For assets leased by essential service providers, the cap rates haven’t changed, says one market insider. “But if there’s any kind of hair on the deal… it’s not doing well.”
The net lease retail sector boasts a reputation for being a solid investment with high-credit tenants and low default rates. Similar to bonds, during normal times, net lease properties offer long-term, stable and predictable returns.
However, in the face of the COVID-19 pandemic and government-mandated shutdowns, what does the future hold for this asset class? Investors in net lease properties have significant exposure to retail, restaurant and experiential categories, which are facing some of the fiercest challenges during the crisis.
The sector, however, is coming off a healthy year of transaction activity.
“Revised numbers for 2019 in the net lease retail sector exceeded $18 billion in investment sales, making it the second-highest annual total on record,” says Lanie Beck, director of research at Stan Johnson Co., which specializes in net lease investments. That’s shy of the $20 billion reported in 2015.
However, deal flow is now slowing significantly following the threat of COVID-19 as the financial markets react and investors reevaluate their strategies.
While first quarter 2020 totals have yet to be finalized, preliminary stats indicate that net lease retail sales volume will exceed $2.3 billion, which is lower than the quarterly average seen in recent years, Beck notes.
Strong net lease transaction momentum was evident in the first two months of 2020, reported The Boulder Group, a net lease investment advisory firm, in its First Quarter 2020 Net Lease Market Report. However, late in the first quarter, activity dropped and the number of net lease retail properties on the market fell by 16.2 percent from the fourth quarter of 2019, from 3,895 to 3,264.
At the end of the first quarter, Boulder reported that primary interest in net lease investments was from private investors and 1031-exchange buyers.
“The most active group of buyers is 1031 exchangers,” Beck notes. “While some extensions have been granted, there are still many investors who have closed on their down-leg and are actively trying to identify their replacement property.”
Activity expected to decline further
Property listings and transaction volume are projected to drop further in the second quarter as many investors adopt a wait-and-see approach, waiting for the markets to stabilize. Due to the uncertain environment, many REITs are sitting tight.
Both the strip center and triple-net REITs have “rallied materially based on incremental positive news about progress with the current pandemic,” according to a published research note by financial services firm BTIG. However, shares are still down significantly year-to-date, and the “economic damage from the virus response could linger for long after the acute phase of the crisis is over.”
“From what we’ve seen on our public REIT side, most of them have suspended their investment guidance, but we’ve talked to them and that’s not the same as saying they’re not looking,” says Michael Gorman, managing director and REIT analyst at BTIG. “They’re still talking to their contacts. They’re still examining deals. They’re still in the deal flow.”
“The market is still out there,” Gorman adds. “It’s just a little more tentative and things will take longer that they would otherwise. And we shouldn’t ignore the impact that there’s probably a pretty significant bid-ask spread in the property market right now.”
A big part of the challenge of the COVID-19 crisis is that it’s all happening at once, Gorman notes. It’s hitting multiple business models, including restaurants, different retailers not classified as essential, entertainment concepts and commercial service providers.
“While there are varying degrees, at last count there were 47 states that had varying restrictions on non-essential businesses,” Gorman says.
One of the biggest issues facing net lease investors and triple-net REITs is that they know how to deal with a tenant bankruptcy, a vacancy, even perhaps business shutdowns in certain regions because of national disasters, but “this is unprecedented.”
Net lease investors are closely examining how different retail tenants are likely to hold up during COVID-19-related shutdowns. Experts agree that essential retailers aren’t going anywhere as they remain open, and many are performing well.
“This is a trend that’s going to be really important going forward for investors,” Gorman notes. “I can tell you the REITs are definitely thinking about positioning their properties and portfolios to have more of that essential component.
“You’re talking about drugstores, dollar stores, grocery stores, convenience and gas stations, and one of the big surprises that was a little bit concerning in the beginning, is quick-service restaurants (QSR) are holding up very well, especially locations with a drive-thru,” he says.
BTIG hears from its restaurant analyst and QSR companies that a well-positioned fast-food restaurant with a drive-thru is running at about 80 percent of typical sales volume.
Additionally, automotive, home improvement and hardware stores fit in the essential bucket. On top of that, medical retail is faring well, as long as it houses essential providers like emergency rooms, dialysis facilities or veterinary offices, Beck notes.
‘Essential’ deals are occurring
Net lease-focused investment brokerage firm B+E executed a listing agreement this week on a portfolio of 17 7-Eleven stores in Texas for $84 million, says Camille Renshaw, CEO of B+E. She also has three Cabela’s stores under contract.
“Within certain categories, it’s incredibly active,” Renshaw notes.
Many essential retailers are strong, she says. “That’s the story and the pricing for these deals is around a 4.5 to 5.0 cap rate,” Renshaw says. For many essential services properties, the cap rate hasn’t changed.
“These are long-term deals. But if there’s any kind of hair on the deal, if they’re shorter term or the wrong credit, it’s not doing well. But when it’s a strong investment-grade credit, essential services, 10 years of term or more, those things are doing very well.”
The flight to quality is a key dynamic in the market right now. “Opportunities are strong for sellers with A++ properties and locations, as there’s a lot of demand for high quality assets from those buyers still active in the market,” Beck says.
There’s significant pent-up demand by investors, according to Renshaw, and she anticipates a surge in deal activity by the fourth quarter, after some normalcy returns.
“Realistically, we went into this thing well-capitalized,” she says. Now net lease owners and REITs are trying to figure out their tenant negotiations, and as soon as they have a clear sense from May 1 rent payments, they’re going to be back out on the market by the end of May, she says. That will push for third and fourth quarter activity.
“There’s a lot of money on the sidelines,” Renshaw notes.
Experiential, non-essential tenants struggle
“Non-essential businesses are feeling an immediate impact,” Beck says. Nationally, fitness centers, malls, clothing retailers, entertainment-focused retailers, and many service providers like salons have been closed for weeks, she points out. Many restaurants are also seeing revenues decline significantly.
Experiential retail has been a big focus across shopping centers and malls as landlords battled mounting e-commerce competition. COVID-19 has pretty much stopped the experiential trend dead in its tracks as these businesses have been shut down.
“That’s one of the real kicks in the teeth for some retailers, and not just triple-net, but for strip centers,” Gorman says.
Additionally, will people feel uncomfortable going back to experiential retailers, service retailers and restaurants after the restrictions are lifted?
Gorman points to a recent ICSC survey, which polled 1,004 Americans about their expectations after the pandemic ends. More than half said they’d get their hair or nails done, go to gyms, or get massages following the lifting of the national emergency, reported Chain Store Age.
Around 70 percent said they would feel comfortable dining at restaurants. “That’s good, but don’t forget that’s still a 30 percent drop from where it was,” Gorman notes.
He says tenants are going to need a business plan that makes people comfortable, and that plan may require some reductions in rent, “because if you’re a theater, and all of a sudden, you can only fill every other seat in every other row, your revenues and business model are going to look very different.”
And is the theater staff going to have to thoroughly clean the theater between every movie and wipe down every seat? Gorman asks.
“You think about the indoor entertainment value: Who’s going to put their hand in a bowling ball in a bowling alley? And gyms and fitness centers fit right into that category, too. You’re sharing machines. You’re sharing locker rooms. All of that is going to be really challenged.”
Going forward, investors will be more aware of the potential risk of experiential properties now that a pandemic has occurred, Gorman says..
“Real estate investors can be bullish or they can be bearish, but they should not underestimate the potential that this is going to have a long-lasting impact,” he adds.