Texas Real Estate Business magazine covers the multifamily, retail, office, healthcare, industrial and hospitality sectors in Texas.
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www.REBusinessOnline.com Texas Real Estate Business • May 2017 • 45 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 recently represented an Ap- plebee's restaurant owner in the sale of 14 properties along Florida's Gulf Coast to separate buyers for a total of $46 mil- lion. "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 anything 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 to the right.] "I think we've seen some institu- tional investors hit the 'pause' button," says Ryan Butler, a senior director with Stan Johnson Com- pany in Tulsa, Okla- homa. "If they get back into the mar- ket, we'll see it pick up some additional 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 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] subsi- dize the real estate business for the last seven years," says Sean O'Shea, a managing direc- tor for the O'Shea Net Lease Advisory group of Los Ange- les-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 buy- ers from sellers, says Andrew Bogardus, a senior managing di- rector for Cushman & Wakefield's Net Lease Investment 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 mar- ket, and a lot of sellers are taking ad- vantage of what people consider to 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. Ryan Butler Stan Johnson Company Jonathan Hipp Calkain Cos. Sean O'Shea BRC Advisors Andrew Bogardus Cushman & Wakefield MURKY MERGER OUTCOME DAMPENS WALGREENS AND RITE AID DEMAND The proposed merger between Walgreens and Rite Aid announced in Oc- tober 2015 is stunting demand for Walgreens and Rite Aid assets as ques- tions 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 properties with CBRE. Subsequently, buyers are displaying a stronger preference for CVS assets, says Schroeder, who focuses on the drugstore category. Put a CVS and Wal- greens with similar terms and locations side by side, and the CVS will likely demand a capitalization rate of about 25 to 50 basis points below the Wal- greens, 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 pharmacies operate face a more daunting challenge, especially 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 offered $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 require 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 investors may be able to employ an opportunistic strategy, says Bill Rose, first vice president and na- tional director of the Net Leased Properties Group with Marcus & Millichap. "The merger alone dictates that something will change," he acknowledges. "But a number of those locations are 'Main and Main' with great access, and the buildings can be re-tenanted pretty easily." — Joe Gose