Fire. That’s the word Ralph Cram, president of Envoy Net Lease Partners in the Chicago suburb of Northbrook, Illinois, uses to describe the net lease market today.
Yes, the net lease business did take a hit during the earlier days of the COVID-19 pandemic. Investors were hesitant to sink their dollars into any property, including net lease ones.
But that began to change this year. As Cram says, the investors came back to net lease assets in a big way starting in early February.
“Starting in early February, the market just got on fire from an investment point of view,” Cram said. “Last week, we worked with a property that generated multiple offers within hours. That tells you how much activity is out there. A lot of people are looking to buy net lease properties.”
Cram isn’t alone. Other CRE professionals are seeing a steady rise in net lease activity. What’s behind this increase? We spoke with two net lease pros, Cram and Simon Jonna, executive vice president with the Birmingham, Michigan, office of Colliers, to find out.
Not enough supply and a threat to 1031 exchanges
Cram said that part of the reason for the higher demand in the net lease space is a lack of supply. During the pandemic, a lesser amount of net lease space hit the market. That has naturally driven up demand.
Then there is the threat to 1031 exchanges. During his campaign for president, Joe Biden floated a proposal to kill off the 1031 exchange program as part of his larger plan to finance child and elder care programs.
This spooked many investors. Cram said that several are now rushing to sell and buy properties before the tax incentives of the 1031 exchange program might disappear. That, too, has spurred activity in the net lease space.
“There is a shortage of new product on the market and there is probably the highest demand for net lease properties that I’ve seen since 2014 or 2015,” Cram said. “There are two areas that are red-hot right now for real estate investors: industrial and net lease. Those are the dogs that are hunting right now. This where lenders want to lend.”
Like all net lease professionals, Jonna hopes that the 1031 exchange program survives. If it goes away? It could seriously hurt the commercial real estate profession, he says.
“If the 1031 exchange program is eliminated, before you know it, real estate becomes a purely black-and-white business. There won’t be any creativity left,” Jonna said. “One of Michigan’s most prominent landlords told me this. He said that our arena no longer becomes a business, it will no longer be a trading game. You just transact. If you decide to sell, you just cut a check to Uncle Sam. I’m hoping this doesn’t become the case.”
Jonna said that eliminating the 1031 exchange would go against what capitalism stands for, and would hurt the U.S. economy.
“It would be a very anti-capitalist approach. I am a big proponent of capitalism and free markets,” he said. “I am totally against any fiscal policy that would take away the 1031 exchange. If you take that away, you inhibit tax deferment, and tax deferment spurs economic growth.”
Jonna said that he, too, is seeing a supply shortage in the market today. And that shortage has resulted in a rise in activity.
“As of late, the velocity of deals has improved,” Jonna said. “Trading velocity has gone up. And we haven’t seen too much of a cap rate discount. Cap rates have remained fairly level.”
Jonna said that most retail tenants have continued to pay their rent during the pandemic. As COVID-19 cases continue to fall and more people get vaccinated, the performance of the retail end of the net lease sector has continued to improve.
This is good, and somewhat, surprising news.
“I am surprised at how resilient commercial real estate has been during this,” Jonna said. “Everyone was wondering if this was going to be the worst retail apocalypse that we’d ever seen. Was it going to be like 2009 and 2010? That possibility was there, right in the midst of the space that I work with. But it never took place.”
And the best performers during the pandemic? Any business considered essential — especially grocery stores and drug stores — has done well, Jonna said. Even dollar stores have thrived, often because many of them also carry food items and groceries.
The cream of the crop
Of course, not all net lease properties are equal in the eyes of investors. Cram said that investors are especially interested in net lease spaces with strong tenants on leases of 10 years or more.
Jonna has worked in the commercial industry long enough to see how investors have valued properties over time. During the Great Recession, for instance, investors wanted to sink their dollars into properties that were recession-resistant. Then investors targeted properties that could withstand the rise of online shopping, most notably retailers and restaurants that sold experiences that consumers couldn’t get from Amazon.
And today? Investors have an appetite for net lease properties that are pandemic-resistant. Again, this mostly includes essentials such as grocers, drug stores and restaurants that offer robust carry-out, delivery and pick-up services.
“You saw the surge in business that grocery stores, liquor stores, dollar stores and other essentials saw during the pandemic said,” Jonna said. “That trickled down into the investment arena. These are the properties that investors wanted part of it.”
Some net lease properties have seen their popularity among investors rise during these later days of the pandemic after struggling to attract dollars earlier in the COVID cycle. Cram pointed to daycare centers and gyms as two examples.
“These types of properties were untouchable last year but are now getting bids,” Cram said. “I just talked to one broker who had 15 daycare center assignments at the beginning of the year and is now down to two. That is how fast the recovery is happening.”
This doesn’t mean that there aren’t any untouchables left. Cram said that movie theaters are a good example: They aren’t attracting investment dollars today.
But overall? The net lease market is growing stronger, Cram said.
“I would think that the hardest thing for brokers today is to find product to sell,” he said.
Jonna said that the future looks bright for net lease. He said that investors are waiting for the next wave of net-lease retail opportunities to hit the market.
“Barring any geopolitical problems, I expect we’ll see an increase in investment in net lease during the next several months,” Jonna said. “Ever since the start of the pandemic, the smart money has been waiting patiently for opportunities to invest. The supply of high-quality assets with long-term leases remains very tight.”