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This is an HTML version of anarticle that ran in the April 2014 issue of RealEstate Forum. To see the story in its original format,clickhere.

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The numbers help tell the story. At the outset of the “Town HallMeeting: State of the Industry” Panel during the 12th annualRealShare Net Lease Conference, moderator Craig Tomlinson produceda chart showing 11 consecutive quarters of year-over-year volumegrowth in the sector. While it's clear that net lease is drawing abigger crowd these days, it's equally clear that the risks aregrowing as cap rates are shrinking.

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To find the risk-adjusted returns they're looking for, some ofthe net lease investors on this year's Town Hall panel will followcredit tenants into out-of-the-way locations. The experts broughttogether for the occasion focused on this and other topics,including their financing strategies and the inevitable rise ininterest rates.

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CRAIG TOMLINSON: How has the first quarter been for eachof you in terms of activity?

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GINO SABATINI: We had a terrific first quarter.We did over $400 million on the net lease side, and that was upfrom prior years.

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PAUL McDOWELL: We had a very active firstquarter as well. We publicly announced that our target for thefirst quarter is $1 billion in new acquisitions. We're seeing avery strong flow of transactions, and that flow feels like it'sgetting better each month.

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GORDON J. WHITING: Our first quarter this yearwas surprisingly strong. The fourth quarter is always our largest,but in the first quarter we either closed or got under contract alittle over $300 million worth of transactions. So I think it bodeswell for the year.

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RICHARD H. ADER: I would say our first quarterwas pretty flat from last year. We're still seeing about $250million in deals a week. We're a little bit more selective thanmost as to what we'll acquire. So our volume is not quite what allthe gentlemen here do, but we still had a pretty good firstquarter, somewhere around $100 million.

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RICHARD ROUSE: We probably closed over $200million of transactions in the first quarter. 2013 was a very goodyear for us, and this year looks to be better.

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TOMLINSON: You've all experienced very healthy activityin the first quarter, and, overall, it seems like the deal sizeshave been getting larger. What's the typical transaction size foryou, in terms of the type of deal you'll consider?

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ROUSE: We're very pleased with the volume we'reseeing. Our average transaction size today is up to $50 million,whereas two years ago, it was probably $25 million. We recentlyclosed a transaction for $160 million, and late last year, wecompleted one for $300 million. So our deal size is updramatically.

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ADER: Our deal size sits between $40 millionand $60 million, which fits very well into our portfolio. Havingsaid that, we're in the process of closing a deal at $20 million. Iwould say that's at the bottom of what we would look at.

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WHITING: Over the past several years, our dealsize has consistently grown. Our average deal size today isprobably somewhere between $80 million and $85 million, but themore interesting transaction is the one that tends to generatehigher returns. The ones that tend to be more fun to work on areprobably in the $15-to-$20-million range or lower. If you're tryingto accumulate volume, it's hard to get some real numbers out thereif you're doing the smaller deals all day long.

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McDOWELL: We do a very broad range oftransactions. We do everything from $1-million mattress stores anddollar stores to very large corporate transactions. We have thebiggest acquisitions team out there, the biggest closing team.We're able to manage flow transactions very, very efficiently. The$1 billion we closed in the first quarter is 100% organic growth,asset-by-asset versus big portfolio acquisitions.

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SABATINI: We have a broad range as well. We godown to about $5 million up to about $500 million. We've done 10deals of over $300 million. If you look at our average, it's maybe$35 million, but that's kind of a misnomer. If it's a good dealwith great risk-adjusted returns, we'll spend the time on it.

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I think that's what sets us apart a little from some of theother groups. We will focus on storied opportunities, and I don'tjust mean credit. If there's a storied real estate opportunity,there's a reason why there's a one-, two-, five- or seven-yearlease in place. We will spend the time to understand it, even if ittakes a month or two months of underwriting. That allows us to lookat a lot of different things, but keeps the average size on thelower end.

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TOMLINSON: Have any of you sought out moreportfolio-type opportunities to get to your numbers or do you, forsome reason, not prefer that?

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ADER: We're not really portfolio buyers. Welook at them, and if it's something really interesting, we would doit. We'd be more of a seller to the portfolio buyers; we build upour investments. We have decent returns, but we do much moreone-off than probably most of the people I'm up here with.

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WHITING: We buy a combination of single dealsand portfolio deals. Typically, the larger deal sizes tend to be acouple of properties—two, three, four buildings—we've done$200-plus-million single buildings by themselves.

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McDOWELL: We're indifferent toward portfolios.If they work, great. If they don't, then that is fine too. We'revery active in the single-asset transactions space, but we're alsoactive in portfolio acquisitions—buying pools of properties versuslarge corporate transactions, in which we've also been active. Wedo buy a lot of portfolios in the smaller retail segment, so it'sthe Dollar Generals, the Mattress Firms, the Lube Stops, etc. We'lloften buy those in what we call packs—five-packs and 30-packs oftransactions—but we don't have a preference. We just have a verylarge appetite to buy property.

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SABATINI: We see more attractive portfolios inEurope than in the US. In the US, there seems to be a bit of apremium for portfolios, including the retail packages that Paul istalking about, and then you have the groups of properties that havealready been put together by people like Paul. In Europe,portfolios are priced somewhat more reasonably, and we've had moresuccess there with larger packages.

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ROUSE: Gino hit the nail on the head. Forportfolios of existing properties in the US, the premium is atleast 20%. That's our problem with portfolios. We look at all ofthem. We've never been able to make sense out of any of them.

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TOMLINSON: In the past six quarters or so, 20% to 30% ofthe net-leased properties that have traded have been in tertiarymarkets. Are you willing to look at those markets to get yourreturns?

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WHITING: We don't search out a particular area.We don't want to allocate a certain percent to the Northeast or theSouth or West, etc. We judge each transaction on its individualmerits. We look at our risk-adjusted basis and say whether we likethat return. That said, given Angelo, Gordon's long-term and corecompetency in real estate, particularly private equity real estate,we end up buying a lot of properties that are in the secondary andtertiary markets. Sometimes tertiary would be a generousdescription for some of the places we're in. We're trying toidentify a property in which a tenant is going to reside for thelong term. Many times, that puts you in a manufacturing facility ina town you've never really heard of. So we're happy to buy theproperties wherever they are. We're just going to do our analysisand figure out what we think the risk-adjusted return shouldbe.

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ADER: We're downside risk averse so we tend tolook at the real estate pretty carefully. However, it also dependson the asset class and market. For example, industrial distributioncenters could be in a very secondary market, but it's an assetclass we like a lot. With office, we might want to be in a moreprimary market and in retail, you tend to follow the credit. That'swhat we do.

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ROUSE: Unfortunately, our parameters are thesame, and that's why we're always competing against you guys. Wejust closed a $160-million deal in Lake Jackson, TX, a 20-yearlease to a BBB credit. Our return on that with a zero residual,assuming we give the property away at the end, was close to 6%. Sowe'll do that deal all day long and hope for a residual that getsus to 7.5%.

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SABATINI: I loved that deal, by the way. Welost to you by 10 basis points. Historically, we've focused onsecondary and tertiary markets and we've gotten paid to do it. Butthat's changed in the past 12 to 18 months. There's an automotiveparts supplier deal that we lost in this past quarter. The propertywas probably worth $5 or $10 a foot. It sold for over $50 a foot ata 7% cap rate. In years past, we would have gotten a 9% to a 10%cap on the deal, and we would have been paid to take the risk, butthat's not the case now. So we're shifting toward a more realestate-focused set of deals because we think we're getting similarreturns at a much lower risk.

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McDOWELL: I'd echo what Dick said. There's goodretail real estate around the country, so we're really followingthe credit and lease term. We don't really care whether the retailstore is in a primary or tertiary market. We try to capture some ofthat different valuation in pricing. In the office or industrialsector, it's a very different thought process. We really have topay attention to the property's location and the long-term demanddrivers in that market. So isolated corporate headquartersbuildings are not particularly our kettle of fish.

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The same is true within industrial. We look hard at thefundamental real estate, how long we think the tenant is going tobe in place, where we think rents are going and how useful thatasset may be to another tenant. For instance, we're a very bigowner of FedEx assets. They're often not in primary markets, but wesee FedEx as a long-term occupant and we're willing to take alittle risk on the real estate.

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TOMLINSON: Investment has three legs—credit, leasestructure and real estate. As the market becomes more competitive,which of those criteria are you likely to bend to get a dealdone?

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McDOWELL: I'm not sure I would characterize itas bending the model. We're pretty active now, for example, in thebuild-to-suit marketplace; we have several hundred million dollarsof transactions. We're trying to move up that chain in thebuild-to-suit markets.

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We also are shortening up on the lease term. We have what wecall the mid-duration strategy. So we're willing to look at shorterlease terms of under 10 years. It would be a second-generationproduct. Cap rates in the properties with shorter lease durationare more in the 7.5% to 9% range, versus the 15-year leases, whichget done in the 6.5% to 7.5% cap rate range. So it isn't reallybending the model as much as it's expanding the net as much as wecan.

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ROUSE: I do like the word expanding better thanbending. Last year, we did expand the model, and the $300-milliontransaction I mentioned earlier was the purchase of three landparcels underneath three existing hotels, a senior land position,with 100-year leases. That was quite different for us. One of thefunny things about that is that the analysts following our stockwere always a little bit critical of our average remaining leaseterm of the whole portfolio, which was about seven and a halfyears. You do one transaction for a 100-year lease, and it expandedthe whole portfolio average by about three years.

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ADER: I like an unsubordinated ground position,and I'm not sure how different that is than a basic net lease,except to the people who don't understand it. We're bending—orexpanding—on the credit side. We're always looking to locate therisk in a net lease. The risk in a net lease is not bankruptcy butaffirmation. If we can get comfortable, we'll expand our creditparameters. We're probably getting a little more aggressive in caprate, but we also want to see pretty aggressive bumps.

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WHITING: We look at things on a risk-adjustedbasis. That gives us flexibility to end up in more tertiarylocations with lesser credits or with a lease structure that isn'tas usual as you might like. We look at the whole investment anddecide what sort of risk-adjusted return we want to have for it,and we'll go ahead and make the investment. It gives us a lot offlexibility, and it certainly allows us to do more deals than wewould, but it still give our investors the returns they're lookingfor.

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TOMLINSON: There have been indications that the Fed maynot be as diligent about protecting rates as early as six monthsfrom now. How has that message sunk into your given companies andare you thinking about starting to alter your financing strategiesand maybe lock in some debt, versus continuing to ride the shortmoney?

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SABATINI: Most people think rates will go up inthe next few years. We recently did a $500-million bond for 10-yearfixed rate money and tried to lock in some of this inexpensivemoney while it's still available. For our managed fund, CPA:18,which we're currently investing, we're still looking atnon-recourse entity level of debt. It's still very attractive, andwe'll to continue to do that while it's available.

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McDOWELL: I hope interest rates go up at somepoint because that shows that the economy is starting to recover.The 10-year treasury needs to compete against other asset classes,and that would push more product into the market. An expandingeconomy is probably good for the net lease sector. At ARCP, we havean investment-grade balance sheet, so we're primarily financing ouractivities with unsecured debt. We did a very large bond offering,$2.5 billion, a few months ago. That will probably be the way we'llcontinue to finance the operation as time goes by.

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ROUSE: We also have an investment-grade balancesheet, so our focus is on unsecured debt. The limitation withunsecured debt is that you can rarely go more than a 10-yearmaturity. So on the land deal, for example, we took outnon-recourse debt at a very attractive rate, and the maturity was20 to 25 years.

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WHITING: We've historically financed ourtransactions with individual non-recourse mortgages at 10-yearfixed rates. It tends to be a lot safer. Sure, you're paying alittle bit more for that mortgage, but it allows us to sleep alittle bit better at night, and we found leverage levels to stillbe quite attractive. We're not looking to finance a lot, though.We'll finance anywhere from 50% to 65% percent LTV and, really, thenet lease business is a spread investment, with cap rates tracking10-year swaps.

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ADER: I'm surprised interest rates haven'trisen more than they have, and they're probably being held downartificially. Rates over the next couple of years are going toincrease fairly significantly, which is a good thing because thatmeans the economy is doing better. The corporate economy is doingvery well. Expenses are being controlled. Earnings are up. Thereare some pretty good stories out there.

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Sule Aygoren

Aygoren oversees the editorial direction and content for ALM’s Real Estate Media Group, including Real Estate Forum and GlobeSt.com. In her tenure with ALM, she’s held roles of increasing responsibility, including Managing Editor. Aygoren has received several awards for her coverage including Best Trade Magazine Report from the National Association of Real Estate Editors and the James D. Carper Award for Young Journalists. Under her direction, Forum has received four national NAREE awards for Best Commercial Real Estate Trade Magazine.