As rising interest rates and slowing investment activity in other property sectors force leveraged net lease retail investors and many 1031 exchange buyers to retreat, net lease retail REITs, aggregators and cash buyers are anticipating an extremely active acquisitions environment for the remainder of the year.
“Market dynamics and the competitive set is different than it was a few months ago,” says Chris Czarnecki, CEO of Broadstone Net Lease, a Rochester, N.Y.-based REIT. “We’ve clearly seen the levered buyers, the PE-backed buyer, [and] the secured financing buyer all generally exit the market, which has created a little bit of cap rate relief for us and ultimately, allowed certain asset classes to look more attractive.”
Net lease retail investors continue to focus on and show a preference for credit tenants and those with strong balance sheets. However, many REIT investors, such as Realty Income Corp. and Agree Realty Corp., are seeing attractive risk-adjusted opportunities in the non-investment grade space. And credit aside, investors are increasingly focused on rent escalations and lease terms.
“REITs are gearing up for a big end of year, given yields have risen alongside cost of capital,” says Spencer Henderson, a director in B+E Net Lease’s San Francisco office. “The most active sellers have been institutional, driven to adjust portfolio allocation and unload shorter-term leases or underperforming assets.”
Expecting an active fourth quarter
In 2021, net lease investors closed $21.9 billion worth of deals, according to commercial real estate brokerage firm Stan Johnson Co. Activity spiked during the third and fourth quarters, with close to 64 percent of 2021’s total trade volume being attributed to the second half of the year.
After a very strong end to 2021, however, net lease retail investment activity tapered off the further we moved into 2022. A little more than $7.6 billion in net lease retail deals traded hands in the first half of this year, compared to $7.9 billion for the same period last year, according to Stan Johnson Co.
During the first half of this year, private buyers—including large-scale aggregators of net lease properties such as ExchangeRight—accounted for 69 percent of all single-tenant retail net lease transactions or roughly $5.2 billion. Public REITs, meanwhile, represented 13 percent or $988 million, according to Stan Johnson Co. This is a marked contrast to 2021, when REITs and domestics institutions accounted for close to 40 percent of acquisition activity, primarily due to a handful of entity-level acquisitions/M&As.
“In 2020, and especially 2021, there were a significant number of large portfolio sales, allowing institutional investors and REITs to take market share from private buyers,” says Curtis Hodges, senior vice president of Stan Johnson Co. “But in the first half of 2022, we’ve seen these investor groups pull back, comparatively speaking. If these groups don’t ratchet back on their targets, we could be looking at a boom in activity in the final months of the year.”
Consider Necessity Retail REIT, formerly known as American Finance Trust—the New York-based company completed the acquisition of 81 retail properties from CIM Real Estate Finance Trust Inc. for $1.3 billion during the second quarter. As of mid-year, it had acquired 93 properties for a total of $1.4 billion.
“We pulled back from the market when we felt that there was too large of a gap between seller and buyer—we were not willing to stretch,” said CEO Michael Weil during a recent Q&A session with REIT analysts.
Opportunities in a dynamic market
Indeed, several REITs announced increased acquisitions guidance during their second quarter earnings calls. San Diego-based Realty Income, for example, increased its 2022 acquisitions guidance to $6 billion from $5 billion after an active first half of the year, during which it invested $3.2 billion in net lease properties.
As of mid-year 2022, Realty Income’s cost of equity was essentially unchanged, though its overall cost of capital had increased, according to president and CEO Sumit Roy. In response to an analyst question regarding cap rates and cost of capital, he said: “The question really is around can we generate the right spread to move the needle on the overall AFFO per share growth, and the answer is ‘yes.’”
Likewise, Agree Realty Corp. achieved a record in investment activity during the first half of the year, adding 205 properties totaling $827.6 million to its existing portfolio, according to President and CEO Joey Agree. The REIT acquired the properties at a weighted-average cap rate of 6.1 percent.
That investment activity, coupled with a strong pipeline and a “superior cost of capital,” has compelled the Bloomfield Hills, Mich.-based net lease REIT to increase its acquisition guidance twice so far this year, according to Agree.
Last year, the company invested or committed to a record $1.43 billion in 297 retail net lease properties. At the beginning of 2022, the REIT sets its acquisition guidance between $1.1 and $1.3 billion. Its new guidance range of $1.5 billion to $1.7 billion represents an increase of 30 percent to 36 percent.
Agree executives said the REIT was ready and able to “take advantage of opportunities in a dynamic market.”
All-cash buyers, including high-net-worth individuals and family offices, are also positioned to take advantage of current market conditions. These buyers are “essentially immune” to rising interest rates and are far less concerned with market volatility, experts say.
“This group had trouble competing in the recent lower interest rate environment, but are now very competitive as many competitors are facing negative leverage,” notes Randy Blankstein, president of net lease brokerage firm The Boulder Group.
Both domestic and foreign institutional investors remain interested in net lease retail since it offers much less downside volatility compared to other retail real estate investments. “On the buy side, as cap rates soften, we expect more institutional buyers to have access to deals that wouldn’t have been accessible earlier this year,” says Alex Sharrin, senior managing director of capital markets with real estate services firm JLL.
Looking beyond investment-grade tenants
The most appealing net lease retail assets are those that are considered essential, service-based and “Amazon-proof”: grocery, quick-service restaurants/convenience stores and medtail. Investors have favored these assets since the pandemic began, and as consumers wrestle with rising costs for necessities due to inflation, net lease investors are increasingly interested in discount retail.
“These particular sectors are most appealing because they are providing necessity-driven goods and services that people continue to require regardless of economic circumstances,” says Joshua Ungerecht, managing partner of ExchangeRight. As of mid-year, the investor had acquired $507.6 million in 104 assets.
However, two investment-grade credit superstars in the healthcare/pharmacy space—CVS and Walgreens—may be losing some of their sparkle. In fact, many buyers are approaching these brands with caution. “We saw Walgreens and CVS caught up in the opioid lawsuits, so [investors and brokers] are watching that closely as large payouts loom,” says Henderson.
In times of economic uncertainty, investors flee toward quality and choose to focus on primary markets and strong balance sheets, Blankstein says. But while investors continue to show a preference for credit tenants, there’s significant interest in non-investment grade tenants too. Roughly 62 percent of Realty Income’s retail deals during the second quarter were sub-investment grade or non-rated.
“There are points in time where the risk-adjusted returns on investment-grade credit is far superior to what we were seeing on the non-investment-grade side, and we pivot there and try to do those transactions,” Roy noted during the REIT’s second quarter earnings call. “And then there are other times where the exact opposite is true, where sub-investment grade is allowing you to capture risk-adjusted returns that are far superior. And so, we find ourselves in that top line today where we are finding very good opportunities on the non-investment-grade side of the equation.”
Credit aside, the largest shift in sentiment relates to lease terms, according to Jeffrey Cicurel, director of capital markets with JLL. “Rising rates and inflation have caused net lease buyers to become more willing to take on shorter term leases, particularly ones with replaceable rents,” he says.
Additionally, as inflation rates outpace annual rent escalations for most net lease retail properties (which tend to be no greater than 3.0 percent), investors are scrutinizing rent escalations more carefully than in the recent past.
“Investors are now almost exclusively looking at leases with rent escalations,” notes Henderson, whose firm recently sold a Tesla service location in Ann Arbor, Mich., for $22.5 million and a 5.4 percent cap rate. “Flat leases are becoming less favorable, given the rapid rise of inflation.”
The good news is that many national retailers are increasingly amenable to higher rent growth and more frequent increases. Agree has witnessed that willingness with his REIT’s “sandbox” of retailers. “While we were seeing potentially one bump or five percent bumps every five years, retailers today, given the inflationary pressures, are more amenable to seeing 10 percent bumps or multiple bumps during the base term and then continuing through the options,” Joey Agree notes.