Not Overheated, Just High-Velocity

While recent economic numbers have shown the US economy may be picking up some steam, most real estate observers believe that investors will continue to flock to the less-risky segments of the market. While the pundits' top choice remains multifamily, a growing number of investors seeking to secure predictable returns on their capital will also have net lease properties high on their list.

The net lease segment was one of hottest performing sectors in real estate in 2011, so much so that some have wondered if net lease and sale/leaseback investments could cool off in 2012. Four top leaders in net lease brokerage and investment tell Real Estate Forum that scenario is unlikely.

Shelby Pruett, chairman and CEO of Chicago-based Equity Global Management LLC, believes that net lease and sale-leaseback investment will continue to attract investors . In 2011, Equity Global's main focus was in the disposition of net lease properties. This year the firm—a private equity investor that focuses mainly on the net lease, saleleaseback and build-to-suit real estate markets—has a much different game plan.

Pruett was co-founder and managing principal of Equity Capital Management, a predecessor firm that was also engaged in net lease investment in the office, industrial and retail sectors. In March 2011, ECM Realty Trust, an entity Equity Capital formed to go public, sold most of the firm's net lease assets to Realty Income Corp. in a deal valued at more than $500 million.

In 2012, Equity Global has taken a seat on the other side of the table and is now looking to purchase net lease properties once again. Pruett reveals that the company, whose portfolio consists chiefly of investment-grade net lease office properties, is currently considering the purchase of up to approximately $400 million in mostly investment-grade industrial properties from multiple buyers. A majority of the properties involve build-to-suit development projects where Equity Global will provide mezzanine or preferred equity financing and eventually be the take-out buyer upon completion of the project. Those projects are in development and are expected to come online in 2012 or 2013. Equity Global is also looking at a couple of large sale/leaseback opportunities as well.

In terms of the overall industry, Pruett says that net lease/sale leaseback continues to be a niche or "sleeper sector" for investors that is garnering more attention as a safe haven with predictable returns.

Likewise, Marilyn Kane, founding partner and president of New York City-based Iridium Capital LLC, a $100-million hedge fund founded in October 2010 that specializes in net-leased retail assets, says that despite increased press coverage, singletenant net lease is still considered an "alternative investment." Kane believes that investors still need to be educated as to why net-leased properties would be a "terrific asset in one's portfolio." Thus far, Kane says that approximately $10 million of the fund has been invested in near-investment or investment-grade net lease properties.

Miami-based United Trust Fund had a "reasonable year," according to senior vice president Fred Berliner. UTF, which specializes in corporate sale-leasebacks and build-to-suit transactions in a variety of sectors, announced this past August a deal involving the funding and long-term leaseback of a 196,000-square-foot build-to-suit orthopedic hospital in Springfield, MS and a 225,000-square-foot medical office building in Edmond, OK for the Sisters of Mercy. The two projects were valued at $203 million and are currently under construction.

Competition in the sector, especially from REITs, has grown considerably in the past two years due to the troubled economy and the penchant for investors to seek out solid, predictable returns on their investments, says Berliner. "All of a sudden everyone is in the net lease business."

Yet while the heat's certainly on, he's not concerned about a bubble forming, for now. "Yes, yields are going down, but that's a factor of low interest rates and heavy demand," Berliner says. "It's not overheated; it's just very popular."

Kane, too, believes the prospect of the net lease sector overheating is negligible even though firms such as Iridium are achieving more than 7% returns. Her fund's 2012 investment goal is approximately $15 million to $20 million. "The fact of the matter is, we know going into these properties the long-term rental rates, what the value will be going forward with the lease and how that will accrue to the investor," she says.

When asked whether the high investor interest in net lease will ultimately send prices skyrocketing, Pruett says, "As we have seen over time, all markets are cyclical. If one employs the right strategy and is disciplined, you can avoid or structure investments to ride through overheated markets. I do think there will be geographic centers that overheat, which has been the case historically—these have often been the coastal regions. But this has been true in all asset classes, whether or not they are net lease."

Pruett notes that many of his firm's existing assets or acquisition targets are regional hubs, distribution centers, corporate headquarters or large call centers that are not located in coastal core markets. "They're in the middle of the country, where there's less volatility," he maintains, adding that while there are barriers to entry in some of these locations, "the cost of the workforce that a lot of these corporations assemble in those markets is very hard to replicate elsewhere, which makes these buildings have high renewal probabilities."

The likelihood of the market overheating is slim, says Tom Williams, co-founder and managing partner of Paragon Real Estate LLC of Oak Brook, IL. That's especially true, he notes, because there's been very little new net lease development or redevelopment compared to the heady days of 2005-2007.

Formed in 2009, Paragon specializes in acquiring, developing and managing retail and industrial net lease and seniors housing facilities nationwide. The privately held company is backed by a $200-million net lease fund, of which $10 million has been invested in several retail facilities and one assisted-living asset. "There's still going to be strong demand for well-located, quality net-leased properties that have strong investment-grade tenants with good lease terms," Williams contends. "If you have all those three elements, you'll definitely find investors and buyers for the property."

In the retail sector, competition in his firm's niche—net-leased properties in the $1-million to $5-million range—will continue to be fierce, he points out. "A lot of developers who in the mid-2000s were focused on larger developments have now scaled back and gone after the single-tenant or small multi-tenant, net-leased development projects because they're less risky and easier to finance," says Williams.

He expects growth from the auto parts/ service sector from retailers such as Auto Zone, Advance Auto, Bridgestone and Firestone. "Those guys will still expand," he relates. "They're feeding off the slow economy, which is causing people to hold onto their cars longer." Similarly, discount retailers such as Dollar General and affordable fitness chains will also be growing in 2012.

On the industrial side, Paragon is also hoping to increase its share of warehouse/ distribution acquisitions in select markets. It's also looking for new development or existing warehouse/distribution product that ranges in size from 100,000 to 500,000 square feet. He adds that the company is seeking value-add opportunities that involve some lease-up risk or redevelopment. "Development volume is going to increase slightly, but there still aren't many tenants out there saying, 'We're going to go gangbusters and open a ton of new facilities across the US in 2012,'" Williams notes.

Several factors hold back sale-leaseback development at the moment, including the continued low interest rate environment that's causing some corporate real estate executives to take considerable time pulling the trigger on new projects. "To the extent that there is any upward pressure on interest rates, you'll see a lot more people making decisions to move forward with sale-leasebacks," Berliner notes.

Activity in the corporate sale-leaseback sector picked up in the latter part of 2011, he says, and 2012 should see growth from the government sector as many federal, state and local entities forced to engage in property consolidation programs turn to sale-leasebacks to help control costs.

Those involved in such consolidation campaigns and companies in expansion mode alike can find ample opportunities in the sale-leaseback sector, asserts Pruett. Barring a major economic incident, he believes net lease volume will continue to be high in 2012, with further cap rate compression.

Iridium Capital CFO Sean Shanahan expects to see interest in net lease from a variety of sources, including investors exiting real estate partnerships, long-term development deals and tenant-in-common entities that are breaking up and seeking to avoid capital gains tax by entering into 1031 exchanges. This, he believes, should continue for the next two to three years. "Net lease has been the go-to asset class for people doing multi-layered 1031 transactions," he notes.

As an example, Shanahan cites an apartment owner who sells his property at an attractive price but cannot find a suitable replacement property to add to his portfolio. Instead, the investor buys a net-leased Walgreen's or CVS to hold onto for 12 to 18 months until it adds the second leg of the 1031 exchange with the purchase of another multi-family property. "There's a consistent number of purchasers who are buying these assets that really don't have any interest in the asset itself other than a placeholder of value," he says.