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Net Lease Investors Take a Pause as Price Discovery Gets Tougher

Low leverage and all-cash buyers continue to drive activity in the net lease space. But investors are tightening acquisition criteria to account for higher risk.

A tightening lending environment, a slowdown in property trades and a bid/ask gap between buyers and sellers are making it more difficult for net lease investors to complete acquisitions in today’s market.

The kinds of deals that are closing involve top credit tenants locked into long leases with healthy rent escalations.

For example, two weeks ago Northmarq’s net lease team closed on the sale of a quick service restaurant to a 1031 exchange buyer. The deal happened because the property featured characteristics that are highly desirable in today’s marketplace, according to Anne Perrault, Tulsa-based vice president with the full-service capital services provider. The site boasted a great location, a good credit tenant, a brand new 20-year lease and 10% rent increases every five years. The asset got three or four offers and sold at a cap rate below 4%. “That was because the asset was really unaffected by the forces we saw in the marketplace,” Perrault noted.

But deals like that are hard to come by and overall net lease investment sales volume is down from cyclical peaks. Last year, net lease sales fell by 25% compared to the year before, according to research from The Boulder Group, a Wilmette, Ill.-based boutique investment brokerage firm focused on the net lease sector. In the first quarter of 2023, sales volume declined between 30% and 40% year-over-year, noted Randy Blankstein, the firm’s president. One of the segments where that decline was most evident was among 1031 exchange buyers, who have been reluctant to take on higher leverage, he said. Institutional investors and all-cash buyers are still active, according to both him and Perrault, but they’ve become much more concerned about over-paying for properties.

Meanwhile, the number of net lease retail properties on the market fell by more than 8.6% between the first quarter of 2023 and the fourth quarter of 2022. The number of net lease office properties up for sale declined 1.48%. Only the industrial net lease sector saw an uptick in the number of assets on the market in the first quarter, with a bump of roughly 4.8%.

As another proxy of the overall state of the net lease market, the Fundamental Income Net Lease Real Estate Index is down roughly 18% year-over-year and total returns on the Fundamental Income Net Lease Real Estate ETF—which is composed predominantly of securities net lease companies—are down about 15% over the past year.

NETL Chart

NETL data by YCharts

As a result of slower transaction activity, even well-capitalized investors have been faced with the challenge of trying to figure out accurate pricing on the assets they are interested in, leading them in some cases to forgo what might otherwise be attractive buying opportunities, according to James G. Koman, founder and principal of ElmTree Funds, a net lease real estate private equity firm headquartered in St. Louis. The firm manages a family of comingled funds whose subscribers include institutional investors and family offices, as well as separate accounts for individual institutional investors. It typically targets opportunistic returns.

“The overall net lease environment, we’ve seen interest rates rise and we’ve obviously seen a decline in transactions [as a result],” Koman said. “A lot of players are sitting on the sidelines. And this has led to a widening of the bid/ask gap, so finding true pricing is getting tougher and tougher.”

In recent months, investors could enter negotiations on assets that fit their acquisition criteria, but in the absence of enough comparable sales and with the cost of capital continuing to rise, it might take “three, four, five months” to discover where true pricing ought to be, by which time the opportunities might fall by the wayside, Koman noted.

Similarly, Joey Agree, president and CEO of Agree Realty Corp., a publicly-traded REIT that specializes in net lease retail assets, said “the challenge remains buyer’s expectations and the cost of capital in terms of appropriate spread. We continue to see a significant number of sellers holding on to 2021 and the first half of 2022 pricing today.”

That’s happening in a market where cap rates on single-tenant net lease assets rose for the fourth consecutive quarter in the first quarter of 2023, according to The Boulder Group. For retail and office assets they reached their highest levels since the third quarter of 2020, up 10 basis points quarter-over-quarter for retail, to 6.05%, and 5 five basis points quarter-over-quarter for office, to 7.00%. Cap rates on industrial net lease assets moved up the most, by 12 basis points, to 6.77%.

Steve Hardy, principal with Gaspee Real Estate Partners, an East Greenwich, R.I.-based investment and development firm, noted that sellers’ refusal to grasp that the market has changed drastically over the past year reminds him of similar behavior during the Great Financial Crisis.

“We are not seeing any drop in value whatsoever. We are not seeing any motivation to sell [at lower prices] yet,” he said. “It’s very similar to 2008, where it’s almost like people are in denial. The holdout is there when someone may have agreed to sell something a year ago, and for one reason or another, couldn’t get that conversation over the finish line. And now, the world is different, and they don’t only think they are going to get the same number, they think they are going to get more.”

He cited the example of an owner-occupied triple net lease property his firm considered buying last year. At the time, he estimated the premium pricing on the asset should have been at approximately $1.5 million. After a few months, the seller asked for $1.7 million. This year—rather than adjusting down—the seller increased the asking price to $2.2 million. But given the higher cost of capital and the underlying fundamentals, Hardy calculates the asset’s current value is $900,000. Some prospective sellers are staying firm on higher prices because they are carrying no or low debt at low interest rates, and don’t have to sell at a discount. But others are making emotional decisions that are not in tune with how quickly market conditions have changed, he said.

“There is this misalignment of expectation and reality, which at this point in the market is completely fair because it’s happening at a speed we haven’t seen [before]. Especially if you held a property for 20 to 30 years, you don’t see that, you are blind to that type of fluctuation.”

Both Koman and Agree said that even in this environment, it’s possible to find a fair number of attractive investment options for well-capitalized buyers like them. In the first quarter of last year, ElmTree’s net lease acquisitions totaled approximately $800 million. The firm continued to be active on the acquisition front in the first quarter of 2023 and is still tallying its totals for the period, but the figure will more than likely be below that mark.


Agree Realty has not posted its first quarter results yet, but the firm’s executives feel they are on track to reach the $1 billion in acquisitions the company forecast to shareholders at the beginning of 2023. In 2022, the REIT acquired 434 assets totaling approximately $1.59 billion. Its total investment activity, including acquisitions, development and its Partner Capital Solutions division, which provides capital to third-party net lease developers, reached a record $1.71 billion.

“We’ve seen stress in the merchant builder space certainly, and we are taking advantage of those opportunities to acquire their projects,” Agree noted of the types of deals where the REIT currently sees the possibility to create value. “At the same time, we are seeing institutional sellers, aware of the cost of capital, adjust pricing expectations. And third, we are seeing various types of stress, whether it’s personal or professional, where there is a need to transact with certainty.”

ElmTree Funds, meanwhile, has been closing primarily on industrial net lease acquisitions in the Southeast and the upper Midwest—distribution centers and manufacturing facilities for users such as auto manufacturers, who continue to need space for onshoring and re-shoring. Cap rates on those types of assets have expanded by between 50% and 75% since last year, according to Koman.

For its part, Gaspee Real Estate Partners, which has traditionally concentrated on ground-up development, has refocused on buying and redeveloping existing properties, especially on those cap rates have risen. With interest rates seeming to tick up on a weekly basis on floating-rate construction debt, picking projects with development timelines that wrap up in several months rather than a year or longer is attractive, Hardy said. There’s also the bonus of not having to deal with the uncertainty of zoning approvals on new projects.

For example, Gaspee recently bought a vacated 10,000-sq.-ft. TGI Friday’s that the firm is repositioning. The price was on the higher end and Hardy admits they may still face some contingencies while doing work on the building. But those factors will still not carry as much uncertainty as potential interest rate increases, he noted.

At a standstill

Overall, however, the pool of prospective net lease buyers has shrunk compared to the heady years of 2021 and early 2022, according to both investors and net lease brokers. With lending requirements tightening in the wake of multiple Fed interest hikes and troubles in the regional bank sector, it’s harder for some investors to make transactions pencil out at the current pricing.

In addition, 1031 exchange buyers are finding it more difficult to find appropriate replacement properties within the required 45-day period, and some are opting to pay the taxes on their assets, according to Perrault. And institutional investors are looking for higher yields than they did before, given the increased cost of capital, she noted.

That’s not necessarily a bad thing. The flush of cheap capital that entered the market immediately post-COVID led to pricing that left experienced investors scratching their heads, according to Joey Agree. He cites examples of assets leased to Dollar General trading at cap rates in the 5% range (the average long-term cap rate for net lease properties leased to Dollar General, given the retailer’s BBB credit rating and flat rent escalations in its initial lease terms, has been between 6% and 7%, according to The Boulder Group research). Assets leased to O’Reilly’s Auto Parts, another tenant with a BBB rating and flat rent escalations in its initial lease terms, were trading at cap rates in the upper 4% range, when they have historically sold at between 5% and 7%.

“We saw a lot of behavior and a lot pricing that didn’t make sense for a couple of years, predominantly coming out from the depth of COVID,” Agree noted. “Across the board, [there was] a compression of cap rates that didn’t pass the smell test.”

Since then, cap rates on net lease retail have risen by about 100 basis points on average, with bumps closer to 125-150 basis points on many assets, he said. And the market has become bifurcated, with well-capitalized, experienced investors on the one side and those who were largely riding the wave of cheap capital on the other.

Pricier debt and signs of stress

Looking back at the REIT’s financial decisions in 2022, Agree said he’s glad Agree Realty pre-equitized its balance sheet in the fourth quarter with an agreement to sell roughly 4.1 million common shares for $282.9 million. The firm’s debt-to-equity ratio at the end of last year was 0.44.

While debt financing for net lease acquisitions continues to be available, the terms have definitely tightened, according to Perrault.

“We are seeing markedly higher interest rates, starting back in the middle of last year,” she noted. “The other thing that we have seen change has been loan-to-value [LTV]. Those numbers have shrunk, requiring buyers to bring more capital into transactions. A buyer’s ability to create positive leverage has become very, very challenged.”

Across different lender types, LTVs on loans for net lease acquisitions have dropped by an average of 10% since last year. LTVs on CMBS and bank loans now range between 60 and 65%. Life insurance companies are staying closer to 60%.

Interest rates on loans for net lease transactions have also moved upward, to 6.0% today from 5.25% or 5.5% last year, according to Blankstein. “There’s plenty of debt capital available, it’s just not aggressive. They want more equity in the game from the borrower.”

As potential cracks in the regional bank sector became evident earlier this spring, banks are putting even long-term clients under increased scrutiny, according to Gaspee. Borrowers who have a well-established track record of paying back their debt still get the “Yeah, but can you do it in the next year?” treatment, he noted.

As a result, investors who can still afford to remain active in today’s market environment are those carrying low leverage or paying all-cash. And even those groups are focusing much more than they have before on the tenants’ credit ratings and on looking for short-term rent escalations that are on the higher end.

Blankstein, points to the sale of a 140,000-sq.-ft. Home Depot in Auburn, N.Y., to a Northeast-based family office that his firm handled in January as an example of the kind of property that continues to have traction. At approximately $4.9 million, the sale price was significantly below the average price for net leased Home Depots, which tend to trade in the $15-million to $20-million range. That made the deal more digestible to an all-cash buyer, according to Blankstein.

Larger investors like Agree Realty and ElmTree Funds continue to focus on credit tenants and rent escalations as well. Agree, for example, is giving priority to the three dozen or so premier retailers in the country that tend to dominate its portfolio, many of which, like Walmart, sell non-discretionary goods and can benefit in times of economic uncertainty, according to Joey Agree. Given current inflationary pressures, the REIT is looking for leases with rent increases that are on the higher side, but “most importantly, we are trying to stay disciplined, and we are not going up the risk curve to drive short-term spreads in terms of tenant credit or private equity-sponsored retailers.”

ElmTree Funds has also been looking at assets that have higher rent increases built into their leases, at 3.0% or 3.5% when 36 months ago, those leases might have featured 1.0% escalations, noted Koman.

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