Traffic Jam | The Net Lease Market
At the start of 2022, we were going 80 miles per hour. The windows were down, music was blaring, and we were all singing along to our favorite songs; life was good in the net lease market. By March, the navigation interrupted the music signaling “traffic reported ahead,” and the music was turned down. Backseat drivers began giving their mixed opinion on how bad the traffic would be, yet most in the net lease market remained relatively optimistic. By June, you could see the brake lights in the distance, and even the most optimistic backseat drivers started to have concerns as rates kept increasing. As of today, we’re in traffic. Every backseat driver still gives their opinion on how bad traffic will be and how long it will last – some based on history, some based on facts, and some based on mere feelings. However, there is one thing we can all agree on right now: we’re not going 80 miles per hour anymore.
The Trouble with Selling
Two issues exist. First, sellers do not want to sell their property for less money than it was worth previously. And second, sellers are taking on more risk and getting the same return.
Selling a property on January 1, 2022, was fantastic. If we were to rate the overall market on a scale of 1 to 10, it was an eleven. This was largely driven by historically low interest rates combined with a ton of demand from investors. As interest rates continued to decline, property values continued to increase. Most net lease owners didn’t realize or wouldn’t acknowledge the bond bubble had to end at some point, and many still don’t understand what that means. More importantly, sellers are still unaware of how that will continue to impact their investments in the future.
Sellers do not like the idea of selling something for less money than it was previously worth, and many have difficulty grasping it. There is a tremendous amount of human psychology as to why, which I will have to save for another article in the future. Unfortunately, with many net lease assets having minimal or no rental increases in the base term, a diminishing lease term, and difficulty backfilling the locations at similar rent, values for these asset classes might never return to what they were just a year ago in our professional lifetime. This psychological issue prevents transactions from occurring.
The second issue is a real problem. Today’s sellers with existing financing have to take on more risk to get the same return they are currently getting. With interest rates higher today than yesterday, replacing cash flow means buying at a higher cap than the one they’re selling. Since a cap rate is a measurement of risk compared to alternative investments, they’re taking on more risk to get the same return. Furthermore, their current loan is an asset, and once they sell their property, that asset disappears. For many owners that might normally transact, it simply doesn’t pencil, and they stop transacting.
Now, some good news for sellers! A rising tide lifts all ships, and rising interest rates have lifted all cap rates. This means for those accomplishing a tax-deferred exchange, the property they’re exchanging into is also worth less money now than it was at the start of the year. Government regulations around the 1031 exchange often prevent owners from perfectly “timing” the market. For the foreseeable future, clients that enter an exchange will likely be able to accomplish just that as property values continue to soften. Furthermore, inflation is everywhere, including CRE rents, which means if you have a short-term lease coming due, with every passing day there is an increasing possibility, not probability, but possibility that the rent can be replaced. This also increases the probability the tenant renews the lease and stays at the location, as well as exercises their options in the event they still have options remaining.
The Trouble with Buying
Cap rates tend to reflect their risk compared to alternative investments, and there is a lag time with real estate values compared to other alternatives. This lag time can be felt in as little as six months, and sometimes it can take more than a year. In this cycle, data suggest that it was closer to a year. Either way, as interest rates rise, they make alternative investments more appealing and real estate less attractive. If you can purchase a ‘risk-free’ United States Treasury Bill in the 4% range or municipal bonds in the 6% range, why purchase an asset with more risk and the same return? Outside of the tax shelter benefits of commercial real estate, you typically don’t.
Cap rates are moving up, and nobody can predict exactly when they will begin to come down. This reality is causing many buyers to stop purchasing new investments right now. It’s quite simple – they don’t want to buy an asset that will be worth less the day after they close escrow than the contracted price. These investors will wait until cap rates settle and they feel comfortable with current market conditions.
While ample debt still exists for most borrowers and deals, it’s simply too expensive relative to the investment they are making. Either debt has to come down, or cap rates have to move up before they can achieve their ideal results; but what will likely occur is both, cap rates will continue to move up, and eventually, debt becomes cheaper again.
Owners looking for an upside share the same concerns but might pursue other investment opportunities outside the net lease market. For owners looking for value-add opportunities, many will chase the rebound of the stock market rather than the net lease market.
The Investor’s Buying and Selling
Just because market conditions are not ideal doesn’t mean all transactions stop.
There are always life-changing events that can cause a desire or need to sell, regardless of market conditions. In addition, we see the baby-boomer generation exchanging out of management-intensive properties, causing a strong demand to exchange into passive net lease properties. While their assets have likely performed well with rising rents over the past year, they face similar market conditions, and their motivation is beyond just dollars and cents; it’s personal. These net lease assets give back the most precious commodity we all have, time. In addition, owning net lease can be a stable part of a well-diversified portfolio of holdings.
We also see transactions occurring between owners with broader concerns over their investments. For example, it’s common for an older investor to want to trade out of a short-term lease for the peace of mind a longer-term lease would provide for fear of the tenant not renewing the lease and leaving the owner with an empty building. We also continue to see owners that are extremely dialed into the industry and motivated sellers exchanging from one asset into another, just not as many.
We also see larger companies with a need to recycle capital, which means selling assets in their portfolio. For the most part, this is done strategically with very select properties that do not accomplish their long-term strategies and use that money to deploy into better investments. With Wall Street more focused on the financial performance of these companies than the actual real estate, we’re starting to see some companies trading out of higher quality real estate at lower cap rates to fund riskier investments that provide a higher initial return. For the time being, at least they can tell Wall Street how great they’re doing!
On the buy-side, investors are still ready to deploy capital if the investment can accomplish their short-term and long-term goals. At this point, the market has moved enough for them to feel comfortable investing in it; this is particularly true with all cash investors. We’re also beginning to see sellers with a very short timeline to transact and willing to take materially less money than the property is currently worth. While exchange buyers are drying up on the broader market, we’re still working with plenty of active exchange buyers that need to purchase an asset. Many of our investors who heeded our advice at the start of 2022 are entering a strong buying opportunity and still have plenty of dry powder to deploy.
The Traffic Jam of 2023
In my opinion, the best analogy for the current market is a traffic jam. As detailed above, when so many buyers and sellers stop, pause, or slow down their investment activity due to current market conditions, it causes a traffic jam for the industry. While our market continues to move, we’re seeing fewer transactions than the previous year.
We anticipate this trend continuing into 2023 and anticipate fewer transactions than the previous year. How long this will last will be determined by sellers updating their expectations and the interest rate market moving forward. On a positive note, many sellers are starting to focus on the market we’re in rather than the one in the rearview mirror. If sellers continue to adjust their expectations with market conditions and interest rates can settle, the net lease market will get through this traffic in time; just not at the same transaction velocity and pricing that we saw in previous years.
What Should I Do in 2023?
Become informed. The net lease market will perform fundamentally differently moving forward than it performed over the last 40 years. The continual decline of interest helped bad investments look okay, okay investments look good, and good investments look great. We’re not in that market anymore. Purchasing a net lease property with minimal or no rent increase, while the lease term continues to deteriorate and expecting the property to increase in value, is a thing of the past. So are the days of purchasing an asset and not understanding the fundamentals of that investment. Many investors need to learn about their asset’s property characteristics that make up risk and values that many investors have overlooked for years. These characteristics can be market rent, property performance, the ability to backfill the box, and various other macro and micro-economic issues. Investors will need to become more knowledgeable and not just rely on market conditions to propel values like in years past. Either way, the market is the market, and barring continued material intervention by the fed, it will sort itself out. The invisible hand theory is undefeated.
If you don’t want to spend thousands of hours learning about the market, speak with a real estate advisor that knows what they’re doing, an expert. As the old saying goes, “90% of the brokers do 10% of the deals, and 10% of the brokers do 90% of the deals.” The longer you’re in the business, the more this becomes a fact of life. The top brokers are the top brokers not just out of pure luck but because of their ability to put their clients in the best position over a long period of time. An intelligent broker can help you create a comprehensive plan analyzing your goals and risk appetite compared to how the property aligns within those metrics. For many owners, the recommendation might be to sit on the sidelines. Remember those brokers when the traffic clears, and we get moving again.
If you own property all cash, the market shouldn’t have a large impact on your decision making, so perhaps you can continue forward with your plan. Keep in mind, you’re trading equity, so if you think an alternative asset is a better investment, do it. Just like your property, the exchange property you’re purchasing was also likely worth more money twelve months ago. Remember, throughout the next few months, you’re finally “timing” the market as prices continue to decline. As we say in the brokerage business, sell high, buy high, sell low, buy low. If you don’t have a plan, speak to an expert that can help you formulate one. If you have a plan, you should still speak to an expert for their opinions.
If you were planning on cashing out, current pricing is still better than pre-pandemic pricing… at least at this moment in time, because that will likely change. If that’s the plan, today is better than tomorrow.
Don’t let the fear of the now prevent you from getting to where you want to go; you don’t want to be the deer in the headlights, frozen by fear. This means you must continue making smart investment decisions despite a changing market. If you own an underperforming asset, it probably makes sense to exchange. If you own an asset paying well above market rent, it probably makes sense to sell. If you own an asset in a tertiary market with no alternative uses and are planning to outlive the lease, it probably makes sense to sell. If you own a tenant that won’t be a company in the near term, it probably makes sense to sell. If you don’t know if you own this type of property, you should speak to an expert. Remember, an expert is someone that can provide information about the characteristics that impact your real estate investments. Don’t get this confused with an accountant, who is great at providing tax advice but might not understand the complexities of one net lease investment from another. Let your accountant be just that, an accountant.
An expert is someone that can analyze your property or portfolio and the opportunities or risk associated with it. They can help you formulate a plan and provide you with recommendations to help you accomplish your goals. However, you are the boss, you make the decisions. When I meet with clients, I make sure to let them know that I recognize that I am not the decision-maker, they are. I am there to help them understand the market, analyze their investments, leverage my resources, and provide strategies for accomplishing their goals. However, you are the owner and decide what to do, and a broker is there to execute the assignment for you. If an owner is not in touch with a qualified and competent commercial real estate expert, now is the time to be.
Change can be difficult, and the market we’re in presents new challenges and concerns for owners. However, it also provides some great opportunities for owners and brokers willing to put forth the effort. To close this out, I will circle back to the traffic analogy I used to start this article. We’re in traffic and that is okay. Even in traffic, progress can and will be made.
