Western Real Estate Business

MAY 2017

Western Real Estate Business magazine covers the multifamily, retail, office, healthcare, industrial and hospitality sectors in the Western United States.

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66 • May 2017 • Western Real Estate Business www.REBusinessOnline.com "If something happens to the 1031 exchange regula- tions, you'll see a huge shakeup in the market," says Jereme Snyder, di- rector of the NNN Group for Colliers International in Ir- vine, California. "A good majority of the buyers in the market are trade buyers." In addition to 1031 exchange buyers, foreign investors are also paying premi- ums for net lease as- sets in the U.S. and providing resistance to higher cap rates, albeit to a lesser ex- tent, Schroeder and O'Shea say. Indeed, in March Schroeder sold a Kohl's ground lease in Brandon, Florida, to an overseas buyer for $9.8 million for a cap rate of 5.7 percent. Another element that could keep a lid on cap rates is the spread between the 10-Year Treasury yield and inter- est rates, Schroeder adds. That spread today is roughly 200 basis points to 250 basis points, up from a mere 75 basis points at the pre-recession peak in 2007, he says. He believes the dif- ference gives debt providers room to maneuver. "The lending market has the abil- ity to help keep interest rates stable," Schroeder explains. "If higher inter- est rates cause a tick up in cap rates, it's not going to be to the extent that it gives the market a big shock." Discerning Lenders Still, net lease professionals sense that cap rates at some point could in- crease materially, especially in light of tighter underwriting. Brokers report that lenders have become more selec- tive on terms such as recourse and loan-to-value ratios. N o n - r e c o u r s e commercial mort- gage-backed se- curity loans, for example, aren't as widely available as they were 12 to 24 months ago, states Patrick Luther, managing princi- pal of the National Net Lease Group with SRS Real Es- tate Partners. Plus, CMBS rates have climbed as much as 50 basis points to a range of 4.75 percent to 5 percent for net lease buyers that need 65 percent to 70 percent of debt to finance a deal, he adds. Life insurance companies and local banks are providing lower cost financing but with recourse and less leverage, Luther notes. "Rising interest rates have to, and will, happen... they signal the end of cap rate com- pression," declares Luther, who is in the firm's Newport Beach office. The environment has become more challenging for buyers outside of the 1031 exchange ranks that need at least 50 percent debt — particularly if they're trying to acquire a new drug- store ground lease that has a flat lease rate for 25 years, Hipp says. Under- writing and still-low cap rates could generate an annual return of only around 2.5 percent, he says. "In five years with inflation and higher interest rates, you could ef- fectively be at a negative return," Hipp points out. "So we're having issues with flat leases, and we're see- ing some disconnect from developers who think they should still be trading at the low cap rates of a year or two ago." That has sparked more demand for assets with built-in rent increases, particularly in the restaurant category, Luther says. He predicts that develop- ers will begin building higher yields into their projects, which in turn will lead to higher rental rates. "The good news is that along with rising rents, tenant sales have been improving in many categories," he says. "The bright spot again being in the food use category." Supply in Check Overall retail and food service sales grew 4.1 percent in 2016, and food us- ers represent some 27 percent of the 29.2 million square feet of new net lease construction last year, according to CBRE. CBRE and Marcus & Millic- hap researchers anticipate that modest supply constraints and demand from tenants outstripping new construction will help to maintain a relatively bal- anced net lease investment market. The health of net lease tenants stark- ly contrasts that of Macy's, JC Penney, Sears Holdings and other traditional retailers that are in the midst clos- ing stores, Rose observes. Operators like California-based Trader Joe's and German grocery concepts Aldi and Lidl are expanding in the U.S., and plan to open hundreds of stores over the next few years, while dollar stores and restaurants intend to continue ex- panding, he says. "You have mixed messages in the market. One is that, 'Oh no, retail stores are closing,' and the other is, 'No, we're opening new units,'" says Rose, whose team is marketing a Tar- get Express (Target Corp.'s smaller infill concept) in Burbank, California. "Many retailers are bullish, but I think one of their problems is that they're just having trouble finding locations." If operators find the right new loca- tions, however, a barrage up of new supply would add upward pressure on net lease cap rates. Ultimately that could lead to a more jarring cap rate shock unless net lease buyers and sell- ers find a middle ground on prices and overcome an entrenched bid-ask stalemate. n The proposed merger between Walgreens and Rite Aid announced in October 2015 is stunting demand for Walgreens and Rite Aid assets as questions about stores closures, how many locations will be spun to the Fred's Pharmacy chain, and whether the sale will even go through remain up in the air, says Ian Schroeder, a senior vice president specializing in net lease investment prop- erties with CBRE. Subsequently, buyers are displaying a stronger prefer- ence for CVS assets, says Schroeder, who focuses on the drugstore category. Put a CVS and Walgreens with simi- lar terms and locations side by side, and the CVS will likely demand a capitalization rate of about 25 to 50 basis points below the Walgreens, he adds. "We had a buyer interested in a Walgreens in Texas, where there are no Rite Aids," Schroeder recalls. "But he still leaned toward CVS just because of the uncertainty surrounding the merger." Investors searching submarkets where all three phar- macies operate face a more daunting challenge, especial- ly if the properties are at or near the same intersection, says Sean O'Shea, managing director for the O'Shea Net Lease Advisory of BRC Advisors. "You have to realize that one of the stores is not going to be around in the future," he says. "So how lucky are you feeling?" Deerfield, Illinois-based Walgreens Boots Alliance of- fered $17.2 billion for Rite Aid Corp. — including about $7.8 billion of debt assumption — and the companies have been awaiting Federal Trade Commission approval. Walgreens in January lowered the price to around $14.3 billion. The final amended price hinges on how many more Walgreens and Rite Aid stores the FTC would re- quire to be divested to Fred's. Some 865 locations have already been sold to the competitor. Still, with the deal in limbo, savvy real estate inves- tors may be able to employ an opportunistic strategy, says Bill Rose, first vice president and national director of the Net Leased Properties Group with Marcus & Mil- lichap. "The merger alone dictates that something will change," he acknowledges. "But a number of those lo- cations are 'Main and Main' with great access, and the buildings can be re-tenanted pretty easily." — Joe Gose Calkain Cos. facilitated the sale of two Florida Dunkin' Donuts assets to an existing franchisee and a private investor late last year, fetching more than $1.3 million for one in West Palm Beach (pictured) and slightly less for the other in Chiefland. Calkain's Doug Aronson represented the institutional seller. Luther Snyder RCG has a cadre of tenants it has done multiple deals with, and has begun operating with those on an account basis. Brett Lesley, vice president of national accounts, re- views the relationship with those tenants — in person — every six months and sees how they are per- forming in RCG's centers versus other properties. He also looks at each retailer's expansion needs and works together to look at new mar- ket opportunities. "We have become educated from those meetings as much as the ten- ants have," says Lesley. "Those meetings help us know what these tenants are seeking going forward so that when we look at properties to acquire — or a vacancy becomes available in our portfolio — we usu- ally have an idea of a tenant who would like to fill that space." As RCG looks to the coming years, the executives expect the company to be a net buyer, despite RCG divesting of assets. The appe- tite for Funds IV and V, with a coast to coast platform, will fuel RCG's growth over the next few years. n O'Shea MURKY MERGER OUTCOME DAMPENS WALGREENS AND RITE AID DEMAND RCG continued from page 61

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