Wednesday, September 8, 2010

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.

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