Broker Q&A: NNN Investment Market
Commercial mortgage bankers take on the NNN investment market
Recently, Slatt Capital President Michael Kaplan and Vice President Andrew MacLeod engaged with four nationally recognized retail net lease brokers to discuss the current state of the net lease market as we emerge from the pandemic with eyes looking toward a strong recovery in 2021.
What changes are you seeing with respect to tenant popularity amongst buyers?
Prior to the pandemic, buyers were turned towards tenants with businesses that are “E-Commerce Resistant” as Amazon was seen as a looming biggest threat to retail. This meant extra demand was paid to service-oriented tenants like Auto Repair, Grocery, Food Service, and Gas/Convenience – something that couldn’t be duplicated online. The onslaught of COVID-19 and the world that followed accelerated the movement of E-Commerce in our lives which increased the buyer psyche of not only pointing extra attention to E-Commerce resistant tenants but also tenants that are necessities in our lives – the “Essential Businesses” of the world. The uncertainty caused by COVID-19 in our economy and the stock and financial markets also created a “Flight-to-Quality” in which buyer demand has shifted heavily towards tenants with strong balance sheets and investment-grade credit.
There has been a compression of capitalization rates for quality locations guaranteed by creditworthy tenants. Buyers are gravitating to Quick Serve Restaurants with drive-thru facilities operated by corporations or larger franchised operations with a minimum of 50 locations, “essential retail” like grocery stores, and discount stores with Credit Corporate guarantees like Dollar General and Dollar Tree/Family Dollar. Investors are focusing on stability and placing a higher value on assets with strong underlying real estate. Investors prefer operations that are not threatened by additional closures and competition from the internet (i.e., Amazon).
Early 2020 and the beginning of the pandemic pushed investors to strong credit or significant balance sheet tenants that were deemed essential and could remain open. This included grocery, corporate QSR/fast food/coffee with a drive-thru, investment-grade drug stores, dollar stores, banks, DIY/home furnishing operators, and urgent care and dialysis properties. While most of that dynamic has persisted through the last year to today, investors are dealing with a minimal supply of those essential credit tenanted properties in the market; as a result, buyers have begun to consider lesser credit opportunities so long as they remain functional with long term intrinsic value. Regional and franchisee credits that have survived the restrictive environment brought on by the pandemic have been in favor over the last several months and multi-tenant opportunities with all tenants open for business have begun to draw competitive interest to start 2021.
Mehdi Star, Colliers International:
My buyers tend to be first-time investors in this product type, so we take a very conservative approach to the variety of net lease tenants available in the marketplace. Trends affecting brick-and-mortar retail locations are taken into account when advising clients on which tenant profiles to focus on. Those tenants offering strong corporate or credit guarantees in service-oriented industries seem to be the most popular among the buyers I work with.
What are you seeing amongst buyers as it relates to investing in certain markets over others? What is typically driving that decision?
After the initial shutdowns, business adapted and many investors became motivated to sell land, industrial, office, and apartments in an effort to secure incomes over the next few years. Worries about the economic impact of the virus and closures, fluctuations in the financial markets, low yields on securities, and future inflation all have fed the perception that the general market will go into a down cycle. Many of the real estate segments that have had long runs on value now face weaker use requirements and governmental mandates like rent control, deferments and leasehold relief. As a result, the popularity of net leased assets has increased. Some of the largest urban areas have seen population declines while more rural states with good economies are growing. Areas of the country that have growth tend to be tax-free states and or in areas that offer affordable housing. We predict continued growth in the following states: Florida, Texas, Tennessee, Georgia, North & South Carolina, Nevada, Idaho, Colorado, and Arizona.
The migration out of certain coastal markets for a variety of reasons (related to or as a result of the pandemic and regional restrictions or expected change in tax policy on a national basis) has led to massive portfolio shuffling and estate planning for family offices and private investors. Generally speaking, we have seen a push to growth markets now growing even faster; the exodus to Texas, Florida, Tennessee, the Carolinas, Rocky Mountain states like Colorado, Utah, Idaho, and Montana has been experienced in increased transaction volumes.
We rely heavily on demographic data pulled from a variety of sources to make recommendations to our clients about the markets they should consider. Population trends are only one layer of the analysis and understanding the role a particular tenant plays in a community is also an important consideration. Finally, since many of my clients are based in CA, the ability to diversify their holdings in more business-friendly states gives them the opportunity to realize greater diversification across their real estate portfolio.
While I think investors still evaluate real estate first and foremost, and every market in America has attractive and unattractive markets, there are certainly some areas of the country that are generating more buzz than others. The sunbelt states continue to generate a lot of buyer demand – specifically states like Florida, Arizona, Texas & Nevada. Markets with population growth like the sunbelt are viewed as safe and appreciating from an investment standpoint. The pandemic and the government-mandated shutdowns that have followed have really shined a spotlight on how a state and local government can affect a real estate investment, therefore states that are viewed as tax and business-friendly (Florida and Texas among others) are in strong favor right now. And while the age of COVID-19 has seen cities lose population and in some cases businesses, investors still have interest in urban centers as most believe that any shift away from the major cities will be short-lived and perhaps now is a better buying opportunity.
Is COVID 19 still impacting real estate? Is this short-term or long-term?
Putnam Daily, Preserve West Capital:
Yes, COVID-19 remains impactful on investors as they consider opportunities. Much like how the 2008 credit crunch challenged investors (and lenders) to underwrite credit more soundly, COVID-19 will challenge buyers to consider the functionality of the real estate for the existing tenant and that tenant’s ability to withstand months of potential closure in the future. While the vaccination rollout will push the US population back to normalcy, that recovery will take time and the investors will continue to question the need for large footprints in a growing E-Commerce and virtual (stay at home) world. Experience-driven commerce/retail will return long term as our economy recovers but it will have changed in some instances permanently.
Buyers’ approach to retail was impacted before the effects of COVID, notably, concern over traditional brick-and-mortar locations and their profitability relative to online sales channels. A good phrase I heard was that COVID “accelerated and amplified” trends we were already seeing. Those retail locations that did not have an established means of selling their product or services due to government-mandated shutdowns requested rent concessions and those tenants that did have a strategy in place were able to weather the storm without burdening their landlords. This certainly influences the types of tenants we consider within the retail umbrella.
Yes, absolutely.Covid-19 is still impacting real estate. There has been an acceleration of E-Commerce in our lives over the past year and its effect on retail has definitely given buyers an approach to how they look at investing in retail assets. Essential, experience, and service retail still rule the day. This shift started prior to the pandemic and COVID-19 only served to accelerate it.
Yes, COVID-19 is impacting buyers, retail that was affected by the government shutdown such as fitness, movie theaters, dine-in restaurants are less popular. Buyers are looking for retailers that will are deemed “essential” with a focus on the tenants that are not in direct competition with internet retailers, convenience items like food, drugs, cellular phones, automotive, and hardware.
Are you seeing any shift amongst tenants with respect to the negotiation of lease term (short vs long), rent bumps vs. flat lease, or other material changes?
Sure. One example of COVID-19’s impact on CRE is Walgreens, which has traditionally only offered flat leases with no rent increases. They also had in their leases a percentage rent clause, which allowed their landlords some insight into the performance of their store. Some of the new Walgreens offerings we see coming to market offer new fifteen (15) year leases with 5% increases every five (5) years, but they have entirely removed any obligation to report sales. So, there are definitely changes we are seeing in lease structures with some of the more reputable tenants.
Tenants are definitely taking a more cautious approach to lease negotiations as the forces of E-commerce, COVID-19 and government shutdowns are fresh. COVID-19 forced retailers to be innovative on the way they offered their products and interacted with their customers – and some of these changes will be permanent moving forward. Retailers are finding that they may not need as much of a footprint and are also looking for ways to cut costs – which plays into the rental rates that they are willing to pay. Tenants are also asking for wider Force Majeure clauses to protect them against lease obligations should they ever be in a position where they are forced into a government shut down again – a direct result of COVID-19.
We have not seen a big shift in demand; the longer-term leases with increases are generally always in favor (both in up and down markets). However, it is evident that the properties that have shorter lease terms and or smaller increases are in less demand & are harder to sell at present. Concerns about the longevity of a tenant at a location are influencing demand and the offerings with longer leases and set increases are selling at a premium.
The most significant material change we have seen has been in forced closure/pandemic-related lease language; tenants are working to protect themselves against future events outside of their control with rights to terminate or pay reduced rent. Some have been more successful than others and we expect this to be a hurdle to work around on the investment/disposition side in 2021 and 2022 depending on the lease language. We saw less overall leasing activity through most of the pandemic as tenants worked to survive; those that did expand built-in these protections.
What does 2021 volume for STNL and MTNL properties look like? Is there a shift toward one or the other?
2021 has gotten off to a blazing start as far as deal volume and activity goes. Flight to quality single-tenant assets is at the top of the demand pyramid and frankly, there has been a lack of strong product available which has driven up pricing on anything with a name brand, strong credit tenant with a long-term lease. Despite the expected distress that many thought multi-tenant would experience, the interest in multi-tenant assets – especially with strong anchors – has flourished as well. Low-interest rates have really driven this activity and we expect it to continue as optimism continues to build that the worst of the pandemic is behind us.
The year 2020 was active despite the Covid Pandemic. The 2021 volume for STNL continues to be strong, investors are taking advantage of low-interest rates, strong sale values of investment properties, and utilizing the IRC 1031 before any major tax reforms are implemented. For Multi-tenant sites, the Buyer profile is a little different, sales will continue to be strong, but we will see discounting on the developments that have above-market rents, vacancy, or are occupied by tenants subject to shutdowns.
We anticipate continued and excess demand for single-tenant credit/essential opportunities; as usually occurs when there is less supply than demand in this segment of the space, we see growing demand for multi-tenant opportunities that require more active management. There has been upward pressure on CAP rates for those multi-tenant opportunities through most of the pandemic, but we are now seeing liquidity in the debt markets and the vaccination roll out assisting in CAP rate compression within this space (so long as the opportunities are functional and stabilized). We expect to see this dynamic play out the remainder of 2021 so long as interest rates hold steady (this product tends to be more closely correlated to financing than in the single-tenant space).
My clients are focused on strong STNL offerings, and so I cannot comment on the trends related to multi-tenant properties. The cap rate compression we are seeing in the STNL space for quality tenants on long-term leases is evidence that more and more investors value reliability and consistency of cash flow to the volatility that often comes with higher cap rate opportunities.