Commercial real estate’s net lease sector is a very popular investment vehicle for groups wanting to get into the industry to own assets but don’t want the responsibility of managing or operating a building. To stay on top of the latest net lease trends, GRS Group’s Barry Bain and Andy Brownstein attended the recent InterFace Net Lease conference in New York City. Among the many topics that interested them was the trend of net lease investors looking at other countries to place capital due to increased domestic commercial real estate competition. Following is a discussion about what they felt were some of the most important issues discussed.
Was there an overriding theme to the conference regarding net lease? Is it still performing really well?
Barry Bain: There were a few takeaways. Some were already known, others were just reemphasized. One topic that seemed to be in the forefront for a lot of the major REITs was because of where cap rates are and their outlook remaining to be the same as a result of a lack of supply, they’re looking more to other countries, Canada, Mexico and in Europe to make investments to get yield.
W.P. Carey made comments about wanting to invest $1 billion or $1.5 billion over the next 12 months, and at least half of that was going to be outside of the United States.
Andrew Brownstein: It seems obvious that investors are absolutely desperate for yield. People who are investing with these large funds see it as a collateralized, relatively safe way to get yield in market where these is no yield anywhere else. Bonds continue to be incredibly cheap from a yield standpoint. Dividend yields on stocks are extremely low, and the stock market looks very toppy. They still see this as a strong way to accomplish yield without taking an inordinate amount of risk. Now, they may be taking a risk anyway based on how high pricing is, but the yield priority seems to be stronger.
Bain: I would definitely agree with that. Typically in past markets to get yield you either go down on the credit spectrum, go to secondary and tertiary markets or you start buying shorter-term leases. In today’s environment, the supply/demand dynamics have compressed cap rates such that there’s not near the delta there was in past markets.
Brownstein: Would you rather have a 10-year or 15-year lease with an investment-grade credit behind it at five percent or if you’re lucky 5.5 percent, or would you rather have a 10-year T-bill at 2.3 percent?
Does the move to assets abroad mean that domestic secondary and even tertiary markets are getting to the point of over saturation for these investors? Or are they looking at other countries for their strong-performing assets?
Brownstein: All of the institutional money is starting to push the smaller investors to secondary and tertiary brands and markets because they can’t compete with the big money in the top markets with the top brand names. And they feel like they can diversify their portfolios by moving to international markets.
Bain: I would not say they’re saturated by any means, cause you’re starting to see development in every size market. I would say the amount of capital chasing deals has warranted the smaller and private investor seeking yield look to the secondary and tertiary markets for it, while the more sophisticated investors have the ability to seek out the expertise to pursue it aboard.
Is there less competition in those markets from investors based there?
Brownstein: Not necessarily, because a lot of the people putting money into these funds are coming from overseas. It’s somewhat ironic that some of them are investing money in U.S. funds and then those funds are turning it around and investing in some of the same countries. But I wouldn’t say that’s happening because they’re aren’t as many European investors as there are U.S. investors. They’re probably looking more at safety than yield. There is yield in Europe, but it is not as safe.
Bain: You’re seeing a substantial amount of foreign investment in the U.S., both through direct investment and through funds. That said, investing through a U.S. REIT, foreign investors are getting diversity and security beyond investing in a European-investment vehicle.
Did they talk about the kinds of assets they’re looking at in other countries?
Bain: I would say the majority of the funds REITs represented at the conference were diversified across most the asset classes, but most are seeking strong industrial (distribution, warehouse and manufacturing) and office product, and I’d say big box retail as well.
What are we seeing in the U.S. as the most popular sectors?
Bain: I’m seeing industrial and office as being more popular than retail. The yields are typically lower in the retail sector than they are in industrial or office, the trade-off being the lease term. I think the primary lease terms are generally 15-20 years in retail while industrial and office investors are more accustom to 10-15 year terms.
Is the smaller investor able to find worthwhile assets in the domestic secondary and tertiary markets?
Brownstein: Yes, you can, but they’re expensive. Cap rates are low. You are not getting an incredible up-front return. You are taking some risk that rates will move up, and the cap rates will move against you. You have to be very careful to make sure that the real estate is solid and that your tenant is good. It is a toppy, expensive market right now, there’s no question. But you can find assets. There is supply. It is coming on the market very rapidly.
Bain: Yes they can, but they have be cautious, yet be able to make quick decisions. You can find good assets in these markets, but with demand outstripping supply you need to be responsive and willing to shorten due diligence periods, and close all-cash. Nonetheless, you’re going to be paying up for a similar asset you’d find in the primary markets because of the market dynamics.
And is it also apprehension about interest rates potentially rising?
Brownstein: Every one of these things is a marker that is telling you the market is toppy. The stock market is very high, making new records every couple of days. Rates have, despite everything to the contrary, have stayed low. And it makes people nervous. Oddly enough, when you go to these conferences and ask people to draw a conclusion, they’ll tell you that the market has room to run.
Bain: There may be some element of nervousness about that, but it doesn’t appear to be changing anyone’s investment strategies at the moment. There was talk about how the 10-year Treasury recently moved up about 19-20 basis points a couple of weeks ago, and there was not even a blip in the market. Those asked where the rates would be a year from now, most stated somewhere in the 20-50 basis points higher than today. Who really knows?
Brownstein: There are some reasons for that, but there is still talk that the Fed is going to move rates up next year. Now we all thought the Fed would have started moving rates up by now, but some things happened in the world markets that caused that not to happen.
So are we dealing with an overheated market?
Bain: The market’s going to continue to do well because even though there is supply coming on the market, there is still a lack of supply, or demand is outstripping supply. The amount of capital that is out there right now is driving that as well. In conversations with some of the lenders they said they’re trying to lend money, and they’re not able to. The reason they’re not able to is that there is so much capital out there that it’s not needed.
Brownstein: People are putting more into these deals than they might otherwise need to because they have so much to place. You need to be even more discriminating, so that you don’t compromise your underwriting standards just to get something done. You need to look even more carefully at the credit of your tenant, the underlying real estate and what its highest and best use at the end of your lease. This isn’t one of those markets where even the dummies can make money.
Bain: And if you’re going to finance a deal, you might consider going as long as you can with the least amount of leverage because valuations have climbed back to a high and you don’t want to be caught when your loan is coming due at the bottom of the market, then you’re going to be contributing equity to refinance your loan with less attractive rates and terms.
So what do you tell clients to help them navigate through this environment?
Brownstein: Getting the proper advice is more important than ever in a market that is clearly overheated, and this is not the time to make a mistake by relying on bad information or a lack of expertise. You also want to take a good hard look at your collateral, and GRS can help in those areas.
Bain: And even though an appraisal says what it says, it doesn’t mean that’s what you necessarily want to pay for the property. An appraised value is a value determined at a point in time in the investment cycle. It is important to understand all the market dynamics, (micro and macro) that may impact your real estate investment to day and in the future. An investor should always consider their exit strategy or potential residual value and alternative uses a subject property may have.
Brownstein: And it doesn’t tell you 10 or 15 years from now what will be your highest and best use for this property when a credit tenant lease is up. You need to think very hard about those issues today. The kind of use analysis that Barry is able to provide a customer is very valuable in those scenarios.