Understanding Net Lease Investors

Certain types of investments appeal differently to investors and their varying needs. These needs might include offsetting tax liabilities and expanding one’s business. Another investor may be concerned with capital gains or bond-like income streams. An investor nearing retirement may be worried about hedging their money against inflation and wealth preservation.

As with any business, understanding the clientele is instrumental to mastering the trade. When it comes to net lease investments, we can roughly separate investors into three primary segments of interest:

Segment A – 1031 & 1033 Exchanges

• Interested in cost segregation and business expansion

Segment B – Capital Gains

• Looking for real estate exposure and capital gains

Segment C – Estate Planning

• Concerned with hedging for inflation and wealth preservation.

We can further analyze these three groups in terms of demographics, lifestyle and usage.

You can view a chart illustrating this here.

This classification schema is helpful because it gets at the roots of an investors interest. There will be numerous situations when these interests overlap and understanding how they interact is vital.

CVS Corporate Bond vs. CVS Net Lease

Where to invest is a question on many people’s minds today. Many are seeking to mitigate risk and avoid the costly mistakes of the past while still owning a lucrative investment. As such, a growing debate has emerged about where best to place capital. Although some would dismiss real estate as too costly; closer inspection reveals a well of opportunity.

Let’s say you were looking to invest in either CVS bonds or real estate earlier this year (CVS rated BBB+ by Moody’s). A 10yr issuance that was done in March of 2009 has maturity date of 2019. It pays a coupon of 6.6% and is priced at $111.45; you would receive a yield to maturity of 5.04%, and an annual yield of 5.92%.

Now let’s look at an opportunity to purchase a brick and mortar store that CVS would lease from you. The lease runs through 2034, and property is for sale at $3.5Mil. Furthermore, there are .50/Sqft increases in rent every five years.

We’ll set the period of observation to 10 years and assume no increase in value (you can see the specifics here). Said differently, we’ll sell the property for what we paid for it, and the bond will just be redeemed for its face value. Also, to keep the playing field level we aren’t going to use any leverage, just cash.

In this example, the property would receive a 78% higher return over the bond. It achieves both a greater yield and cash flow for the same amount of money invested. Some of this is due to the tax benefits of depreciation expense, but even in a world without taxes the property still outperforms the bond. The risk profiles of the two investments are also virtually identical in that CVS is the guarantor of both streams of income. All things being equal if one had to make a mutually exclusive investment decision between the two choices the answer is obvious.

Lack of Inventory = Lower Cap Rates?

Today, the largest challenge the net lease market faces is a severe lack of inventory. Buyer demand for high quality net lease assets is high and cap rates have compressed in response to this. However, there is simply not enough high quality inventory to match demand. This is forcing cap rates down and clogging the market.

Buyers want the best assets available; risky assets are no longer popular. This means high credit tenants in major metro markets; such as Walgreens and McDonalds. These are coveted because they combine low risk with high returns and passivity. High net-worth buyers with excess cash are not satisfied with the 1% return they are receiving from banks, are leery of the turbulent stock market and worried about increased inflation. They desire to invest their cash into secure assets which produce high returns. In many ways, net lease investments are the perfect option. The problem is there are so few high quality net lease assets available.

The recession caused companies to halt construction; cutting the amount of new product in market down to a trickle. Even today, we are 6 months to 2 years away from new construction. This process has bottlenecked supply. Today we are seeing cap rates between 5.75-7.50% (they were at 6.75-8.5% six months ago). These are numbers not seen since the height of the market in 2006. This is not a long-term trend as much as the odd environment we are currently in. Lack of supply plus increases in demand has equaled lower cap rates.

Current conditions are projected to continue until construction picks up and new product beings entering the market. We can expect to see this in the next 6-24 months. Once substantial new product enters the market, we can expect to see a rise in cap rates and transactions. For now cap rates will remain low.

Seeking Shelter From New Health Care Tax

Many investors could be facing an unexpected extra tax. However, despite viral hoax emails to the contrary, it is not focused entirely on real estate transactions, in fact if you’re a real estate investor you’re probably in as a good a position as possible. Let’s examine:

The Health Care and Education Reconciliation Act of 2010 added IRC § 1411. Under this new regime, beginning in 2013 individuals with net investment income (interest, dividends, rental income etc...) and making over $200,000 and married couples making over $250,000 will face the specter of a 3.8% tax on the lesser of the amount their MAGI exceeds $200,000/$250,000 and their net investment income.

This new measure is an attempt to capture and subject the “unearned” income of the “wealthy” to the same Medicare payroll tax that earned income is.

If you’re a real estate investor you’re probably about as well positioned as you can be as stocks and bonds don’t provide nearly the sort of opportunities to shelter income that real estate does, mainly through depreciation expense.

Of note distributions from Pension Plans, 401K, 403B, and IRA’s are exempt from the tax. Also, for real estate investors who materially participate in their investments the ability to elect to become a Real Estate Professional and turn their passive income into earned income may present some planning opportunities.

Oh by the way, this tax is in addition to the more well known new “Hospital Insurance Tax” of 0.9% imposed on earned income in excess of the aforementioned MAGI thresholds. All in, these new taxes could amount to an almost 5% increase in taxes to the “wealthy”. I guess someone has to pay for healthcare reform though.....