It looks like another banner year for the triple net leasing market, with demand far exceeding supply in most areas of the country. Thanks largely to the baby boomer population seeking out new types of retirement investments, demand continues to be high, and the demand, for the most part, comes from people who are in the midst of 1031 tax deferred exchanges. And even in light of interest rates trending upwards, cap rates tend to remain low with prices holding steady. Shopping Center Business recently spoke with several companies that are active in the triple net market to find out more about these trends and what we can expect for 2006.
Demographic Shift
The main reason for the current state of the triple net market is the significant demographic shift of baby boomers moving into their retirement years. According to Bruce McDonald, president of Net Lease Capital Advisors, there are about 75 million baby boomers, the oldest of which are just hitting the age of 60, so there are a lot of older Americans who have built up substantial wealth in real estate portfolios. Their ability to go into the net lease market allows them to avoid paying capital gains tax and move from management-intensive real estate to passive real estate that provides a stable income. “There are a lot of people who have built their portfolios out of single-family, duplexes or triplexes, and they are getting too old to bother with that and now have a yin for a management-free investment that produces a regular cash flow,” says Ralph Bunje, president of Reverse Exchange Services, Inc. “The traditional triple net model for these investors was a single-tenant property, such as a Burger King or post office because it fit their criteria. Now, as a result of this demographic shift, there has been the creation of the TIC [tenant in common] industry.”
In addition to a management-free investment, a lot of these retirees are looking for “safer” investments as opposed to the traditional stock market approach.
“There are a lot of people who had perhaps previously invested in the stock market or other investment opportunities and feel more comfortable getting into the triple net market now,” says Leith Swanson, president of Prime Net Realty Advisors, Inc. “There are a lot of very wealthy investors — individuals and entities — that are in the market and, at the same time, there has been a shortage of quality investment-grade net lease properties available for that pool of investors to buy. So what you’ve ended up with in the last couple of years is a huge pool of investors that are investing because of 1031 requirements or simply because they’re in the market and they are doing a dozen deals a year.”
Though most agree that triple net investing is becoming more and more popular, one person we talked to thinks the stock market still has some appeal. “I think the media has been successful in helping create the perception of the real estate bubble out there,” says Keith Sturm, principal with Upland Real Estate Group. “I don’t think there is a bubble, but certainly clients have been a bit more hesitant about real estate just based upon what they hear on TV. With that, I’m noticing that the stock market has become sexy again. People have very short term memories and have forgotten how their 401Ks turned into 101Ks over the last stock market ‘crash.’ Those memories have been fading, and people are thinking about jumping back in.”
Gaining Interest
Interest rates on triple net investments may be rising, but cap rates so far have not necessarily followed, according to several people we talked to, and pricing still remains steady. “The demand continues to be strong because folks are simply looking for non-management properties and net lease seems to fit the bill,” says Jay Bastian, senior vice president of acquisitions for Commercial Net Lease Realty.
“If treasuries stay where they are or trend lower, I think cap rates will probably maintain their current levels, but obviously treasuries are a driver of cap rates in some respects. Everyone talks about increasing interest rates, but I don’t see the demand sliding because of it; it’s just going to change pricing on deals.”
“It’s still an incredible seller’s marketplace,” notes James Dwoskin, president of ICA Realty. “Sellers are still holding tight to prices that were originally put in place at a lower interest rate environment, but there doesn’t seem to have been any movement in the cap rates on the highest credit deals. On the lesser credit deals, there’s always been more flexibility and play in the pricing.”
According to William H. Winn, president of Passco Companies, LLC, supply is still constrained and there is more demand by buyers. “However,” he says, “the movement of the interest rate has changed the market somewhat. Rising interest rates have, and will continue, to put downward pressure on yields, and as the trend continues, demand will be reduced on the buyer’s side.”
Winn continues: “If sellers do not lower their price expectations, the result will be less transaction volume because buyers and sellers will not be able to agree on purchase price.”
McDonald says he has yet to see a change in pricing.
“Everyone would think that the cap rates will track interest rates,” he notes. “If interest rates continue to go up, there may be a change in pricing at some point, but so far it’s early. There’s usually a delay anyway, but I think in this market, there’s likely to be a longer delay between the interest rates and the cap rates.”
Jonathan Hipp, president of Calkain Companies, takes a similar view.
“There’s a lot of activity with tax-motivated buyers and plenty of fresh equity that’s not tied to an exchange,” says Hipp. “Although interest rates have gone up, cap rates have not correspondingly seemed to move in conjunction with the interest rates, so there are some pretty aggressive cap rates compared to what the debt is.”
According to Sturm, the lower-priced, quality properties are holding their cap rates, and in the category of non-investment-grade properties that are in the .5 to million range, there’s real pressure to increase cap rates.
“The trend I’m seeing now is there’s incredible pressure on cap rates, based upon interest rates rising, that is causing a little bit of a slow down in the market until cap rates can adjust to interest rates,” says Sturm.
2006 Market
So what effect will the demographic shift and rising interest rates have long term?
The great risk is that people are buying at a market high, according to Bunje, but how long that will last is the burning question.
“The demographic shift will probably continue to push for this type of investment for the next 10 years, at least,” he says. “But the question is, will these investments be popular and will the demand be there if the housing market should fall apart? If housing values go down, the whole focus is going to have to be on long term interest rates. So you just watch the 10-year Treasury rate and that will tell you what happens in that marketplace.”
There are several forces that are going to cause cap rates to ease in 2006, says Barry Silver, senior partner with Silver Willis Investment Real Estate.
“For the first time in my experience, investors are not willing to accept such small returns and they’ve turned to the TIC market,” he notes. “And they are being sold a higher current return without giving a tremendous amount of thought to the ramifications of what’s going to happen when the debt adjusts up to the interest rates that they’ll be seeing in 5 or 10 years.”
Swanson says cap rates for net lease properties are going to be higher in 2006.
“We may not see a fourth quarter that will look as good as the third quarter results are looking. But cap rates historically have lagged behind movements in interest rates, and though cap rates have continued to drift lower in September, October and November, interest rates have been fairly stable overall. But there are some inflationary pressures, and we’ll see an increase in cap rates possibly late next year.”
“An average cap rate for a long term triple net property is between 8 and 10 percent,” adds Bunje. “Many of them are selling at 5 and 6 percent today, and that’s largely because of low interest rates. If interest rates go up, then cap rates go up, and as cap rates go up, investors who invested will lose their money because the cap rates will change.”
While competition remains fierce, it may be a tougher market in 2006, according to Paul Domb, asset manager for United Trust Fund.
“As interest rates increase, the primary players — the large REITs and the CNLs — will continue to do business, and I think a lot of the Johnny-come-lately’s will not be able to compete and will find a very tough market.”
Hot Property
What, where and how 1031 investments are being made. With the success of triple net leasing and 1031 exchanges, what types of investments make the most sense these days? Shopping Center Business recently talked to James Dwoskin, president of ICA Realty; Paul Domb, asset manager for United Trust Fund; Ben Simon, partner with The Simon Companies; Leith Swanson, president of Prime Net Realty Advisors, Inc.; Bruce McDonald, president of Net Lease Capital Advisors; Jonathan Hipp, president ofSusan H. Fishman ; Keith Sturm, principal with Upland Real Estate Group, Inc.; Michael Shephardson, executive vice president of Trustreet Properties; and Dan McCabe, president of Investment Exchange Group to find out more about the types of properties and investments that are at the top of the list for today’s investor.
SCB: What types of properties are hot for 1031s right now?
Domb: From our perspective, one type of property is no better than the other, and we do everything — office, retail, industrial, bank branches, pawn shops, 7-11s, you name it — all single tenant.
Simon: On the seller side, it’s the Eckerd’s and CVS’s that are popping out of the ground. If you can get with a builder that’s doing those, then you might be able to get your arms around a newer product.
McDonald: All properties are sought after for 1031. I think that what typically separates it is the size of the 1031 buyer in terms of how much money they have to reinvest. On a typical bell curve, there are just a lot more 1031 people who have smaller dollars — million to million — to invest. You have a large volume of smaller retail properties, such as drugstores and fast food restaurants. If you put it in a larger perspective, retail has the most transactions, but it’s not as high because industrial and office tend to be larger deals.
Hipp: It used to be mainly retail, but now there is a lot more office and industrial. But I’d still say retail because it’s the most produced product out there — like a 7,000 square-foot Advance Auto or a 3,000 square-foot video store. The most sought-after property is any pure triple net property with reasonable or good credit behind it and rental increases. More than ever, I’m seeing buyers who have to buy something other than what they had hoped for and at yields lower than they had expected.
Sturm: The single-tenant net lease, good-credit, well located properties are what’s really selling most today. We do a lot of retail, and it’s what we classify as the minimal management properties. The best-selling ones we see currently are passive real estate investments, where the owner just gets a check on a daily basis.
McCabe: There are a wide variety of sought-after properties for 1031s. I’ve seen everything from large industrial complexes that are broken down and the typical semi-regional shopping center to gas and oil interests and multi-tenant office buildings. It almost depends on what the originator can find. I’m seeing a significant number of multi-tenant product, i.e. office buildings, medical facilities. There are too many inexperienced dollars chasing too few good deals.
SCB: How hard is it to find properties?
Dwoskin: The better properties are very hard to find. There are a lot of lesser credit, specialty type buildings, things like net-leased franchisee restaurant properties — those are always readily available. The harder things to come by are leased properties that are significant assets, such as warehouse distribution facilities, office buildings or well located retail facilities that are leased to investment-grade credit tenants. Over the last several years, most of the high-credit big-box users, like Wal-Mart, Target, Costco, Home Depot and Lowe’s, have decided that they no longer want to be tenants if they can avoid it and want to own all of their properties. So those deals are evaporating; there are very few, if any, in the marketplace. So what’s left of the investment-grade credit deals is coveted, and people will pay more for them.
Hipp: Properties are not hard to find; it’s hard to find something that makes sense. It still continues to be a market where, if you see something you like, you’ve got to go after it.
Shephardson: We’re very niche-focused and work in two primary sectors – 90 percent of our business is in the restaurant arena and the other 10 percent is just general retail that includes drugstores, banks and convenience and gas stations. We’ve found that because we’ve been in the business for so long and know so many restaurant operators, and because we have a very strong acquisition business in our origination efforts, we don’t have any challenge finding product.
SCB: Where are people looking for property?
Domb: To the 1031 investor, private ownership is a big factor, so local properties would be key. Credit and the type of real estate are secondary or tertiary considerations. The 1031 investor is hard-pressed to find quality investments.
Swanson: We typically deal with clients in the million to million range and above, and the area doesn’t seem to matter, although obviously they’re not buying a lot of property in Louisiana and Mississippi. The driving catalyst behind the growth in the net lease market is the fact that the investor can move across state lines and not be relegated to his own backyard.
McDonald: The product is spread across the country; there are certain areas for different product types. Florida and the whole Southeast are big growth areas and so are the western states. Office and industrial headquarter building deals are being done all over — they tend to be in the distribution hubs, such as Memphis or New Jersey.
SCB: Are TIC structures still on the rise?
Swanson: TIC structures offer the individual investor who doesn’t have million to million an opportunity to jump in, so that’s really propelled the market growth that we’re seeing.
McDonald: They are certainly on the rise. In 2001, they did about 0 million in equity and in this year, they’re expecting to do billion of equity — and that’s just on the securities side. So there is obviously a huge demand, and that ties into the fact that the majority of 1031 buyers have less equity and TICs allow them to have somewhat of a passive investment. So it’s clearly a product that there is substantial demand for.
Hipp: They are becoming a very popular vehicle and much more publicized and well known. There are a lot of people out there with 0,000 to 0,000, and it’s hard to buy something without taking on a lot of leverage. They would much prefer to partner with a group of others to buy a more quality asset and let somebody else worry about the management.
Hipp: The TIC market is certainly becoming more popular, and I think they serve a purpose. But when people start buying properties with interest-only loans so they can cash flow, I think it’s a double-edged sword because when that loan comes due in 5 years, they’re going to be out to the market looking for debt in a different interest-rate environment. I’m not sure they realize exactly what they’re buying.
Sturm: We think the TIC structure is really the future for passive real estate investments. The baby boomer generation as a demographic group just turned 59 and a half, and it’s not long until their 401K plans are going to be available to them to start pulling down money on a tax-deferred basis. But what we’re finding is that the quality TIC properties that are investment-grade are able to attract very good financing right now. We’re able to get long term fixed financing in the 5 to 6 percent range, while the 1031 or net lease properties we’re talking about have been financed in the 6 to 7 percent range.
Shephardson: TICs have wonderful application in the larger 1031 arena where you are selling a pool of assets or you’re going to sell one large asset at million to million and you want to syndicate it amongst many buyers. So the only thing that’s holding the TIC market back is the potential ruling on whether it’s a real estate product or a securities product. We expect that we’ll be doing TICs sometime in the not too distant future because it expands the buyer’s universe.
by Susan H. Fishman
Susan H. Fishman
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