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The Retail Net Lease Sector Begins to Show Slight Signs of Wear

Cap rates for retail net lease assets ticked up in the third quarter, while more assets hit the market.

Cap rates for retail net lease properties continued ticking upward in the third quarter of 2018, but only slightly.

The average cap rate for single-tenant net lease assets in the retail sector increased by 5 basis points to 6.25 percent, according to the Third Quarter 2018 Net Lease Report from the Boulder Group, a national commercial real estate firm that focuses on the net lease sector.

However, that’s the third consecutive quarter of cap rate increases for the sector. In the second quarter, cap rates finally pushed upward to 6.2 percent—the biggest increase in seven years.

Also, the average cap rate in the third quarter marked the highest level since the fourth quarter of 2015. However, the recent increase in the 10-year Treasury rate was expected to push cap rates higher. The 10-year Treasury yield peaked at 3.10 in the third quarter—its second-highest level since early 2014, according to Boulder’s report.

Demand for net lease properties has remained strong in 2018, says Randy Blankstein, president of the Boulder Group. However, he says the biggest surprise is that cap rates were relatively stable, while most investors expected them to rise by a more significant amount.

The relative stability of cap rates may be partially due to the fact that the rising Treasury rates had the biggest impact on the weaker net lease assets, including those with no rent escalations, lower credit tenants and locations in secondary or tertiary markets.

“It’s still a hot sector,” Blankstein points out. However, he says interest rates continued to rise pretty much through the entire second quarter and there was talk of them going up a lot further.

“So that really put a damper on transaction activity,” he notes. “There were still transactions, but it was for the higher quality assets. If you were in major markets with a prime tenant in a long-term lease, that really wasn’t so much affected. But what changed was secondary assets and short-term leases and secondary credits. The bid-ask moved out and less transaction volume occurred. Volume fell off slightly on the secondary stuff and stayed pretty much the same on the better stuff.”

Still plenty of investors

“Single-tenant net retail is still very much in demand,” says Scott Holmes, senior vice president and national director of the national retail group at brokerage firm Marcus & Millichap. “Private capital tends to be the largest single source of that demand for the same reason it has always been in demand. It’s a stable source of cash flow return. It’s generally low risk. It’s very low in terms of the management responsibilities.”

One newer trend is multifamily investors are becoming active in the retail net lease sector, Holmes notes. “For people who have owned apartments for quite a long time, as they’re capitalizing on the extreme tightness in the apartment market, we’re seeing a lot of them use the 1031 structure to come over into single-tenant net lease retail,” Holmes says.

Clients on the apartment side are selling at 4.0 and 4.5 percent cap rates and looking at single-tenant net retail that trades at around 6.25 to 6.50 percent on average, he notes.

“That’s 200 basis points of yield spread, and it’s a relatively safe, stable income return, especially as some of these people are getting older,” Holmes says. “Maybe they’re retirees and they just want a good income return on their investment, primarily from cash flow.”

Overall, demand remains strong, according to Blankstein, but it’s differentiated now. For example, he says the cap rate hasn’t changed for new construction of an Aldi with a 20-year lease in a major metro. However, a property with a three-year Dollar General lease in a tertiary market—that cap rate has changed as far as fewer people are looking at it. “That’s where the bifurcating is occurring,” Blankstein notes.

Deal flow slowed

Transaction volume decreased by 9 percent in the third quarter from the second quarter of 2018, and year-to-date volume is down 5 percent from 2017 levels, according to the Boulder Group data.

Stan Johnson Co., a brokerage firm specializing in the single-tenant net lease sector, reports that investment sales volume in the single-tenant retail sector in the third quarter totaled $3.29 billion, a drop from $3.65 billion in the second quarter. Sales volume year-to-date totals $10.1 billion.

With quarterly averages in 2018 ranging between $3.1 billion and $3.7 billion, the fourth quarter isn’t likely to drive sales for the year much past the $12 billion to $13 billion range, the company projects.  Annual sales volume topped out at more than $15 billion in both 2016 and 2017.

More properties on the market

The number of retail properties listed nationally is up slightly over the second quarter as more property owners continue to look to sell before cap rates rise further. The number increased by 3.11 percent to 4,347 properties, the Boulder Group reports.

“I think a lot of people are realizing perhaps we’re at the later stages of the cycle and the window of opportunity to dispose of properties is certainly getting narrower,” Blankstein says. “People want to move their properties onto the market before the window changes.”

Despite a slight rise in the supply of net lease properties in the market, Blankstein notes that there’s a lack of newly constructed assets with long-term leases. As a result, cap rates on recently constructed properties tenanted by strong credit tenants, including 7-Eleven, CVS and FedEx, either experienced no cap rate movement or slight compression during the third quarter.

Blankstein also notes that 78 percent of the net lease investors in the third quarter were private buyers. The price range for private investors typically goes to about $8 million or $9 million, he says. At the $12 million mark is “where a lot of private buyers drop off,” he adds. “Institutions look for assets over $12 million and don’t have to compete with the 1031 exchange buyers. They buy portfolios rather than a one-off Starbucks for $1.5 million. There’s less competition and better yield.”

What does the future hold?

The Boulder Group is in the middle of conducting a poll looking out to 2019, and so far, Blankstein says the majority of respondents are expecting 25 to 50 basis point increases in cap rates next year, because they believe that interest rates are heading up. “Not dramatically, but certainly slightly,” Blankstein says.

“With the expectation of cap rates going up and interest rates going up, the trend will be more of the same, which is more bifurcation and more differentiation between the better and lesser properties,” he notes. “So short-term leases will have more difficulty trading. Not much change will happen with the prime assets.”

Since there’s less new construction, there are fewer prime assets with longer term, he adds.

There will likely be lot of dollar stores and quick-service restaurants built next year, but those have been steady throughout, Blankstein notes. “You’re seeing little to no big-box development. You’re seeing fewer banks and drugstores; those have historically been a major part of the net lease market. Construction is down in that part of the sector. Other parts are expanding, but they seem to be lower dollar volume, smaller space.”

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