NNN Investment Outlook Q&A
Barry Slatt Mortgage Company’s President, Michael Kaplan, recently sat down with 3 prominent net lease investment brokers to discuss the current NNN investment market and what their outlook is for the balance of the year. A special thank you to Putnam Daily, Partner with Preserve West Capital, Chris Sheldon, Executive Director with Cushman Wakefield’s Capital Markets Net Lease Group and Rick Sanner, Partner with Capital Pacific for sharing their insights on the net lease market. Below are some key excerpts from the recent discussion:
Have you seen a shift with investor appetite in the NNN (single or multi-tenant) retail space? If so, where have you seen the shift?
Investor demand has been pretty steadfast across the board in all retail sectors when priced appropriately. I believe there is a real demand for net leased industrial properties which could potentially have an adverse effect on retail cap rates. However, for your typical retail investor who is searching for long-term NNN leases to credit tenants, there are but a handful of industrial properties on the market at any given time that meets those parameters. Despite where their appetite may lie, retail is really the only viable option for many, especially lower price point buyers.
While demand has been gradually declining in the net lease investment market for a little more than 2 years, we have recently experienced an uptick in activity amongst private capital and 1031 purchasers for both single and multi-tenant retail in the last quarter. While the summer months have historically been slower, this year’s feel different with rates having been flat for several months with less volatility. Going into the fall quarter, we expect this momentum to continue. On product type, the same dynamics that have played out the last two years continues; buyers are considering functional retail assets with long-term stability either intrinsically or amongst users they feel will survive the continued evolution of retail with e-commerce changing the space. Smaller price point single tenant offerings in the food/medical/service space have held values more consistently irrespective of geographic market while yields on multi-tenant strip product have increased from lows experienced in 2016 and now mirror the neutral leverage point on long-term financing in nearly every market (the last time this occurred was in 2014/2015). Investors continue to be drawn to growth markets in states like Texas, Florida and the Carolinas (to name a few). Coastal capital continues to compete with regional interest on newly built and stabilized product while single and multi-tenant retail with shorter lease term(s) have become more regional in secondary and tertiary markets. This is partially caused by an increase in the supply of this product and a continued lack of supply in high-quality major market located investments.
We have seen a recent shift with the “Amazon effect” of more investors having an appetite for multi-tenant net leased properties, purely from a risk hedging strategy with multiple tenants. Historically investors have had more of an appetite for single tenant NNN investment properties where absolute net leases are more common and credit is typically stronger, but with the future of retail changing and becoming less certain with e-commerce, investors have been willing to sacrifice absolute net leases and stronger singular credit for multiple tenants with generally weaker credit as a hedge diversification strategy. Additionally, multi-tenant strip retail product with smaller suites and square footage typically house tenants that are perceived as more e-commerce resistant versus much of the box retail that exists in the single tenant realm. With that said, single tenant QSR, automotive, and C-store tenants remain very attractive to investors due to their perceived e-commerce resistant business models. As for geography, we still see investors looking for NNN assets in strong markets with growing or established populations.
What is the outlook for year end with respect to cap rates? Have you seen any disparity in the upward movement in cap rates as it relates to different product types or geography?
While there are anomalies in each market/region, the trend is CAP rates are moving upward with less demand, more supply, and higher rates. We expect this to continue gradually the next couple quarters depending on where interest rates move from early fall to the end of the year. But the lag in value adjustment to supply/demand and interest rate movement experienced in 2017 and early 2018 seems to be balancing out some as we start the fall quarter. We expect CAP rates to adjust closer to the neutral leverage point or to reflect positive leverage across the board as supply continues to outweigh demand. As is usually the case, investment in western states, the northeast, and in those growth markets mentioned previously, CAP rates will continue to be compressed in comparison to other markets as demand for those assets remain healthy.
We are seeing a market slowly in transition as it relates to cap rates. There still seems to be limited inventory, particularly in strong coastal or CBD markets across the country, which has kept cap rates from moving upwards drastically in relation to the rise in interest rates. “A” properties (based on credit, lease terms, business model, and location) are still securing benchmark low cap rates and are typically acquired by all-cash investors. But cap rates for “B” and “C” properties have started to move upwards. These “B” and “C” properties can be characterized by weaker locations, fundamentals, credit, and business models, and near-term lease expiration. I think cap rates will continue to slowly climb as we approach year end, but the limited inventory of new product (especially in strong markets), will keep this movement gradual. As I mentioned above, in the single tenant market, the cap rates for the larger box tenants have moved upward much more substantially than the smaller footprint QSR, automotive, and C-store tenants, due to the “Amazon effect” and the perceived risk associated with the uncertainty of e-commerce. If a business model seems to be e-commerce resistant, then the corresponding cap rate for that tenant has generally resisted the upward movement of the market much better.
I think retail cap rates should remain relatively flat for the remainder of 2018. I also expect there to be strong buyer demand to finish out the year which should negate an uptick in interest rates. Sporting goods tenants have seen a dramatic upward swing in cap rates as well as big-box assets. QSR properties are in high demand.
What is the outlook for retail construction and new product coming to market?
This is tough to forecast from my position in the investment sales arena, however, my thought is that new construction and new product coming to the market will start to slow down as costs continue to rise. We have been hearing that it is harder to make new construction development deals pencil with the rising costs for land and construction in relation to the rents that tenants are willing to pay. I hope I am wrong here as much of what we sell is new construction product, and this would definitely affect our pipeline!
The current ground-up retail development pipeline feels like it is slowing. Large programmatic rollouts from tenants have all but slowed to a trickle. Couple that with steady increases in land, construction, and labor costs, and developers aren’t able to make projects meet their financial targets and/or they are just too tight to move forward with given the uncertainty around interest rates 12-18 months down the line.
With construction costs at all-time highs, retail rents on build-to-suit projects and new centers are hitting highs in a lot of growth markets; this is slowing the ability of developers to make deals work as investor’s expectations for sustainable rents with performing tenants weigh on exit CAP rates. This is having its effects on supply in many markets with the biggest adjustment in the junior box and larger user footprint space where fewer deals are being completed featuring new construction as some operators downsize and close stores. Retailers are also choosing to backfill previously occupied spaces to save on rent as well. Smaller users and those in the categories previously mentioned where demand favors them continue to move along with new locations.
Please contact your Barry Slatt Mortgage Banker for any questions around NNN investment or any other commercial real estate financing or investment needs.