The Search for Yield Ends Here

Investor demand for U.S. net-lease product remains strong, with 2016 transaction volume of $53.6 billion the second-highest annual amount in the past 15 years.

Net-lease transactions are also increasing as a share of total annual investment, rising from an average of 12.4% between 2001 and 2007 to 20.2% between 2008 and 2016.

Strong Investor Appetite Maintains Pricing Pressure

Despite rising 10-year Treasury rates and marginal softening in net-lease cap rates, spreads remain in line with long-term averages, ranging between 300 and 400 basis points (bps) depending on asset specifics. With further increases in long-term rates expected, spreads are likely to be under pressure given the long-duration hold period for net-lease assets. Furthermore, investors are likely to become more selective on asset type, lease terms and credit quality.

While private buyers remain the dominant buyer group, accounting for a stable 40% market share in the past four years, the net-lease segment is becoming more appealing to institutional and cross-border buyers.

Analysis of CBRE-Brokered Net-Lease Retail Investment

Retail is the strongest performing net-lease asset type, with the highest returns in the medium (five years) and long term (20 years). The sector accounts for 27% of net-lease transaction volume and is the most actively traded by number of properties. Drugstores and casual-dining properties represent about half of total transaction volume, fueled by favorable consumer trends and opportunities for sale-leasebacks.

Analysis of a sample of $3 billion in CBRE-brokered investment sales of net-lease retail properties and portfolios in 2016 reveals:

  • The average cap rate was 6.63% and ranged between 5% and 10%, reflecting continued investor appetite for deals with a range of price points.
  • The remaining length of lease term at the date of purchase impacted cap rates significantly. The average cap rate for properties with more than 10 remaining years was 189 bps lower than the average for properties with less than five years.
  • The net-lease retail segment remained fairly stable through market volatility and rising interest rates in late 2016, with minimal movement in transaction volume and cap rates throughout the year. There was a gradual increase in the time taken to close deals, possibly as a result of increased due-diligence requirements.

Significant Wall of Equity Capital Chasing U.S. Real Estate

Investor interest in the net-lease segment should remain strong in 2017, as capital availability—particularly from institutions—remains high. Institutional investors are under-allocated to real estate by about 130 bps in the Americas,[1] and Preqin estimates that total available capital for close-ended funds in North America is at an all-time high ($144 billion, Feb 2017).

Headwinds from Debt Market and Tax Reform

Two of the challenges facing the net-lease segment in 2017:

  • Debt market conditions: Lending volumes face headwinds in both CMBS and bank markets, as risk-retention rules affect not just appetite for construction lending but also higher-risk deals. Rising interest rates also present increasing pricing pressure—market observers, including CBRE Econometric Advisors, expect the 10-year Treasury to approach 3.0% by year-end 2017. Investors are likely to become increasingly selective on asset type, lease terms and credit quality to best absorb changing debt metrics.
  • Potential tax reform:  Uncertainty surrounding proposed tax reforms raises key questions for the net-lease segment, particularly retail. Shifts in investor appetite could occur due to changes in tax rules for 1031 exchanges, income classification of net-lease income and limits on mortgage interest deductibility that could alter lease vs buy mechanics. Additionally, the proposed Border Adjustment Tax on imports could dramatically impact retailer profitability, especially apparel retailers, and the real estate demand from these tenants.

On balance, given the weight of capital currently in the market and favorable macroeconomic and consumer trends, the net-lease segment is expected to remain a strong investment option in the near term, albeit with some pricing pressure.

By Revathi Greenwood, Americas Head of Investment Research, and Taylor Jacoby, Senior Research Analyst, CBRE.

[1] Cornell Hodes Weil, 2016.