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Cap Rates Dropping for Strong-Credit Net Lease Properties

December 10, 2010

If there's an arguably positive consequence of real estate bubbles, it's that development tends to come to a screeching halt when they burst - helping prevent product over-supplies from getting even further out of whack.

And at this point in the cycle, that adage appears particularly relevant to an investment category ranking among the lowest-risk of the small-cap arena: net lease properties. It's holding true especially for small-cap properties leased long-term to corporate tenants with solid credit ratings.

Capitalization rates of these assets have compressed in the vicinity of 100 basis points over the past year - and continue to decline. In other words values of these properties in many cases may soon recover to within perhaps 15 percent of cyclical peaks, calculates broker and tax advisor Jeff Bogart with net lease specialist Calkain Cos. in Reston, Va.

As so many real estate investors know all too well: that's a relatively low-pain sting given the deflation associated with other small-cap property sectors.

Even better for those who've been holding credit tenant, net leased properties or have purchased same over the past year or so: supply and demand fundamentals appear poised to push cap rates down further as 2011 progresses, Bogart predicts.

And he's in a pretty good position to make that projection: Calkain services the strong-credit side of the net lease niche. Its website lists 40-some net lease properties for sale today at between $300,000 and $5 million alone.

But as Bogart and other net lease specialists emphasize, supply-demand fundamentals in the strong-credit component of the net lease space have not moved in tandem with properties leased to weaker-credit tenants.

And keep in mind we're not talking about general local space supply and tenant demand. Rather, net lease pros speak in terms of investor interest in, and actively offered inventories of, properties subject to (mostly) long-term net leases.

Hence the contrasting fundamentals on the ends of the credit spectrum. With fixed-income yields generally at historic lows and mortgage financing for quality assets far improved from a year ago, investor demand is quite strong today for credit-tenant deals.

In addition to passive investors who have entered this market as a result of dissatisfaction with current bond yields, REITs, too, have been pretty active buyers of solid net lease properties priced as low as $3 million, Bogart relates.

Even some offshore buyers have paid head-turning prices for exceptionally positioned small-cap net-lease properties. In some cases, they've outbid various other "sophisticated" investors by 10 yield basis points for ground-level retail condominiums at residential mixed-use redevelopments in fast-revitalizing urban locales, Bogart notes.

And financing terms that banks and specialty lenders offer for credit tenant properties have loosened up in recent months - notably more so than with lower-credit net lease deals.

Indeed as the latest research from Northbrook, Ill.-based net lease specialty brokerage/advisor firm The Boulder Group concludes: "financing remains readily available for investment grade tenanted properties and in limited availability for lesser properties."

Meanwhile, supplies of these assets are now very low, as so many creditworthy retailers and restaurants delayed expansion with the Great Recession. "We just didn't have a lot of Walgreens coming out of the ground," as Bogart puts it.

Development activity appears ready to pick up, but it will take some time before development teams offer these deals to outside investors.

Add it all up and a Walgreens that would have traded at an 8.25 cap a year ago is coming in at more like 7.3 today. And the latest negotiations on comparable deals are generating offers closer to 7.1 percent, in contrast with asking prices factoring to returns of perhaps just 6.75. The same deal might have commanded a price factoring to about a 6.25 cap at the strongest point in the cycle, Bogart recalls.

Boulder's research indicates the median cap rate (based on asking price) for a Walgreens fell by another 40 basis points to 7.1 percent during the third quarter alone. The comp for bank branches was a 44-basis-point dip to 6.56. Stalwart McDonalds: steady at 5.75.

But again as Bogart stresses, lower-credit deals aren't seeing anywhere near the level of demand, do not attract the same LTV levels - and consequently haven't seen cap rates come back down nearly as much. They typically moved into the 9s and in many cases remain just above or below the 9 percent mark.

Indeed Boulder's research indicates overall net lease cap rates actually rose slightly during each of the last two quarters - but that's primarily because amid a shortage of available strong-credit deals, owners opted to offer a bunch more lower-credit transactions.

As the Boulder team headed by president Randy Blankstein and partner Jimmy Goodman likewise concludes, "for credit tenants with long term leases, cap rates continue to compress as demand for these assets far exceed supply."


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