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 • 47 "If something happens to the 1031 exchange regulations, you'll see a huge shakeup in the mar- ket," says Jereme Snyder, director of the NNN Group for Colliers International in Irvine, California. "A good majority of the buyers in the market are trade buyers." In addition to 1031 exchange buyers, foreign investors are also paying premiums for net lease assets in the U.S. and providing resistance to higher cap rates, al- beit to a lesser extent, 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 interest 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 difference gives debt providers room to maneuver. "The lending market has the ability to help keep interest rates stable," Schroeder explains. "If higher interest rates cause a tick up in cap rates, it's not go- ing 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 increase materially, especially in light of tighter underwriting. Brokers report that lenders have become more selective on terms such as recourse and loan-to-value ratios. Non-recourse commercial mort- gage-backed security loans, for example, aren't as widely avail- able as they were 12 to 24 months ago, states Patrick Luther, man- aging principal of the National Net Lease Group with SRS Real Estate 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 lo- cal 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 compression," de- clares 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 drugstore ground lease that has a flat lease rate for 25 years, Hipp says. Under- writing and still-low cap rates could generate an an- nual return of only around 2.5 percent, he says. "In five years with inflation and higher interest rates, you could effectively be at a negative return," Hipp points out. "So we're having issues with flat leases, and we're seeing some disconnect from de- velopers 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 developers 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 catego- ries," he says. "The bright spot again being in the food use category." Supply in Check Overall retail and food service sales grew 4.1 per- cent in 2016, and food users represent some 27 per- cent of the 29.2 million square feet of new net lease construction last year, according to CBRE. CBRE and Marcus & Millichap researchers anticipate that modest supply constraints and demand from ten- ants outstripping new construction will help to maintain a relatively balanced net lease investment market. The health of net lease tenants starkly contrasts that of Macy's, JC Penney, Sears Holdings and oth- er traditional retailers that are in the midst closing 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 con- tinue expanding, 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 Target Express (Target Corp.'s smaller infill concept) in Burbank, Califor- nia. "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 locations, however, a barrage of new supply would add upward pres- sure on net lease cap rates. Ultimately that could lead to a more jarring cap rate shock unless net lease buyers and sellers find a middle ground on prices and overcome an entrenched bid-ask stalemate. n Jereme Snyder Colliers International Patrick Luther SRS Real Estate Partners 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.