARKET The net lease sector senses changes, beginning with upward pressure on cap rates. By Joe Gose C ertain that interest rates are on the rise, real estate profes- sionals are mulling the end of cap rate compression in the retail net lease market and an emerging bid- ask gulf between buyers and sellers. Couple these changes with no clear view of tax reform or how other fiscal and regulatory polices may affect the economy, and the unknowns are pro- longing a choppy market that began before the election. Twelve to 18 months ago, net lease assets often fetched multiple offers, says Jonathan Hipp, CEO of Herndon, Virginia-based net-lease brokerage Calkain Cos. Today there's generally less interest. "There are still buyers in the mar- ket, but there's not the same veloc- ity," explains Hipp, whose team recent- ly represented an Applebee's restau- rant owner in the sale of 14 proper- ties along Florida's Gulf Coast to sepa- rate buyers for a total of $46 million. "Buyers don't see capitalization rates coming down (or prices going up) from where they are today, so they don't think that they are losing any- thing by waiting." Hipp and other net lease brokers are quick to point out that the de- mand is still sufficient enough to gen- erate net lease sales volume on par with or slightly better than last year. Some $14.5 billion in retail net lease assets traded hands in 2016, a drop of about $4 billion from the banner year of 2015, according to CBRE's U.S. Net Lease Market Trends Report issued in late March. Investors are still enamored by the bond-clipping characteristics of net lease assets, brokers contend. But buyers also are focused on high-qual- ity locations, tenants and lease terms, and they are hesitant to buy large big boxes housing struggling retailers or Walgreens locations in light of that re- tailer's pending merger with Rite Aid. [See sidebar on page 66.] "I think we've seen some institu- tional investors hit the 'pause' button," says Ryan Butler, a senior director with Stan Johnson Company in Tulsa, Oklahoma. "If they get back into the market, we'll see it pick up some addi- tional steam." Cap Rate Tug-O-War Net lease real estate minds are con- centrating on interest rates and cap rates. The Federal Reserve has raised its federal funds rate by 50 basis points to a target range of 0.75 percent to 1 percent since December, and it could hike twice more this year. The 10-Year Treasury yield, which has climbed to as high as 2.6 percent in the new year, hovered around 2.35 percent in early April, an increase of roughly 60 basis points from a year earlier. Meanwhile, the average retail net lease cap rate of 6.43 percent in the fourth quarter of 2016 represented an increase of 18 basis points over the third quarter, according to Calkain's most recent Cap Rate Report. Much of the increase could be attributed to high cap rates for convenience store and big box sales that had lease, loca- tion or credit drawbacks, the report noted. Still, many sellers are still ask- ing peak-of-market prices that were the norm a year ago and that don't reflect the direction cap rates are mov- ing today, brokers say. "If we're being honest as real estate practitioners, we have to recognize that the Fed has [helped to] subsidize the real estate business for the last sev- en years," says Sean O'Shea, a manag- ing director for the O'Shea Net Lease Advisory group of Los Angeles-based BRC Advisors. "We've been in a bubble, and we're past the peak. Cap rates are going to move up on some schedule," he says, noting that sellers will need to come to terms with this reality. Historically, cap rates have adjusted and stabilized three to six months af- ter interest rate hikes, net lease brokers say. Whether that's the case in this cycle is anyone's guess amid contrary forces at work in the market. High net-worth individuals have joined in- stitutional buyers on the sidelines to wait until net lease property prices adjust to the higher interest rate envi- ronment. Typically, a cap rate spread of 25 to 75 basis points separates these buyers from sellers, says Andrew Bo- gardus, a senior managing director for Cushman & Wakefield's Net Lease In- vestment Services. "Buyers aren't reaching to pay a low cap rate," adds Bogardus, who is based in San Fran- cisco and is part of a four-person team that closes 40 to 60 net lease deals a year. "They want a little better return than they got last year." Ordinarily, a drop in demand would hasten lower prices. But 1031 like- kind exchange buyers, which make up a sizable share of net lease inves- tors, are helping to maintain low cap rates, particularly for well-located as- sets occupied by solid credit tenants with more than 10 years left on their leases. "There's a tremendous amount of 1031 exchange business in the market, and a lot of sellers are taking advan- tage of what people consider to be peak pricing," says Ian Schroeder, a senior vice president who specializes in retail net lease investment proper- ties with CBRE in Newport Beach, California. "So long as apartments sell and fuel a bullish exchange market, it's going to keep cap rates as aggres- sive as they have been." Cash Considerations Typically 1031 ex- change buyers need little to no debt, which also allows them to pay higher prices for assets, adds Bill Rose, first vice president and national director of the National Re- tail and Net Leased Properties groups with Calabasas, California-based Marcus & Millichap. 1031 exchange investors make up a good part of Marcus & Millichap's private client business and they typi- cally pay $3 million to acquire the av- erage net lease property, he adds. "It's not true to say that net lease asset cap rates are completely pro- tected during a rise in interest rates," says Rose, whose firm brokered more than 2,800 retail transactions in 2016. "But they are not impacted as much as multi-tenant shopping centers are." Market and regulatory threats could derail 1031 exchanges, however. High- er interest rates could lead to a drop off in demand in other property mar- kets, thereby reducing the inclination of would-be 1031 exchange investors to initiate a sale that would in turn necessitate an acquisition, according to Marcus & Millichap's Net Leased Retail 2017 Outlook. What's more, in- vestors are concerned that tax reform could incorporate changes considered by Congress in recent years to water down or eliminate the 1031 exchange rule. In late March, a private investment firm in Spain acquired a Kohl's ground lease in Brandon, Florida, with slightly less than 10 years remaining for $9.8 million, or a cap rate of 5.7 percent. CBRE's Ian Schroeder represented the seller, a private investment firm in Hawaii. Stan Johnson Co. brokers oversaw the sale of a 15,600-square-foot Natural Grocers asset nestled in the Rocky Mountain town of Frisco, Colorado, last year. Ryan Butler in Tulsa represented the seller while Julianna Clementi-Ryan in Chicago represented the buyer. Bogardus Butler Hipp Rose