Amidst Fiscal Wrangling, Net Lease Investors Look to Robust ’13
The following is an HTML version of a story that ran in the January 2013 issue of Real Estate Forum. Click here to view this article in its original format.
Coming off a good year for net-lease buyers, these investors remain optimistic about the outlook for 2013. Even as concerns about an upcoming hike in the capital gains tax in 2013 helped push deal activity into 2012, net-lease investors that Real Estate Forum talked to (using input from Real Capital Analytics to identify major net-lease property buyers for 2012) have hopes of maintaining or exceeding their 2012 buying activity in 2013.
As David Blackman, president and COO of Newton, MA-based Select Income REIT puts it, “I would expect that there were some people that rushed to get deals done in 2012 in order to pay their capital gains at a lower tax rate. Once you get into a higher capital gains tax environment, I don’t think people will elect not to transact because they think the capital gains tax will go down.” The REIT, a subsidiary of CommonWealth REIT, which went public in March 2012, engaged in more than $400 million of acquisition activity in 2012.
And Chris Volk, CEO of STORE Capital, subscribes to the Warren Buffett theory that “if somebody can make a gain from investing in real estate and they want to sell it, they’re still going to make the gain even if they have to pay a higher tax rate.” Scottsdale-based STORE, for Single Tenant Operational Real Estate, has closed about $750 million in sale-leaseback net lease activity for 2012, with December being one of its busiest periods, Volk reports.
W. P. Carey, with investment activity of about $1 billion for 2012, also enjoyed additional deal flow toward the end of the year as politicians wrangled over fiscal issues in Washington. The New York City company, which became a public REIT in October 2012, invests in a diverse portfolio of net-leased commercial properties.
The REIT made its first foray into Japan in 2012, with the acquisition of two buildings housing warehouse and distribution centers in Saitama Prefecture for about $55 million. The facilities are leased to Wanbishi Archives Co.
The REIT has been investing internationally since 2001 and Japan is the nineteenth country that it has a presence in, according to Trevor Bond, W. P. Carey president and CEO. “We are very well known in Europe and have a growing presence in Asia,” he says. “We’re always looking for opportunities that are good risk-adjusted returns internationally.”
And Jay Whitehurst, president and COO of National Retail Properties, anticipates that the Orlando-based REIT’s investments in single tenant, triple net-leased retail properties will total about $500 million for 2012.
Whitehurst expects that National Retail’s 2013 acquisition activity will be at least $200 million. He says, “You can never see very far ahead for what’s out there and we do not want to overpromise. Some deals that would have been in the first quarter of 2013 were pushed into 2012 for tax reasons. Our guidance is for $200 million in 2013, but we certainly hope we can meet, and preferably exceed, that.” Similarly, the other net-lease investors hope to meet or exceed 2012 acquisition activity in 2013.
So what strategies are these investors looking to engage in to ensure success in 2013?
Whitehurst says that convenience stores, a sector that fared well during the recent recession, make up about a fifth of National Retail’s portfolio. “The businesses that are run on those properties are strong, enduring and profitable, and the real estate attributes are compelling,” he notes. For 2013, National Retail aims to continue pursuing such retail properties, particularly in the Southeast and Southwest, considering that retailers are opening more stores in those parts.
Similarly, Volk finds that the sorts of single-tenant operational real estate retail properties STORE favors are more dominant in the Sunbelt areas of the US, just because those markets are more suburban in nature. In general, it will seek out “high-quality companies operating in business sectors we think are going to have long-term sustained relevance and have prospered through a substantial recession.”
W. P. Carey’s Bond expects that the company’s build-to-suit activity is likely to pick up in the next couple of years. The REIT aims to have a diversified portfolio, which helps reduce the company’s risk, and will not target any particular acquisitions.
However, the company tends to be interested in property sectors that other investors do not favor. In 2012, for instance, the REIT engaged in suburban office acquisitions that were attractively priced since the sector was not favored by many other investors.
“Considering that it was out of favor, we paid attention to real estate fundamentals and decided it was an attractive entry point. For 2013, it is difficult to predict which sectors will be less in favor relative to others,” Bond notes. In one such deal, the REIT acquired eight suburban Minnesota office facilities, totaling 1.1 million square feet, for $169 million. The properties are triple net-leased to Blue Cross of Minnesota, with six of them located in the tenant’s suburban Minneapolis headquarters.
Select Income REIT also sees value in suburban office properties, based on the consideration that the lack of capital pursuing these deals gives the REIT a good return. Another niche of interest to Select Income is sale-leasebacks of corporate headquarters. Blackman reports that six of Select Income’s acquisitions, totaling $300 million for 2012, involved sale-leasebacks of corporate headquarter buildings, and he expects to continue doing these sorts of deals in 2013. “We will continue to pursue sale-leaseback transactions and the acquisition of corporate headquarters or buildings that we believe are strategic to the tenants,” Blackman explains. “Companies tend to invest more capital in their corporate headquarters. And when they invest capital in the building they tend to be more likely to pay rent and renew their leases at expiration.”
As these investors look forward to continuing their acquisition activity into 2013, how do they expect to go about financing their deals? For National Retail Properties, a $500-million line of credit through a syndicate of banks is the preferred source of financing, and the REIT prefers not to take on mortgage debt. As the line gets used up, the REIT expects to pay it off by issuing long-term debt or equity.
For STORE’s Volk, it’s a source of pride that the company has its own conduit that is a master trust and can issue ‘A’-rated bonds. Volk notes, “Because our average real estate investment is about $2 million, the portfolio we have is very granular and lends itself very well to going into an asset-backed securitization.” While STORE could also access the CMBS market or use life insurance company financing, Volk sees the conduit, into which STORE put $300 million of assets in 2012, as providing additional flexibility.
W. P. Carey is also happy with the flexibility that it gets from owning a captive fund- management platform that it expects to continue to use to raise capital. “It is quite valuable strategically for us because, as we discovered during the financial crisis, parts of the public markets can dry up,” Bond notes. W. P. Carey, which can also access the public equity market, will selectively use non-recourse mortgage funding, taking care to ensure that no single deal that could get into trouble impacts the overall portfolio value too much.
As for Select Income REIT, the preferred financing sources are unsecured bank debt, equity financing and the institutional bond market. While the company prefers not to take on mortgage debt for property acquisitions, it will not rule out buying a property that has mortgage debt on it and assuming the loan.
Net-lease investors expect that all the major financing sources for other areas of commercial real estate—including banks, life insurance companies and CMBS financing—will be active in the net-lease niche in 2013. Select Income REIT’s Blackman expects that there will be “modest increases” in originations in the CMBS market, which is becoming more active.
And according to Volk, “If you go up the credit chain, from ‘A’ to ‘AA’ or from ‘AA’ to ‘AAA’, you find that the spreads have narrowed a lot. If people can provide capital—whether it is insurance companies or banks or the CMBS market—in ways that can get them higher yields without taking commensurate risk for that, I think they will be very attracted.”
And as spreads have narrowed in today’s environment of historic low interest rates, it certainly appears that net-lease investors could face competition from low-cost financing alternatives to sale-leaseback arrangements.
Bond notes that in today’s interest rate environment, “The biggest competitor for any single net-lease investor is not other net-lease providers, it’s the debt market.” However, sale-leasebacks offer certain advantages over mortgage debt financing—based on considerations such as balance sheet flexibility and the absence of a balloon payment at maturity—that tend to make this sort of financing attractive to corporates, according to Bond.
And, Volk points out, “If you are an unrated business and have no access to high-yield debt or investment-grade debt and you are bank-dependent, the banks have been far less responsive. The rates are low, but if they will lend to you, that’s a different issue.” This comes about as banks grapple with regulations such as Dodd-Frank and Basel III.
Another impact of the historically low interest rate environment is that cap rates are also low today. Net-lease investors see scope for further compression in cap rates in 2013. Volk says, “The longer interest rates stay low and the more people are comfortable with interest rates staying low, the more compression in cap rates is going to weigh on the marketplace.”
Blackman expects that cap rates could compress a bit in 2013 if the economy improves. “Right now, cap rates are somewhat of a function of the low interest rate environment we have available today to finance real estate,” he says. “There are still a lot of leveraged buyers out there to buy properties and they can get a very attractive spread on their investment because of the low interest rate they can get on debt. “
So if the economy improves sufficiently in 2013 to the extent that interest rates rise, cap rates could follow. However, Blackman doesn’t see any indication that there is going to be a “material increase” in interest rates in 2013.
One aspect these net lease investors are watching closely, as are other US investors, is for any fallout from the fiscal wrangling in Washington. While some of the uncertainty has been resolved, with the income tax hike on the middle class that would have taken effect in 2013 being averted, the issues related to spending cuts and the US debt ceiling are still in discussion.
Volk is still in a recessionary frame of mind, expecting there will be some kind of recessionary influence, whether or not there is an official recession. Considering that there is not a lot of growth in the US economy currently, he is wary of any further slowdown.
With this in mind, Volk says, “We’re focusing on industries and tenants that have made it through the last recession, people that we think can withstand a downturn. With all the changes, whether it is the fiscal cliff or whether it is the healthcare reforms that will kick in, that will produce economic uncertainty.”
Blackman too is wary of any recessionary fallout from fiscal wrangling. Even if the issues are resolved so that there is no recessionary fallout, he expects that growth in use of office space will remain slow considering that tenants will continue to pack their workforce into less square feet than they previously used to occupy.
Even then, he expects that the environment will remain robust for net-lease acquisitions. “There probably was some capital gains tax-motivated selling in 2012,” he says. “But by and large we are acquiring properties from institutional owners who are recycling capital out of well-leased suburban properties in order to reset their acquisition bases. So we think that continues into 2013.”
Even if the economy does weaken, Blackman expects that there will still be transactions for Select Income REIT to pursue as the weakening will likely result in less competition for the REIT from other sources of capital interested in property acquisitions.
Bond is more sanguine about the economic environment for 2013. He notes that the uncertainty caused by fiscal cliff issues has acted as a drag on corporate expansion plans. This means that once the uncertainty is resolved, there is a good chance of a significant expansion in the US manufacturing sector. Businesses could even continue onshoring or reshoring efforts to move production back into the US, according to Bond. This will come about as energy costs in the United States decline and Chinese wages go up, and also for quality control reasons. Thus, Bond expects that there will be a beneficial impact on the build-to-suit portion of the REIT’s business as the uncertainty in the US economy is resolved.
In general, he anticipates that the demand for net-lease investments will continue to be strong considering that the Federal Reserve appears committed to its monetary easing policies. He expects that there is still a long way to go to get to the 6.5% unemployment rate that the Fed would like to see before starting to tighten monetary policy.