Where California Buyers Go for NNN Yield

LOS ANGELES—The California net-lease market is hot, which is driving up prices and compressing cap rates as compared to cooler markets, Colliers International's EVP, retail investments Christopher Maling, and AVP, investment services and co-chair of the Colliers Net Lease Group Peter Bauman tell GlobeSt.com. We spoke with Bauman and Maling exclusively about how California-based buyers can get better yields and the benefits of owning multiple locations of the same brand.

GlobeSt.com: With an estimated 35% of national NNN buyers based out of California, according to your firm's research, how can locals compete for these deals?

Maling: First, let's look at the appeal of this asset class. What we're seeing is a generational shift of real estate, for a couple of reasons. First, for estate-planning purposes private clients—individuals or high net worth investors—are looking at preserving capital for the next generation that will be inheriting the real estate and they do not want them to be burdened with the asset- or property-management issues of multi-tenant properties. The other determination for the flight to NNN assets is that existing operators say they've had enough of being an active owner/operator of multi-tenant real estate. They're looking at simplifying their life, and usually something is a trigger: for example, either they themselves, a family member or friend or someone they know has had a change in their life—a health issue, death or other occurrence that's a wakeup call. They need or want to spend more time with family, travel and do things that are on their bucket list, so they're migrating to single-tenant investment properties to give them that freedom. The way the lease is structured with NNN deals is that there's no landlord obligation, and it's strictly a tenant's responsibility. Owners still get their yield, rental increases allow growth of income, and when it's secured by a national tenant or a franchisee with a track record, it's a desirable asset.

Why is California a major source of capital looking to buy these types of assets? It has to do with yield. In California, yields for these types of investments are compressed compared to other parts of the country. 7-Eleven properties outside of California trade between 5% and 5.7% cap rates, but those same properties in various submarkets of California are trading at sub-4% returns. So, if yield is important to the client, they need to look elsewhere. The difference can be anywhere from 100 to 175 basis points better in terms of overall return.

Bauman: There's a flood of investors in today's global economy. With so much uncertainty in different investment vehicles, the net-lease sector provides stability and long-term investment return for clients. We're not only seeing money coming from within California, but also foreign capital and institutional groups. Everyone is chasing down these yields.

Maling: A lot of people don't look at this as underwriting criteria, but in California, we have incredible rent growth, so there are situations where leases executed 10 to 15 years ago are 50% below market today. There's a lot of value creation in rental growth,alone, but in certain markets like the Midwest and Texas, rent growth is becoming flat. If you're in a suburb or secondary market like Oklahoma, you're not going to see much rent growth for 10 to 20 years, or if you do, it's modest. Locals say they need a better yield because they're not going to get better rent growth.

Bauman: When it comes down to purchasing a net-lease asset, I consider it a seller's market. They're setting new cap-rate records on sales day over day. My advice to clients is that cash remains king. If they're able to purchase all cash and place debt on it after the closing, that's going to be better received than an offer contingent on financing. We recommend clients show proof of funds and shorten up due-diligence time frames to make their offer more attractive to the owner.

Maling: If a client sells a very desirable West L.A. apartment building at a 3-cap, and we put them into a group of 7-Elevens at a 5% to 5.5% cap, that's a 2% to 2.5% spread on returns. They may be paying more, but they can control the real estate. Also, they know the tenant and the location, and they'll have rent increases. This client is better off because they sold high and are buying low, which prices everybody else locally out of the marketplace. That's the reasoning behind California-based money today. The key thing: A lot of buyers are using the IRS code 1031, and there's pressure to buy because they have deadlines to close. A lot of people don't have the luxury of negotiating, so if a seller knows a buyer is in an exchange, they know they can hang tough on pricing because there's a motivated buyer there. At the end of the day, the market changes day to day, year to year. What you buy today will have different cap rates in 10 to 15 years. We're making sure people are executing strategically and efficiently to maximize profits. The tax liability would far greater exceed the differential on pricing if they're negotiating 25 to 50 basis points.

DIVERSIFYING MARKETS

GlobeSt.com: What is the benefit of owning multiple locations of a brand in different markets?

Maling: It's similar to dollar cost averaging in the stock market. If Rite Aid stock has gone from 35 cents to $8, and you bought it at 35 cents, you keep buying along the way and adding to your position. It's the same with single-tenant investing. If you like Wendy's or 7-Eleven as an operation and would like to own in tax-free states like Florida or Texas, you might be able to do better on a cap rate by 25 or 50 basis points depending on the lease terms. You're saying you're sold on the company, but you're spreading your investments in various markets to get the benefit of tax-free states. There's an inherent benefit to the investment, and you might be able to pick up a 25-to-50-basis-point spread differential.

Bauman: We're seeing this all across the board, from individual investors to institutions. It's a practice more dominated by institutions because they have more capital to place. When you buy in other markets, it eliminates the risk of a geographic recession. When you buy in only one market, you have a geographic-recession risk. By diversification, you mitigate that risk. Of course, it's always best to evaluate the credit of the tenant and how the rent compares in the specific market in which you're investing.

GlobeSt.com: We hear that small-capital equity firms are now buying up product. Where do you see this trend leading?

Bauman: We continue to see all buyer profiles purchasing product, but specifically with small-capital equity firms, it's further compressing cap rates in the net-lease sector. Some specifically buy Rite Aid assets, and Rite Aid assets are trading 150 to 200 basis points lower than where they were in 2013. It's indicative of small-capital equity groups driving product-type cap rates lower and creating more value for owners.

Maling: The cost of capital for these equity shops tends to be lower, so they can buy portfolios all at once and get a large spread. They take down a portfolio and exit in tranches of smaller batches or individual sales and compress 200 to 300 basis points. It's a very simple model in order to make money.

Bauman: As long as the Feds continue to change their minds on when interest rates are going to rise—they've kicked the can down the road two times this year, and if they don't do it by the third quarter, they won't do it during a Presidential election year. Therefore, interest rates are probably not going to rise until 2017, which will continue to compress cap rates in the net-lease sector.

GlobeSt.com: What else should our readers know about the NNN-leased market?

Bauman: Stay true to real estate fundamentals. At the end of the day, you are buying a piece of real estate. Yes, tenant credit is important, but keep a pulse on the market and have a resource in the market that serves as a sounding board.

Maling: It comes down to real estate. Good real estate will always be good real estate no matter who the tenant is. As we've realized in the last 10 to 15 years, who would have ever thought that Circuit City and Borders Books would become extinct? But we will continue to see that trend. And if it's good real estate, you will be able to backfill that space. People get hurt in the single-tenant net-lease sector when they don't have a pulse on the market and there are shifts, either in major employment generators or traffic flows due to new highways, or there are concepts that are going to fail because of technology, or there is other competition taking over. Back in 2004, Borders was a $4 billion to $6 billion company, and within four years, it was filing Chapter 7.