Year-End 2020: The State of Net Lease
Q: “We’re seeing a surge in activity in the net lease market right now. What do you attribute that to?”
CR: “When real estate markets and the larger economy do poorly, investors move into net lease real estate and, while this is pretty common across all asset types, investors gravitate toward categories that have less risk. That’s effectively what’s happening in 2020. You saw this in 2008 and 2009 as all real estate categories dropped—multi-family, office, industrial, multi-tenant retail, etc. And at the beginning of the great recession, volumes dropped in net lease as well. However, as a category, net lease spiked against all those other sectors in terms of volume and overall activity. The same thing is happening now, especially in categories that are considered “essential services.” If a business is open, vibrant, and deemed necessary by the current pandemic and economic conditions, then it becomes incredibly desirable real estate for investors. They’re interested in things like FedEx distribution facilities, Amazon distribution and truck facilities, 7-Eleven convenience stores, groceries, and quick service restaurants—especially the ones that have drive-thrus. These are all really popular categories in this current crisis. Additionally, mortgage rates, relative to those cap rates, are historically low and they continue to drop and get lower. Previously, an investor might have found the delta between their mortgage constant and return on their 5-cap net lease investment compressible, but now if they can get a mortgage constant that is closer to a 3, they have a 200-basis-point spread that is material for their returns. It’s not just that they’re rushing in and paying more, they’re actually getting more secure investments with slightly higher returns.”
Q: “Now that Joe Biden is in office, what does this mean for 1031 clients? How would clients fare if Biden were to eliminate the code entirely or change it somewhat?”
CR: “Well, there’s been a lot of talk around 1031 exchange as it relates to Joe Biden and the tax plan that he puts forward. Hilary Clinton also talked about doing away with 1031 exchange. Donald Trump talked about doing away with 1031 exchange. Bush talked about it. It’s always discussed until you consider what it provides to the overall economy. There are a lot of jobs that are created by the 1031 exchange code, and that includes title services and exchange services. A lot of categories beyond real estate brokerage are the places where we provide jobs for women and people of color within commercial real estate, and certainly residential real estate as well. These are good-paying jobs that will go away if 1031 exchange disappears or reduces in volume. I think that Biden’s administration will be sensitive to that as a fairly centrist democratic administration that wants to both encourage jobs and economic growth and provide fairness and opportunity for all Americans. That’s one of the things that 1031 exchange does. Additionally, what we don’t know yet is what will happen in the Georgia election. Whether or not you like the specific candidates, if you are someone who prefers a centrist government and a balanced government between the court, the president, and congress, having a republican senate provides a lot of balance. If that occurs, it will be nearly impossible for the Biden administration to put through an aggressive tax package that would include something like the elimination of 1031 exchange. I will comment that in nearly every presidential election when there is some change in candidate, we discuss this. Having done commercial real estate for a couple of decades, I can tell you that the question of the 1031 tax code is always topical. There’s nothing new about that when you consider that the number 5 and number 6 lobbies in D.C. are the National Association of Realtors and the American Association of Retired People; those two lobbies want to keep 1031 exchange just like it is today.”
Q: “What is your prediction for the remainder of Q4 and early next year?”
CR: “In terms of net lease activity, B+E is having our biggest quarter ever, and in terms of net lease as a sector, it is going to be one of the biggest quarters ever across the industry. There was so much capital that sat on the sidelines in Q2 and Q3, just really preserving cash because we didn’t know what existing tenants would do. But most of the worries that investors had simply didn’t occur. There were only a few funds that were impacted in a large way by tenants not paying. The majority of our clients did really well. They came to the end of the summer and realized they had all this money sitting on the sidelines that they needed to spend, and all that money has shown up in Q4. I anticipate that it will push into Q1 and even Q2 just because there’s not enough supply to meet the demand. We certainly have cap rate compression happening because of that huge demand. I see a lot of large 1031 exchanges coming out of core markets, which is very healthy. We’re seeing a lot of 30-million-dollar exchanges to 75-million-dollar exchanges coming out of New York, Los Angeles, and Chicago and a desire for diversification, which often is the call for action coming out of an economic crisis. Investors want lower risk. They want to diversify. Investors are looking for pharmacies and convenience stores, and they’re looking to get into industrial. An interesting trend that we’re seeing right now is that we will end the year with nearly 50% of net lease activity in the U.S. attributed to industrial real estate. And that’s a new record. I think currently it’s about 47% per RCA, so that’s quite a jump. One big trend to note is that commodity net lease owners are moving more heavily into industrial single tenant net lease, especially for brands and uses that are easy or easier to understand, certainly industrial that is light manufacturing or distribution. Those things are getting more and more popular with investors.”
Q: “What are some other trends in the market that keep you hopeful?”
CR: “I’m excited by the continued demand for net lease as a product type. As with a lot of insights that have come out of COVID-19, it’s not a new trend that investors are beginning to prefer single tenant over multi-tenant assets because it’s easier for them to understand. It’s easier to underwrite the single credit of a single tenant asset versus a blended group of credits needed for multi-tenant properties. Multi-tenant blended credits can be difficult to underwrite, while a single tenant is just much simpler and cleaner. It has a lot more in common with purchasing stocks or investing in the stock market. Another aspect of COVID-19 is that, with a single tenant property, a landlord doesn’t have common areas to worry about right now—to manage, keep clean, attract tenants to, to make sure the public actually wants to be in. And in the middle of anything involving a contagious disease, that’s really attractive and easy for investors to understand for the same reason it’s attractive to the tenant. Overall, it feels less risky to investors, and now is a time where investors will pay more for less risk. I feel like this is the biggest trend going into 2021 and that it will continue to accelerate.
I’m also really excited to see more women and more people of color coming into net lease as it is becoming more popular and investors in general are really coming to understand the segment. Younger people are beginning to invest in net lease as well. If you don’t truly understand how commercial real estate operates, a great way to put your toe in the water is to buy a property in which the tenant is responsible for managing and maintaining the property. It’s very simple, very straightforward, and you can learn about the segment without having to worry about some of the day-to-day issues that come with commercial properties. Then if you want to build from there to more complex commercial real estate types—the kind that might drive greater returns but might also have greater risk—you’ll be much less likely to make any mistakes. It’s exciting because I see this investment strategy as a trend that’s being accelerated by COVID-19 as we go into 2021.
And, of course, I’m extremely excited that we now have sourced at least two vaccines, and it looks like we have line of sight to a healthier, more open 2021. I hope this time next year that we can do this interview in person.”