Long-income funds: Net leases gain respect
The net-lease real estate market in the US is gaining momentum with institutional investors
What offers bond-like safety with stable income flows, yet produces higher risk-adjusted returns? Net leases operate as a rare panacea in today’s yield-starved environment. Under triple-net (NNN) leases, tenants assume responsibility for taxes, maintenance, insurance and utilities, shielding landlords from rising costs. The passive nature of NNN leases shifts the burdens of operating costs and allays the risks and hassle of ownership. “No one is calling up at 2am to fix the roof,” says David Piasecki, CIO at Elm Tree Funds.
Little wonder these vehicles are gaining popularity. Historically, before the global credit crisis, many large institutional investors looked at real estate from a value-add or opportunistic perspective. “Pension funds are allocating more real estate investments to income producing strategies,” says Jim Hennessey, CFO at Oak Street Real Estate.
Institutional investors tend to apportion their real estate investments to four categories on a spectrum ranging from the lowest to highest risk-return characteristics. The spectrum extends from core and core-plus, which constitute major market portfolios, to higher-risk value-added and opportunistic strategies, such as ground-up developments.
Both Elm Tree and Oak Street maintain that income-producing niche strategies like net leases and leasebacks can actually deliver opportunistic returns while taking core risk.
Leasebacks are a major subset of the net-lease universe, with the attractive feature of long durations. Shelby Pruett, co-chairman and CEO of Capri EGM, contrasts 15 to 20-year sale-and-leasebacks with the 10-year conventional mortgage market. “Using a sale-leaseback gets 100% of the value out, versus a mortgage, which covers 65-70%,” he says.
Guy Ponticiello, managing director at CBRE Corporate Markets, reports that CBRE has tracked about $32bn (€27bn) in net-lease deals through September 2017. In 2016, the market dipped due to challenges in the bid-ask spread and some price discovery. Now, he expects volume to hit about $50bn by the end of the year, representing the third most active year over the past decade. “Typically, 30-40% of volume in the space takes place in the fourth quarter,” he says.
Fuelling the increased appeal of these structures, low interest rates are creating an underpinning in a competitive fixed-income landscape. “Foreign capital sources have also caught on to these long-term, annuity-type investments,” Ponticiello adds. However, Piasecki dispels the notion that global appetite represents a currency play per se. “It’s more a matter of interest rate differentials than a weak dollar,” he says.
Over the past seven years, the net-lease market has become deeper and more liquid, both in the US and globally. As the net-lease sector expands, liquidity breeds liquidity. Real estate transactions are never as seamless as, say, selling a stock, but can still offer liquidity in a robust real estate climate. “You can expect to sell a property in 60 to 90 days at a price you will be happy with,” Piasecki says.
Further expanding the market, hedge funds, activist shareholders and private equity firms are all using sale-and-leasebacks to fund expansions, underwrite mergers and unlock value.
A notable trend in the US net-lease sector over the past three years is the emergence of foreign buyers. Ponticiello reports that in 2013, 33% of purchasers were real estate investment trusts (REITs), the dominant buyer in the sector, while foreigners represented only about 4%.
By 2016, REITs had shrunk to 12% market share and foreigner acquirers jumped to 14%, represented by US firms like Arch Street Capital and Bentall Kennedy. That capital has been flowing into office and industrial rather than retail segments. In 2017, Canadian and Chinese buyers have accounted for over half the deal flow. “Those are the leaders, by a wide margin,” says Ponticiello, who expect the wave of foreign interest to continue.
In a landmark foreign transaction, Elm Tree Funds secured a $950m recapitalisation of a net-lease portfolio with a subsidiary of China Life Insurance Group, the largest Chinese financial insurer. The 48 properties are mostly recently built projects leased to investment-grade tenants in promising markets.
Douglas Weill, managing partner of Hodes Weill Securities, which advised Elm Tree, says: “We looked at average credit ratings, lengths of leases, diversification, residual values and other factors, since each building often represents a range of credits, industries, markets and stratifications. The portfolio trades at a premium to its individual assets to obtain the benefit of diversification.”
Weill highlights the importance of retaining tenants. “If the property is mission critical for the corporation, and they have been a long time in the market and have strong employment support, chances are they may keep their headquarters.”
The China Life transaction illustrates another key trend – a shift away from prime markets like California, New York City and Washington DC, to portfolios with properties in the industrial heartland. It was notable that the Chinese investor agreed to buy into secondary, non-core locations like Fort Wayne, Indiana and Des Moines, Iowa, rather than limiting itself to core and gateway markets, as might have been expected.
“They realised that tenants were likely to stay a long time, cap rates were better than in areas like California, and that they were being paid to take on the perceived risk of owning in non-core markets,” says Piasecki.
A third trend involves the extraction of cash from firms’ real estate assets. Marc Zahr, CEO at Oak Street Real Estate, describes how his company works with large, mainly global, investment-grade clients.
“We help them to monetise non-earning real estate assets and redeploy those proceeds into more accretive uses,” he says.
In this year’s largest deal, Stonemont Financial bought 100 properties across 20 states for $1.3bn from Oak Street. Investment-grade tenants supply 96% of operating income, including MetLife, Mylan Technologies and Ericsson. “Debt markets were exceptionally accommodative, financing up to 83%,” Ponticiello notes.
Industry leaders believe that the learning process will push net-lease investment further towards the mainstream.
“Organisations may still be trying to decide whether funds should be from their real estate or fixed-income allocations,” Weill says.
The Oak Street team is confident. Hennessey points out that in the US the line items called property, plant and equipment stands conservatively north of $7.5trn. Assuming the net-lease market is averaging about $45bn a year, “that leaves plenty of room to run”.