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.....

A Tax Tsunami

As commercial real estate struggles to break through the economic quagmire, it must contend with a flurry of changes on the horizon. Specifically, changing capital gains tax rates, estate taxes, and FASB standards could heavily alter the landscape. Of course, they also may not. There is much uncertainty in the future and all we can really do is theorize.

Capital Gains Taxes

If the Bush tax cuts are allowed to expire (which all signs are pointing to) then the capital gains tax rate will increase from 15% this year to 20% in 2011. There are few things this rate change could induce. Investors may be more likely to cash out this year or consider continuing their investment via 1031 tax exchange.

Estate Tax

In one of the oddest strokes of lawmaking to come from Washington, the estate tax expired in 2010 but is scheduled to make a deafening resurgence in 2011. In 2009 the max rate was 45% over $3.5 million; in 2011 it will be 55% over $1 million. This will certainly cause an increase in asset planning, especially with regard to trusts. Whole swaths of people who never needed to worry about the estate tax will be searching for financial planners in order lessen this tax hit.

FASB 13

This is a tricky one. Mostly because no one really knows what the final lease accounting changes in FASB 13 will be. But there will be changes. That has been enough to worry many industry insiders, who could see these changes having serious affects. More likely than not, the concept of operating leases will go away, and no more lease classification will exist. Investors could face a shortage of financing, and tenants may demand shorter leases. However, it is too early in the game to know for sure and debate is still heavy on whether there will be any impact at all.

How these changes will affect commercial real estate (and net leases) may in the end, be an art for scryers. What will their individual impacts be? How will they affect the industry in unison? Investors undoubtedly will continue to "swap until they drop" and receive a step-up in basis for capital gains purposes, and with proper estate planning will side-step the draconian estate tax. More likely than not more money and attention will be spent on tax planning in 2011 than ever before. Lease accounting, estate tax considerations, and capital gains tax rates rising will cause most developers and investors to put their tax attorney on speed dial in front of their lender contacts.

Industrial Snapshot

Calkain Research has done a quick overview of the issues facing the industrial market and industrial net leases specifically. Our analysis focuses on pertinent facts, conditions and trends to glean where we are today and will be tomorrow.
Market Statistics:

• CoStar Group reported 13 million SF of positive net absorption in 2Q 2010. This is the first positive reading since mid-2008.
• The national vacancy rate decreased from 10.1% to 10% according to Costar, the first drop in over two years. Availability also slightly decreased from 14.8% to 14.7%.
• Real Capital Analytics reports that single tenant industrial cap rates had a weighted average of 8.5% in 1Q 2010. 85 basis points higher than the same period last year.
  

Market Conditions:

• Occupancies have leveled off.
• Many current customers, due to their own economic uncertainty, choose to stay in their current space and negotiate more favorable terms.
• Cost to move is very high.
• Due to negative demand, development is down.
  

Current Trends:

• Companies have shifted to leasing space rather than owning, preferring to invest their capital in their core products/ product development (Coca Cola is prominent in this).
• Current Buildings that have been around for decades are becoming functionally obsolescent to meet modern design specifications.
• Because rental rates are so low, demand will have to drive rents up, narrowing the gap between today’s cap rates so that developers can once again make a profit. Currently, developers are sitting on the sidelines until that happens.
  

Positive Indicators:

• When demand does turn around, industrial has a short construction cycle and can therefore respond quickly.
• Building obsolesces alone will account for a huge increase in demand over and above an economic recovery that would result in increase supply and demand.
• Most industrial properties have NNN leases which means most cost increases are passed onto tenants.
  

Expert Opinions:

Gordon Whiting, founder and Senior Portfolio Manager of Angelo, Gordon's net lease real estate strategy:

The strength of the industrial market today is still market specific and varies depending on the location and type of industrial asset. In general the bid and the ask spread has compressed and sellers have much more realistic valuations. In the single tenant triple net lease market, particularly in the less than investment grade area, where we specialize, initial cap rates are still double digit with annual rental increases. Those increases are usually tied to the increase in CPI and most times have a minimum rental increase. I believe that now is a good time to buy these assets and it is also a good time for sellers to sell. Mortgage financing has loosened up and that is a helpful market dynamic.

Trophy Markets

MIT Center for Real Estate reported a nearly record setting jump in prices for investment grade U.S. commercial real estate in the second quarter. Though sales remained stagnant, investor demand for stable, high quality assets greatly increased; amounting to a 17.3% increase in prices for properties sold by major institutional investors.

David Geltner, director of research at the Center for Real Estate, made this statement in relation to these events:

“High investor demand for safe investments [is] pushing prices sharply up from the deep bottom for “trophy” buildings- prime properties fully leased out to solid tenants”

This coincides with a recent trend of higher price points reached by net leases. However, it has less to do with “trophy buildings” than “trophy markets” with high investment rated tenants. Net leases in populous urban areas are in the perfect position to take advantage of the demand for stability in today’s market.

For further illustration, here is some recent activity witnessed by Calkain:

TD Bank
1515 15th St. NW, DC
Sale Date: March 2010
NOI: $301, 606
Sales Price: $4,300,000
Cap Rate: 7.01%

Walgreens
3130 Lee Highway N. Arl, VA
Sale Date: July 2010
NOI: $500,000
Sales Price: $7,300,000
Cap Rate: 6.85%

Blue Cross Blue Shield
8896 SW 136th St. Miami, FL
Sale Date: On Market
NOI: $468,815
Sales Price: $6,378,435
Cap Rate: 7.35%

The areas these assets are located in (Washington DC and Miami) continue to experience prosperity today. Furthermore, the above properties are located within some of the best parts of those urban centers; ensuring stability and demand. Because of this, investors are willing to pay heavily for “trophy markets”.