Our Perspective 4/ 4/ 2023

Mike Philbin and Ryan Butler share insights with GlobeSt: Net lease cap rates at highest levels in nearly three years

The depth of the 1031 buyer pool will be limited when compared to historical standards.

MINNEAPOLIS, MINNESOTA (April 4, 2023) – Cap rates in Q1 2023 represented the highest levels since Q3 2020 for both the single-tenant retail and office sectors, according to a new report from The Boulder Group.

Decreasing transaction volume for the greater real estate market continues to limit 1031 exchange buyers transitioning into net lease properties, it said, as cap rates in the single tenant net lease sector increased for the fourth consecutive quarter within all three sectors in Q1 2023.

New construction properties with recession-proof tenants including 7-Eleven and McDonald’s represent some of the lowest cap rates in the sector.

“However, these tenants are not immune to upward cap rate pressure,” according to the report.

“In Q1 2023, cap rates for new construction 7-Eleven and McDonald’s properties increased by 35 and 15 basis points, respectively. Furthermore, the spread between asking and closed cap rate increased for all three asset classes.”

The spread rose to 30 basis points for retail, 40 for office, and 27 for industrial, according to the report.

“Investors will continue to follow the Federal Reserve’s monetary policy,” The Boulder Group writes. “Investors largely believe there will be an end to the larger rate increases, of 50 basis points or more, in the near term.”

Transactions will be driven by low leverage or all cash 1031 buyers for the highest quality product, The Boulder Group said.

“However, given the overall uncertainty in the broader real estate market, the depth of the 1031 buyer pool will be limited when compared to historical standards.”

Mike Philbin
Senior Vice President

Lower-Credit Assets ‘Back Where They Should Be’
Mike Philbin, Northmarq senior vice president, tells GlobeSt.com that “we are closely approaching the one-year mark of when we started to see the peak of the net lease investment market fizzle away.

“Due to the repeated interest rates hikes, this was inevitable. However, not all net assets had as drastic of CAP rate shifts. The higher-credit, investment-grade tenants have had a maximum of 50 bps upward movement in this time.

“The lower credit, smaller franchisee, in tertiary market tenants have seen closer to 150-200 bps. We did have a very frothy net lease investment market moving into Spring 2022. But relatively speaking, the lower credit assets are back where they should be and the investment grade net lease assets are back to the 2018-2019 range, which was a strong market.”

Price Maximization Especially Difficult for Larger Transactions
Alex Sharrin, senior managing director, JLL, tells GlobeSt.com that investment momentum persists for performing retail that can be acquired with positive leverage.

“The net lease market sits at the crux of real estate and credit, but intrinsic fundamentals are trumping credit amidst volatility,” he said.

“Private capital continues to lead the bidder pool for NNN assets across the country and is often winning deals due to the unleveraged nature of the capital/underwriting.

“Capitulation has been faster than expected for liquidity and re-investment.”

Sharrin said price maximization has been especially difficult for larger transactions (i.e. $75MM+).

“Instead of making comparisons to early 2022, a more realistic pricing benchmark is 2018/2019 levels or, pre-pandemic and pre-stimulus,” he said.

Ryan Butler
Senior Vice President/
Managing Director

Transaction Volume Will Soon ‘Level Off’
Ryan Butler, managing director and senior vice president, Northmarq, tells GlobeSt.com that investors across all commercial real estate asset classes have been paying close attention to the responsive actions of the Federal Reserve and US Treasury as they work to address the ongoing regional banking crisis and continue the fight to tame record-high inflation.

“As a result of the swift actions taken by both bodies, we are starting to experience a broad expansion in capitalization rates across the Net Lease sector,” Butler said.

“However, it is important to note that this cap rate expansion cannot be painted with a broad-brush stroke. Investors in our space are still seeking well-positioned industrial and retail assets leased to ‘recession-proof’ tenants and, as a result, still transacting.

“We anticipate a leveling off in the downward trend in transaction volume through the end of the year as investors make sense of this changing market. Realizing that the net lease asset class will continue to be a safe and stable investment vehicle within the real estate sector.”

Bid-Ask Gap Widening
Eli Randel, COO, CREXi, tells GlobeSt.com that cap rates on closed net lease assets have risen almost 5% YoY with transaction velocity slowing as buyer demand has cooled because of macro-market conditions.

“The segment a year ago was at parity between asking and closed prices whereas now sales are transacting below asking prices illustrating a widening of the bid-ask gap,” Randel said.

With increases in interest rates, both costs of capital have increased, and similar alternative vehicles are now generating attractive yields (for instance a liquid “risk-free” savings account at Marcus has a 3.75% interest rate), Randel pointed out.

“Yet, net-lease real estate still has many benefits to passive investors and remains historically active and strong. Net lease continues to attract 1031 buyers and real estate investors looking for good yields with future upside and often buying in cash.

“While slightly less active, higher-yielding, and with more discriminatory underwriting of terms (largely term-length and credit), net lease remains an important category and a great investment product for many in today’s environment.”

Stale Assets on the Market, Decreasing Inventories
Geoffrey West, senior vice president, MDL Group/CORFAC International, tells GlobeSt.com that amid the historic pace of interest rate increases experienced over the past year, single tenant net lease sellers have been reticent to quickly meet the increased cap rate market expectations resulting in decreased transaction volumes, stale assets on market, and decreasing inventories of available product.

West said specifically in the California, Arizona, and Nevada markets, multiple surveys of available fast-food STNL assets (excluding ground leases) conducted over the past year in conjunction with maintaining market positioning of existing listings indicate an overall increase in average asking cap rates from April 2022 to April 2023 from 4.1% to 4.7% and a significant decrease in the quantity and quality composition of the available assets.

And within that survey, secondary and tertiary market locations in those states appear to be adjusting to a higher cap rate environment more quickly while primary and core market locations lag as they seek to maintain historical premium cap rate levels.

“The recent restabilization of the US 10-year treasury rates around the 350bps level appear to have put reduced upward pressure on asking cap rates as surveys conducted in February 2023 and April 2023 only reflected a 10bps increase in asking cap rate,” West said.

“While prospective buyers with 1031 Exchange motivations cannot acquire treasury note assets and those don’t enjoy the benefits and burdens of real estate ownership, the yields being offered in those financial instruments, especially short-term yields, are often superior to core location yields being sought by sellers.”

West added that, as such, investors without 1031 Exchange motivations and flexibility may look to temporarily park monies in these alternative investments and benefit from the premium yields being offered by the inverted yield curve until Seller expectations and the current bid-ask spread tighten and transaction activity levels rebound.