Assessing three ways to play for net lease investors

It is a good time to be in the triple-net lease business. With operating costs and insurance premia on the rise, having an arrangement in which tenants pay taxes, insurance and maintenance – in addition to the rent – shields property owners from the income erosion being experienced across commercial real estate. Because of this, managers in the space are feeling bullish about their position.

“The triple-net structure, coupled with duration, is a particularly well-suited instrument for this environment,” says Marc Zahr, president and founder of the net lease-focused platform Oak Street, a division of Blue Owl Capital.

While net lease strategies face many of the same challenges as the broader real estate market – a limited pool of for-sale assets, rising construction costs and a reticence among lenders – some of those same factors are also incentivizing corporations to monetize their real estate holdings through net lease arrangements to generate needed liquidity.

“This is a great time for net lease in general, you are going to see a lot of net lease transactions in this market,” says Gordon Whiting, head of net lease real estate at New York-based alternative investment manager Angelo Gordon. “You are going to see a lot of sale-leasebacks happening, especially. These economic conditions, and where we are, will be really good for the market.”

Not all net lease strategies are created equal, of course. There are three main styles of net lease investment: sale-leasebacks, built-to-suits and triple-net lease purchases. Each has its own set of driving forces, which have been flavored by current market conditions.

“Each of these [methods] has relative advantages that, depending on a specific asset’s characteristics, including tenant, location and other related factors, may make an investment compelling,” says James Koman, founder and chief executive of the single-tenant net lease firm ElmTree Funds.

Across all three approaches, net lease arrangements have proven particularly well suited for the fast-growing industrial sector, due to the “mission-critical” nature of such properties and the difficulty of relocating such operations. 

More than half of single-tenant net lease transactions closed last year were industrial assets, up from the 10-year average of 40 percent, according to data compiled by the brokerage Colliers and the analysis firm MSCI. Offices and retail accounted for 27 percent and 21 percent, respectively.

“[Industrial assets are] really the only place where rent, as a total component of a company’s cost structure, is low and yet the assets produce so much of the profitability of the company,” says Teddy Kaplan, managing director and portfolio manager for New York-based New Mountain Capital’s net lease strategy. “Competitive assets or alternate spaces are in short supply and if you are disciplined about underwriting market rents, tenants can’t save money by moving and it is super disruptive if they try to.”

Yet, for all their advantages, net lease strategies are not immune from the challenges of the broader real estate market, including limited buying opportunities, rising construction costs and a reticence among lenders. The hardships, too, are playing out differently in each of the three core styles of net lease investing.

Overall, single-tenant net lease transaction volumes fell by 25 percent year-over-year in 2022, according to Colliers and MSCI. That steep decline, however, is partially related to a return to normalcy after a record year in 2021 in which more than $90 billion of transactions were closed. The totals posted last year were on par with the average volume seen between 2015 and 2017.

Both the record uptick and rapid comedown were tied to interest rate movements. When borrowing costs were at their effective lower bound in 2021, investors clamored for net leased assets. Since rates shot up last year, market participants have had to think twice about transacting.

“The interest rate environment has forced sellers to decide if they want to sell in this higher cap rate environment or hold through to what they hope to be another cycle of cap rate compression. That is driving lower volumes,” says Matt Tucker, senior managing director and co-chief investment officer of Salt Lake City-headquartered Bridge Investment Group’s net lease strategy. “We are relying on relationships that we have had in place through multiple cycles to identify proprietary opportunities where we don’t see a lot of competition and/or we can leverage an existing relationship with sellers who have liquidity needs today.”

In this uncertain moment in real estate and financial markets, each of the three main approaches to net lease investing has its own set of pros and cons.

Sale-leasebacks

The sale and leaseback arrangement involves a firm buying a property from a corporate occupier then leasing it back to them over an extended period, typically between 10 and 15 years. This is generally the primary driver of the net lease market and that has held true in the current environment.

For occupiers, such arrangements are an alternative to traditional borrowing. Instead of paying interest on a loan, they pay rent. As borrowing costs climb, this trade-off becomes increasingly appealing to corporations with significant real estate holdings and has enabled buyers to secure more favorable lease terms.

“There is more openness to signing longer term leases, because the tenant has the opportunity to lock in a known cost of rent for a long period of time,” Tucker says. “Typically, in industrial net leases we see annual fixed escalators range between 2 and 3 percent, but in this higher inflation environment, we have seen, in select cases, annual rent escalators as high as 5 percent.”

The primary challenge in the sale-leaseback space is deal selection. Buyers must ensure their funds are not being used as rescue capital for struggling businesses – unless they are being compensated for such a risk.

This speaks to a debate among net lease managers about what tenants are best suited for the strategy. Firms in this space tend to pride themselves on their ability to underwrite credit, but some feel that such acumen is best used to draft terms for the most creditworthy tenants, while others are prone to seek out diamonds in the rough.

Zahr’s platform Oak Street, which was launched as a standalone net lease specialist firm in 2009 before being acquired by Blue Owl in 2021, only deals with investment-grade-rated tenants. This focus, he says, has served him well through periods of uncertainty, noting that his vehicles have continued paying monthly distributions between 7 and 8 percent.

“Credit quality is one of the backbones of our strategy. We select attractive companies to put in the real estate that we are buying, or we buy from companies that have strong credit,” he says. “The assets are important to the companies, so the likelihood that rent gets paid increases. Because of that, our portfolio is doing just fine in this environment.”

Others, meanwhile, shy away from blue chip tenants. Kaplan says New Mountain leans on the sectoral expertise of its private equity team to find strong tenants that are not necessarily household names. This has led the firm to pursue more light manufacturing assets rather than distribution warehouses, for which capitalization rates have been low despite individual properties accounting for a small share of the profitability of global operators. “If you own a single-tenant, master-leased distribution portfolio, that is probably a pretty good proposition and we own some of that,” Kaplan says. “But, if you own one random warehouse of many, it is hard to say that is really mission critical.”

Build-to-suits

Where sale-leasebacks acquire assets that are already very important to tenants, the goal of the build-to-suit approach is to create properties that will become integral to a company’s core business. Koman says this approach mitigates the risk of a property losing value over the course of a triple-net lease, while increasing the chance that it remains mission critical. This sets up more favorable exits, he notes, adding that ElmTree only pursues build-to-suit opportunities.

The post-pandemic effort to re-shore critical manufacturing industries in the US will create more build-to-suit opportunities in the years to come, Koman says. “We believe that as corporations continue to onshore their supply chain operations and expand their logistical footprint in the US, our pipeline for built-to-suit investments will remain robust.

“And, along with our extensive corporate and developer relationships, as well as our demonstrated track record, we believe [that] will allow us to source and capitalize on investment opportunities at attractive basis.”

Still, construction costs are rising, and many lenders are wary of taking on development risk when the economy may be at the precipice of a recession. For net lease platforms with proven track records, this has created a lucrative opportunity to bridge a funding gap, Tucker says.

“The lack of availability of construction debt has really thinned the market for new capital to support build-to-suit development activity,” he notes. “As a result, the opportunity for better unlevered returns on cost on development projects, including build-to-suits, is as good as it has been in several years.”

Acquisitions

Purchasing existing net leased assets is the weak link in the net lease chain, as deals struck before the current inflationary period tend to include more modest rent escalators. Also, many firms in the space prefer to craft their leases a certain way.

Still, given the underlying credit and liquidity issues throughout capital markets, Zahr says opportunities could arise to buy net leases at a discount.

“For the first time in a long time, you might be able to buy something that is lightly marketed, if it is of scale and needs assurity of close,” he says. “We haven’t picked up anything that has been marketed yet, but I am hopeful that we can.”

The argument for net lease acquisitions might not be as strong as the sale-leaseback or build-to-suit approach, but across the gamut of strategies, triple-net lease investing may well be having its moment in the sun.