FEATURE ARTICLE, SEPTEMBER 2007

NET GAIN
Net lease investments are broadening investors’ interest.
Michael Maffia

Maffia

In the past 5 years, the net lease investment market has experienced an impressive boom, indicative of lower capitalization rates and a greater transaction volume.

It has been one of the most significant runs in the past 45 years, if not the greatest boom in history, industry experts say. This growth has been driven primarily by historically low interest rates as well as from the reallocation of private equity, moving from management intensive assets to net lease properties.

The net lease investment market is a national business; however, the majority of buyers are from the western United States, and more specifically California. West Coast 1031-exchange proceeds have been driving the national net lease investment market for non-institutional properties. These properties are generally in the $1 million to $35 million price range and feature new construction and national tenants on long-term net leases.

For example, during the last 6 months, the firm has represented a retail developer on the sales of six separate National Tire & Battery stores throughout the country. These properties feature 25-year terms, fixed cumulative CPI increases capped at approximately 12 percent every 5 years and are absolute net. Averaging a sales price of $3.2 million, all of deals closed at approximately a 6.25 percent capitalization rate. Of the six deals, which totaled $19.365 million, five of six were sold to 1031-exchange buyers from California. This trend also exists for out-of-state, multi-tenant properties that are leased to national tenants on a net basis.

Volatility in the capital market is affecting the net lease market. In the past 3 months, the market has experienced a real shock in the form of both widening spreads by commercial mortgage-backed securities (CMBS) lenders and increased 10-year T-bill yields. Lender spreads for net lease investments have widened on average by 80 basis points. During this same period of time, the 10-year T-bill has increased by approximately 20 basis points. This equates to lower leveraged yields and fewer loan proceeds because of the resulting higher debt service coverage ratios. In fact, because most net lease investments are purchased with negative leverage, the cash-on-cash yields have gone down by more than the cumulative increase in interest rates and widening spreads.

For instance, in May, a Walgreens net-leased investment was trading at a 6.15 percent capitalization rate. At that time a CMBS loan was approximately 95 basis points over the 10-year T-bill of 4.65 percent, which equates to a total interest rate of 5.60 percent fixed for 10 years with a 30-year amortization. If the purchase price was $6 million and the loan-to-value ratio was 65 percent, then the leveraged yield was 4.77 percent.

In today’s market, the same property is being offered at a 6.15 percent capitalization rate, but now the CMBS lender spreads have increased to 180 basis points over the 10-year T-bill of 4.82 percent (as of August 8th) or a total interest rate of 6.62 percent. Given the same parameters of the above example, the cash-on-cash yield would be 3.3 percent. Fortunately, borrowers can turn to insurance companies that continue to make competitive loans. For investments similar to Walgreens and other net lease assets, insurance companies are quoting spreads of approximately 140 basis points over the 10-year T-bill at a fixed interest rate and a 30-year amortization. This is an average discount of 40 basis points, which will certainly benefit both buyers and sellers.

What does this mean? Borrowers will experience higher interest rates by 50 to 80 basis points, while sellers will likely give up 15 to 25 basis points in capitalization rates. Buyer demand still outpaces available supply, although the gap is narrowing. Leveraged buyers will ultimately purchase properties at lower initial yields, so expect to see more interest in properties that have fixed rental increases. This will protect them against future interest rate risks while increasing their return over the life of the investment. Overall, the net lease market is experiencing some softening from its record pace of activity during the past 5 years. Transaction cycles are longer and buying and selling in the western U.S. markets has slightly slowed but not fallen dramatically. The West Coast will continue to be the dominant source of capital in the non-institutional, $1 million to $35 million range.

Michael Maffia is a partner in the San Francisco office of NAI BT Commercial Investment Services.


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