Net leases: Low capital costs, returns growing buyer pool
Cheap capital and an environment of low-interest returns have pushed an increasing number of credit-chasing investors into the net-lease property market.
Net-leased properties offer a bondlike product where tenants often cover most, if not all, of the operating costs associated with the property and lease for long periods of time.
"Everyone is looking for opportunities," said John Banas, director of the Philadelphia office for Marcus & Millichap Capital Corp.
Returns on net-leased assets are not as high as multifamily properties, but they also are not as labor intensive, he said.
Net leases give buyers the ability to avoid being hands-on while having a steady income stream from tenants who are typically corporate retailers, quick-service restaurants and convenience store chains, as well as banks and pharmacy or drugstore companies.
Auxiliary medical office facilities built for health systems often create net-leased opportunities.
"I've seen interest triple and quadruple," said Ben Appel, a net-lease specialist in the Philadelphia office of Marcus & Millichap's National Office and Industrial Properties Group.
A lot of real investment trusts and other institutions are chasing quality products to add stability to portfolios, he said.
"High-net-worth individuals came in to buy this bondlike product because they are sick of sitting on money getting 1 percent in the bank," Appel said.
Capitalization rates on net-leased properties have been compressing, due to limited new properties coming to market, but there is still value for investors, he said.
"There is pent-up demand out there for quality net-leased product," Appel said.
A lack of new assets is driving demand nationally, he said, citing offers for a recent Northeast portfolio from buyers in New York, New Jersey and the Boston area, as well as others from San Diego, Houston, Denver, Chicago, Detroit and Miami.
"The fundamentals in the Northeast are very strong," Appel said. "We don't see huge booms, so we don't see huge busts. Huge booms create a lot of activity that drives demand for office and medical office. It drives retailers, which drives industrial demand."
Because we don't see much overbuilding in the Northeast, supply tends to be more limited, which creates more competition, he said. That should mean higher pricing for sellers (see "Midstate pricing," this page).
"If you are a long-term holder, these are great assets to hold," Appel said, adding that he expects cap rates to rise as interest rates tick back up.
Sellers might be getting out because of the cap rate compression and decreased value due to a shorter lease term.
"If you are a seller in the next 18 to 24 months, you should consider why you're not selling now," Appel said. "If you need to extend a lease or lease up vacant space, now is the time to be in the market."
Prospective buyers are really focusing on quality of the real estate, said Michael Curran, a senior associate and office leasing specialist in CBRE Inc.'s Harrisburg office.
"That's certainly a driver with developers, specifically existing owners, looking to expand portfolios," he said. "What's the real estate look like? Is there a redevelopment opportunity if a tenant leaves? Am I going to be able to lease it?"
With changing tenant demands in a tight office market — increased efficiency and smaller footprint needs — the pool of regional buyers looking at general office spaces is taking more of that redevelopment perspective as they scout opportunities, he said.
"For quality real estate that is well positioned with good construction and management, and well occupied by good tenants, there is certainly more activity than a building with significant deferred maintenance and only 50 percent occupied," Curran said.
Common in these net-lease deals is what is known as a 1031 tax-deferred exchange.
Using this tool, a commercial real estate investor replaces a property with an investment of equal or greater value to avoid paying capital gains taxes.
"It's pretty prevalent," Banas said of 1031 deals.
Investors that use this type of structure are often looking to step up into a larger property, or they might be downsizing and need a steady profit stream with less day-to-day oversight, he said.
"It depends on their (investment) strategy," he said about financing options. "Ultimately, it comes down to what a buyer's game plan is and what they are looking to do with a property."
What is a net lease?
There are several variations of net leases. The most common is a triple-net lease.
With a triple-net lease, a tenant is responsible for all operating costs in addition to rent, which include net property taxes, insurance and maintenance for the duration of the lease.
Generally, single-tenant office buildings are leased on a triple-net basis.
A triple-net lease can be set up in which the landlord manages all expenses and the tenant then reimburses the owner. It is more common that the landlord just receives a monthly rent check, said Ben Appel, a net lease specialist at Marcus & Millichap Real Estate Investment Services.
In December, a net-leased medical office built for PinnacleHealth System in 2006 was sold for $4.26 million at a capitalization rate of just above 7 percent.
The sale of the 13,050-square-foot Lower Paxton FamilyCare office in Lower Paxton Township set a sales record for Central Pennsylvania at $326 per square foot, according to California-based Marcus & Millichap Real Estate Investment Services, the firm that arranged the sale.
"Across the board, private investors, high-net-worth individuals, net-lease funds and institutions continue to chase a limited supply of net-leased assets, forcing capital to consider secondary and tertiary markets for what they consider to be 'higher yields' at 7 percent," said Ben Appel, a net-lease specialist in the firm's National Office and Industrial Properties Group.
Supply has been restricted because of challenges in the construction sector.
The average cap rate in the Philadelphia region last year was 7.3 percent. That was on 64 properties, according to Marcus & Millichap.
New medical offices typically yield leases of 10 years or more, Appel said. The PinnacleHealth deal was originally a 20-year lease.
“In markets where there are fewer barriers to entry, we (typically) see longer term leases,” he said. “In more dense suburban markets with higher barriers, we see 10- to 12-year leases.”
Marcus & Millichap reported a total of 1,365 single-tenant net-lease transactions in 2012, totaling $3.4 billion. Sales volume was up 40 percent compared with 2011, Appel said.
The firm had the largest market share, with 862 single-tenant net-lease sales through the third quarter, according to data provided by Marcus & Millichap. Its next-closest competitor had 274.