Net Lease Cap Rates – All Markets Are Not Equal

What happened to cap rates in 2010?

Rick Fernandez: The year started strong with investors returning to the market as interest rates fell and debt became available to a larger pool of investors. Unfortunately, the financial crisis in Greece and the potential for instability within the European Union quickly cooled the New Year’s optimism. The net lease market changed again in early July in part due to another drop in lending rates and a lack of quality supply of NNN properties. A more positive lending environment and improving market fundamentals along with the volatility of the stock market drove investors to look for more predictable and stable returns. In a few markets, cap rates began to compress dramatically. Sellers in these markets suddenly saw offers 50-100bps below the caps recorded at the beginning of the year.

What markets were particularly strong?

Rick Fernandez: Professionals in the net lease community agree that, from an investor’s perspective, first there is New York and Washington DC with Chicago and San Francisco trailing behind and then everywhere else. Those eager to invest quickly discovered that NNN properties in these markets were in short supply and properties of real quality were rarer still. The DC metropolitan region in particular is an extremely stable economy and investors from around the world have turned to the area for net lease investments. These investors viewed the DC metro area as one of the most stable markets in the world. International investors closed on bank and pharmacy deals in the DC metro area in 2010. The lease structure provided long initial terms with regular rent increases that, along with the investment grade credit rating of the tenants, offered a secure, stable and solid return on investment for the investors. The forecast remains strong and ULI in Emerging Trends In Real Estate 2011 predicts the DC area to be the top market for investing in 2011.

Rick Fernandez is Managing Director of Calkain Urban Investment Advisors.

You can read the full report here.

Chick-fil-A: Private Company Trades like Investment Grade

Although Chick-fil-A is a private company, there is great demand for their free-standing stores as net lease investments. The properties are well located near major shopping centers, university and college campuses, and business centers. More than half of Chick-fil-A’s 1,500+ locations are stand-alone restaurants, which meet customer demand for convenience and access in high-traffic areas.

Chick-fil-A is notorious for have strong franchised restaurant operators, proven by the fact that Chick-fil-A maintains a franchisee turnover rate of less than 5% per year. For net lease investors, it is reassuring to know that the Chick-fil-A triple net leases have a corporate guaranteed by Chick-fil-A, Inc. Many investors are becoming more comfortable with this top QSR brand and recognize that they carry a certain implied credit-worthiness. Chick-fil-A net leases properties provide a long-term investment with no property management responsibilities in the form of a 15 to 20-year primary term nnn ground lease. Also, it should be noted that the contracted rent typically increases 10% every 5-years throughout the lease and option periods.

When purchasing a Chick-fil-A ground-leased property, investors are buying the real estate upon which the Chick-fil-A restaurant sits. These ground-leased properties provide additional investment security given the nature of the real estate investment made by Chick-fil-A’s real estate team, which generally pays for the design, construction, and equipment for all new stores. Finally, from a real estate fundamentals perspective, knowing that store locations and developments are chosen based on corporate goals for target markets; it is not surprising that new stores are typically located in high-traffic areas and are often found as out-parcel/pad sites at major shopping centers.

Pros

• Excellent operators and exceptional, growing sales and market presence
• Strong real estate fundamentals
• NNN ground lease structure with rent increases

Cons

• Private company
• Franchised Operators
• Ground lease provides no depreciation on land

Read the full profile and many others here.

Part 2: A Chat with Cole's Micera on Office and Industrial

Cole Real Estate Investments (“Cole”) is a commercial real estate investment management firm founded in 1979 by Chris Cole. Cole’s investment programs are built on a strategy of acquiring income-producing, singletenant properties that are net leased to creditworthy tenants.

Robert J. Micera is the Chief Investment Officer of Office and Industrial for Cole Real Estate Investments.

HIPP: What (if any) regions are you focusing your investment activity in?

MICERA: Cole pursues acquisitions throughout the United States. Currently we own properties in 46 states. Our acquisition criteria focuses efforts on long-term, single-tenant assets (office, industrial and retail) net-leased to high-quality, creditworthy tenants. We look at assets in major markets, as well as secondary and tertiary markets, especially if the asset is strategically important to the growth and operation of a company. For smaller markets, we typically require 15 to 20 year triple net leases with annual rental increases.

HIPP: What types of property are you focusing on?

MICERA: Cole focuses primarily on acquiring single-tenant office, industrial and retail assets that are leased to creditworthy tenants under long-term net leases. Cole also acquires multitenant retail, such as power centers and grocery anchored centers, where the majority of space is leased to one or more creditworthy anchor tenants. Our current portfolio of properties maintains approximately 20% allocation to the office and industrial sector, and the remaining properties are retail assets. Our typical deal size ranges from as low as $5 million to as large as
several hundred million dollars.

Read the full interview here.

A Chat With Cole's Micera on Office and Industrial

Cole Real Estate Investments (“Cole”) is a commercial real estate investment management firm founded in 1979 by Chris Cole. Cole’s investment programs are built on a strategy of acquiring income-producing, singletenant properties that are net leased to creditworthy tenants.

Robert J. Micera is the Chief Investment Officer of Office and Industrial for Cole Real Estate Investments.

HIPP: How do you view the current climate in relation to office and industrial investing today? One year?

MICERA: Current valuations, combined with improving market fundamentals, create a solid buying opportunity that we believe will continue well into 2011. More office and industrial product came to market the last six months of 2010 and we expect volume levels will increase in 2011 based on the following key factors:

»» Sellers, who had been holding off bringing product to market, are now encouraged by the current “compressed cap rate environment” and by the brokerage community to bring their assets to market;

»» The low interest rate environment is facilitating buyers’ ability to acquire quality assets at lower cap rates;

»» More readily available debt, particularly CMBS, is allowing more buyers to return to the market; and

»» A slowly improving economy will allow corporations to grow which should result in increased build-to-suits, saleleasebacks, corporate acquisitions and refinancings, mergers, and expansions – all of which contributes to increased commercial real estate sale activity.

As more commercial product comes to market and diminishes the “2010 scarcity premium,” it would not be surprising to see cap rates stabilize, or even increase, especially if mortgage interest rates continue to increase or remain somewhat volatile. While the overall economy continues to improve and we see more evidence of consistent job growth, companies will consider expansion opportunities. This will lead to an increase in build-to-suits and sale-leasebacks. We have already started to see evidence of this increased build-to-suit activity in 2010. Also, manufacturing production has been increasing which means companies are building inventories again to address increased demand.

Read the full interview here.

West Virginia Market Represents High Returns and Stable Demand

An analysis of West Virginia’s most recent demographic data reveals a State that is stable and predictable. The market exhibits the following characteristics:

• The highest rate of home ownership in the nation
• #7 ranking for the percent of population living in the state of birth
• Population growth of 0.6% between April 2000 and July 2009

The slow, steady growth in West Virginia should be viewed not as inhibiting investment but as a variable in one’s market assessment that can be easily quantified. As a net lease investor, this should provide confidence that with careful analysis, any fluctuations in this growth factor should not be enough to jeopardize your investment’s success.

For certain net lease tenants that target lower income households, such as Dollar General, this is especially auspicious. West Virginia’s high rate of home ownership creates a large base of Dollar General’s target demographic that is largely immobile. This strong demand will likely mean continued growth of net leased tenants like Dollar General and similar tenants in the West Virginia Market.

It is no secret there is a scarcity of high quality inventory in primary markets. This is leading to a “downward compression of cap rates across all sectors.” If this trend continues, the strength of these markets will no longer justify the inflated price tags and slim yields of the assets themselves. Opportunistic net lease investors will need to begin looking beyond these supply constrained markets to have any chance of earning a superior risk-adjusted rate of return.

West Virginia net lease investment represents the opportunity to realize property value appreciation while still delivering a secure stream of cash flows. The State benefits from the same creditworthy tenants that make up the nation’s primary markets and West Virginia banks enjoy the eighth highest ROA in the country. For the willing investor, there should be plenty of opportunities that have been overlooked in this thinly traded market.

Industrial Assets – A Shifting Investment Paradigm

It has been estimated that as much as $97 billion will be invested in the US commercial market by global investors in 2011. DTZ, a British-based real estate services firm, stated this represents a 54% increase from their December 2009 prediction. In short, growing confidence in real estate investment will pull investors off the bench – leaving the industrial sector poised to benefit. However, investors scrambling to find viable and profitable net lease investments are running into a short term problem. There is a lack of both current supply and new industrial construction in the pipeline.

Investors want quality, top rated tenants in the strongest urban markets. These investments are increasingly rare. However, “Mission Critical” net lease industrial assets are available - investors may just need to rethink their criteria. These properties often have existing permitted industrial uses, are located in and around quality commercial markets, and provide goods and services unique to their businesses. The real values of these investments are not only the tenant, or even the property, but the permitted use so critical to the nature of the business. Sellers are willing to sign long-term leases at higher returns than current market rates because these properties are so critical. Increasingly, investors are overlooking traditional analytics and considering these investments. With intelligent investment they can provide a highly profitable return.

Another strategy worth a long look is value-added investing. As infill land becomes scarce and land prices rise, this opportunity makes increasingly more sense. According to Marcus & Millichap, last year approximately 30 million square feet of industrial space totaling $2 billion was sold for redevelopment or demolition nationwide.

Value-added investing provides an opportunity for 3^rd party or sale-leaseback owners who are able and willing to renovate or retro-fit their properties. Often these buildings are structurally sound with adequate ceiling heights but need functional changes such as more loading docks, upgrades of fire protection systems, lighting, HVAC, or internal reconfiguration. A quality rehab in the right location can command the same rates as new construction in outlying, less desirable locations. In addition, rehabbed properties in the right location can double their pre-renovation value.

Mature buildings and mature industries provide an opportunity for buyers and sellers to think creatively in making their real estate NNN play.

W. Douglas Wright | Director- Industrial
CALKAIN COMPANIES, INC.

Wild Wild Wawa

As a relative newcomer to the net lease market, Wawa convenient store gas stations are one of the hottest sought after triple net lease investment properties in the market today. With an implied credit rating of BBB- / outlook Stable, most investors understand the credit-worthiness of this privately owned company, which is considered one of the strongest convenient store operators in the country. In 2009, Wawa was ranked No. 55 in Forbes’ America’s Largest Private Companies list. Wawa currently operates more than 570 convenient stores throughout the mid-Atlantic, 270+ of which include gas.

Most Wawa net leases properties offer an investor long-term security and absolutely no management responsibilities in the form of a 20-year primary term nnn ground lease. These ground leases provide additional investment security given the nature of the real estate investment made by Wawa’s real estate team, including the Wawa Engineering and Construction Department which is responsible for the design, engineering and construction of all new stores and remodels. As with any ground lease investment, a landlord should be comforted by the fact that the tenant, in this case Wawa, has made a significant capital investment in the construction of the building, which at the end of the lease will become property of the ground lease owner.

Also driving the demand and value of Wawa triple net lease properties is the strong real estate fundamentals of the property sites. Wawa’s real estate team has specific site select criteria, which focus on key trade area location characteristics. Wawa net lease properties are typically located at signalized corners and out-parcel/pads of shopping centers with good visibility and ingress/egress. Ideal trade area characteristics include adequate population and minimum traffic counts of at least 25,000 vehicles per day. Sites should be located on high-volume intersections near other commercial traffic generators.

Pros

• Implied BBB- credit; investment grade
• Strong real estate fundamentals
• NNN ground lease structure

Cons

• Private company
• Gas pumps raise environmental concerns
• Ground lease provides no depreciation on land