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FEATURE ARTICLE, MARCH 2008
NET LEASE UPDATE
Risk and valuation concerns regarding net lease properties have come back to the fore.
Sean O’Shea
Viewing the net lease market from the vantage point of Southern California has been a near-intoxicating experience in the last few years.
Net lease assets have been afforded a special cache in their niche of the investment marketplace, often as an IRC 1031 replacement solution for multifamily investors, who had achieved substantial capital gains and wished to defer such gains. They had a tight timeline for making a multi-million dollar decision under IRC 1031 or 1033 timelines and wished to get out of the management business of running apartments, even if they had the benefit of qualified third-party management.
There has been substantial cap rate compression, due, in part, to the ability of these multifamily investors to sell assets at 3.5 to 4.5 percent cap rates and the ability of buyers to finance such acquisitions at historically low interest rates with historically higher leverage during this period. Pretty heady stuff in the last few years — the halcyon days for sellers and listing brokers alike.
Real estate brokers quoted cap rates while mortgage brokers quoted non-recourse debt with high leverage and low rates, many times pumping up yield using interest-only debt structures at 70 to 80 percent loan-to-value underwriting. The CMBS market was humming along; mezzanine debt was available on larger projects for developers with track records.
There was a Walgreens transaction in summer 2006 in Texas, where the quoted pricing on a Friday was $4.275 million at a mid-6- percent cap range. When the LOI was being drafted the following Monday, the buyer’s broker called to verify pricing and availability, only to be told that a newly revised price was $4.675 million. The buyer’s broker inquired with astonishment about the change, fearing that he had unintentionally misstated the asking price to his client 48 hours earlier. He had spent weeks researching 1031 replacements all over the country and had hoped they were close to a selection with the 45-day identification period deadline looming large in the next week. The broker was told that the price had simply changed with no particular explanation. Upon conferring with his client, he was further amazed to learn that the buyer was prepared to revise his offer by the $400,000 up-charge and the deal closed escrow in cash 40 days later.
Such a case study unavoidably raises the issue very directly, “What is the value of such a property?” The historical response would be “whatever someone will pay.” So, compelled IRC 1031 buyers, a frothy NNN market, low interest rates and available debt have all conspired to produce the NNN lease marketplace that many sellers and brokers have enjoyed during these last few years.
This high-flying era of real estate investment appears to be officially over. So where do we go from here?
The implications of the intervening events of the national “credit crunch” and the highly publicized subprime debacle are settling in the real estate investment landscape. This was not a residential mortgage broker’s nightmare or a day of reckoning for unqualified buyers. It affects all of us — investors, clients and as real estate practitioners — in profound new ways.
The concepts of risk and valuation are now paramount. A review of the current or proposed debt structure of a transaction that investors have entered into is now a point of new focus for many. The issue of balloon balances at maturity and the impact of interest-only debt structures have a new impact on more sober review. If valuations fall — whether by a re-calibration, which fully values the recent role of accessible, cheap debt in pricing, or a more risk-averse loan underwriting environment — it will be a painful adjustment for sellers and buyers alike.
The days of non-recourse debt appear to be nothing but a memory. The current reappraisal of “location, location, location” based on new valuation models will differentiate properties from the prime markets and secondary/tertiary real estate markets significantly. In the recent past, the equity chasing deals did not fully value the difference. Now, whether life companies or banks are your lending sources, they both may not look favorably on secondary locations in terms of loan-to-value ratios, dictating more equity required to complete a deal. This, of course, will be compounded by higher debt rates and lower cash flows in this next phase, which could last a couple of years.
Sean O’Shea is managing director of Los Angeles-based BRC Advisors.
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