Investors Look Outside California for Single-Tenant NNN Assets

MCALLEN, TX—Three recent transactions represent a rising trend of local investors looking outside of California for a particular asset class. MetroGroup Realty Finance recently provided a total of $11.75 million in financing to private investors for three separate 1031-exchange transactions involving the acquisition of four single-tenant triple-net lease assets in Illinois and Texas, which represents a larger phenomenon, according to JD Blashaw, vice president of MetroGroup Realty Finance.

“Cap rates have compressed and, consequently, yields have declined significantly in California, so we are increasingly seeing local credit tenant net lease investors seeking higher cap rates and yields on their investments,” says Blashaw. “This search has taken them away from their back yards into other states and sometimes secondary markets, and the passive nature of triple-net leases matches well with these investors desire to own properties with little or no management obligations.”

The credit tenant net lease market has perennially been attractive to 1031 exchange buyers seeking safe, long-term and passive investments for their capital, Blashaw says. Due to limited supply and increased competition in the Southern California market, local investors are receiving premium prices on the sale of commercial properties. However, those same factors are creating headwinds for investors seeking attractive yields on the upleg of a 1031 exchange while trying to remain in home markets.

“Many California investors make credit tenant net-leased investments in markets outside of their area to some extent to diversify, but to a larger extent, to seek higher yields,” Ivan Kustic, vice president of MetroGroup Realty Finance, tells GlobeSt.com. “We’ve seen this firsthand as we often finance the sale of nationwide portfolios of investment-grade tenants across the country. We see the same tenant, size and age of building, as well as the same lease term in a variety of diverse markets.”

Purchases outside of investors’ local markets is also a result of a shortage of supply of high quality net-leased investments, Kustic says.

“The shortage of supply is largely driven by strong competition in the space for good credit, net-leased properties with long lease terms in place,” he tells GlobeSt.com. “Beyond this, coastal community values are often affected by a lack of available land. Many Northern and Southern California cities are geographically restrained for expansion. There continues to be a large flow of capital to net-leased investments including US institutional funds, foreign capital and individual 1031 exchange buyers. That said, sellers are being extremely cautious in qualifying the buyer. If a buyer requires financing, they are often given very little time to procure it.”

The price ranges for Coastal California are 5% to 5.25% cap rates, in major metropolitan areas are 5.5% to 5.75% cap rates and smaller metropolitan areas are 6% to 6.25% cap rates. The major factor in the pricing tiers is perceived rent growth at lease expiration in the higher-priced markets, Kustic says.

“We recently financed the acquisition of a new 15-year lease by DaVita Inc. (Moody’s Ba2) dialysis center in Donna, TX,” he tells GlobeSt.com. “The property traded at a 6.1% cap rate. Similar new DaVita leases in Southern California are trading in the 5% to 5.25% range. That is an approximate 20% increase in yield and cash flow with the same credit risk.”

Kustic says investing in credit tenant net-leased properties is generally considered a safe strategy, however, every investment has its inherent risk.

“We have seen several credit tenant net-leased properties decline in value,” he tells GlobeSt.com. “We have seen this erosion of value as a result of creditworthiness of the tenant changes (Kmart, Blockbuster), sales near lease expirations and changes in tenant space requirements or use (online sales effect, drive-thru). The fact is, even though investors have the security of a long-term lease with an investment-grade tenant, it is extremely important to make sure the fundamentals of the property are there regardless of who the tenant may be.”

Kustic says Texas is emerging as an attractive environment for real estate investors for many reasons. “One of which is that Texas is the leading destination for companies relocating from out-of-state,” he tells GlobeSt.com. “Large companies from across the US are migrating to the region and this is something that is expected to continue over the next several years.”

In addition to this migration, there are several other factors that make Texas a strong market, Kustic says. It led the country in exports at $315 billion in 2018, it is the 10th largest economy in the world, 50 of the Fortune 500 companies are located in Texas, 100 of the 1,000 largest US companies are located in Texas, 290,000 jobs were added in 2018, Texas is one of the largest US energy producers, Texas has no personal or corporate income tax and it offers affordable housing options compared to East and West Coast states.

“There are also many great metropolitan areas in Texas that offer varying lifestyles and opportunities,” Kustic tells GlobeSt.com. “All of the national lenders that MetroGroup represents consider Texas a safe and desirable market in which to make mortgage investments.”

In addition to geographic diversification, credit tenant net lease investors are also eyeing transactions with features that drive yield in other ways, such as more specialized properties, i.e., bank branches, shorter lease expirations and more complex asset classes such as retail, says Blashaw.

“While sourcing debt for transactions that might be perceived as riskier can be challenging, features such as strong sponsorship, conservative leverage, strong cash flow and tenant creditworthiness appreciably counterbalance that risk and make loans like these attractive for lenders,” says Blashaw.

The firm arranged financing for the following properties:

1006 E. Interstate 2, McAllen, TX: MetroGroup Realty Finance provided $2.55 million in permanent financing to a private investor for the purchase of a 10,050-square-foot medical office building as part of a 1031 exchange transaction. The property was developed in 2017 by the seller, DaVita Inc., the real estate division of the tenant, and is fully occupied by DaVita Dialysis in the sale/leaseback arrangement. The 10-year fixed rate loan at 70% loan-to-value features a 25-year amortization and limited recourse. The loan was arranged by Blashaw and Kustic of MetroGroup Realty Finance.

“Private investors in 1031 exchanges are seeking reliable assets and need to place their money somewhere, but with spreads shrinking in California, deals in markets like Texas backed by a national investment-grade tenant like DaVita Dialysis make a lot of sense,” says Blashaw. “MetroGroup worked with a familiar capital source with a national lending platform specifically tailored for credit tenant net lease transactions that could provide aggressive, long-term fixed-rate financing in a tertiary market.”

5001 N. Big Hollow Road, Peoria, IL: MetroGroup Realty Finance provided $5.8 million in permanent financing to a private investor for the acquisition of a 46,432-square-foot stand-alone retail building at 5001 N. Big Hollow Rd. in Peoria, IL as part of a 1031 exchange transaction. The property is fully occupied by a Best Buy retail store. The 6.25-year fixed rate recourse loan at 75% loan-to-value features a 25-year amortization and a flexible prepayment provision that expires after three years. The financing was arranged by Blashaw and Kustic.

“Private investors prefer the lower risk profile of national credit tenants like Best Buy for 1031 exchange transactions—particularly out-of-state transactions where they may not be as familiar with the market and/or tenants,” says Blashaw. “MetroGroup leveraged its long-standing relationship with a lender who has a strong presence in Orange County but is based in the Midwest. The lender was able to get comfortable with the asset due its proximity to the lender’s home base and provide the necessary leverage and competitive rate to meet the client’s investment objectives.”

4160 S. Archer Ave., Chicago, and 601 N. Harlem Ave., Oak Park, IL: MetroGroup Realty Finance provided $3.4 million in permanent financing to a long-time private investor client for the purchase of two TCF Bank branches in the Chicago market, including $1.825 million for a 2,542-square-foot property at 4160 S. Archer Ave. and $1.575 million for a 2,700-square-foot property at 601 N. Harlem Ave. Part of a 1031 exchange transaction, the properties, which are 100% occupied by TCF Bank, were sold by Chicago-based Clark Street Real Estate. The loans were a combined 47% loan-to-value and feature a 10-year fixed rate and 30-year amortization. The financing was arranged by Blashaw and Kustic.

“Buyers are drawn to credit tenant net lease transactions like this one because of the inherent stability of this asset class and long-term occupancy by creditworthy tenants,” says Blashaw. “MetroGroup identified a capital source with a national lending platform that was comfortable with an out-of-state borrower, provided aggressive, long-term fixed rate terms and was able to meet the exchange timeline. This lender also has an expertise with single credit-tenant leases and was comfortable with the bank branches as collateral.”

Risks associated with net lease single-tenant deals are similar to those of any other income-producing real estate, but the significant risks are fewer. But fewer major risks does not eliminate the need for thorough due diligence and review of the investment prior to purchase. To understand risk and select the right investment property, a complete due diligence review prior to purchase should consider vacant or dark property value, lease length, the area’s economy, tenant type and the credit rating of the lease guarantor, according to George Renz, owner/operator of Renz & Renz Investment and Commercial Brokerage in Gilroy, CA.