Is now the time for net lease?

PERE investigates whether net leases are becoming more attractive and whether they will remain appealing if inflation tapers back down.

Net leases are a major feature of the US commercial real estate market, with strong advantages on both sides of the rental transaction. From a lessor perspective, as Andrew Burych, managing director at Brookfield Asset Management, notes: “You get a low-volatility income stream and inflation protection, similar to a bond, with the real estate as collateral in case there is a default.”

From a lessee perspective, it is an alternative source of financing for mid- market businesses. Burych says: “It is a way for companies to access liquidity for growth or other general corporate purposes. Real estate is capital-intensive and is not always a good use of capital for some businesses.

“Freeing up the capital allows them to grow, further improving their credit. They maintain long-term control of real estate that is critical to operations, while also freeing up capital to invest in the business. Fixed rental payments provide visibility into real estate costs.”

Bond-like benefits?

David Piasecki, managing member at BV Net Lease Capital, an affiliate of Blue Vista Capital Management, agrees net leases provide an excellent risk-adjusted return to investors. “For many institutional commercial real estate investors, returns are highly dependent on aggressive exit assumptions, whereas in a properly structured, medium- to long-term net lease, approximately 70-90 percent of total return comes from contractual rent,” he says. “So, there is less dependency on riskier residual assumptions.”

The sector has long-duration leases of typically 15-20 years, while providing direct exposure to the real estate value appreciation. The debt-like characteristics of net lease real estate make it particularly attractive.

Piasecki notes that several institutional investors put their net lease investment in their fixed income bucket, but that fixed income is “too simplistic a way to think about it.” 

He argues that net lease is in fact superior, as it is an asset with collateral value, certain tax attributes and a much lower volatility on pricing than long-duration fixed income.

Plus, most fixed income product “doesn’t have a built-in inflation hedge due to contractual rent increases,” he says. “Data has shown a much narrower bandwidth of cap rates on net lease pricing versus the range of interest rates on fixed income and even more so on high yield.”

But there are some caveats. Michael Steingold, director of private markets at manager and advisory Russell Investments, cautions that “they are a good proxy in many ways for corporate credit, but it is very important to consider both the creditworthiness of the underlying tenant and the value of the property if the tenant leaves.”

Net leases are not risk free, and managers have to be thoughtful about asset selection. Steingold says: “The danger is if you have a tenant defaulting, you have the double whammy: a negative credit outcome and a property on your hands which needs reletting. In this situation, it is therefore very important that net leases exist on generic properties, by which I mean properties that can be used by different kinds of tenant.”

This is a point taken up by Brookfield’s Burych. He prefers generic properties and focuses “on the credit health of the tenant (and their ability to pay rent) as well as the physical real estate value.” 

He notes that Brookfield employs a multi-faceted underwriting approach to “create strong downside protection.” 

In a world where mid-market lending is hard to come by and high yield financing is expensive, Burych says that sale-leasebacks become a more attractive way for mid-market businesses to finance themselves. “We are already seeing this in the robustness of our pipeline at Fundamental Income Properties,” he notes. Fundamental Income Properties is a portfolio company in which Brookfield invested in April 2020. 

The looming recession may impact a tenant’s ability to cover rent, particularly in cyclical industries, “but a good underwriting process and focus on mission-critical assets mitigates many of the potential issues that come with that,” Burych says. 

According to data from Northmarq, the commercial real estate investor resource, the US industrial market for net lease real estate had its second strongest year ever in 2022, with more than $40 billion in sales, and the office and retail net lease sectors posted numbers in line with average volume years.

Piasecki notes: “We are operating in a bit of a ‘risk off’ world right now, where certainty of return looks pretty attractive, particularly when borrowing actually costs something. In addition, the accounting rules relating to leases… have now been clarified and understood.”

Not all is bright, however. At $14.9 billion in sales, Northmarq’s numbers for Q4 for the single-tenant net lease market are down nearly 16 percent quarter-on-quarter and 66 percent year-on-year. 

“We must be conscious that we are going into a macroeconomic environment where there will be choppy crosscurrents. In addition, debt is not as accretive as it once was with net leases, which lowers a key benefit,” says Steingold. “Yields are higher but credit risk is an issue. Overall, while value looks better today than it has in recent years, the risks are also elevated.”

Additionally, Burych worries that 1031 exchanges, where a seller can roll over gains into a new property to postpone paying capital gains taxes on the sale, and which account for a large portion of the net lease market, are now “yet again at risk of being eliminated in the latest federal budget.”  

The European perspective

In Europe, Alistair Calvert, the CEO of pan-European manager Clarion Partners Europe, says: “Individual credit risk is of course an issue as economic conditions worsen, but we seek protection against this by ensuring any assets we are involved in are ‘mission critical.’ It is also important to ensure that they are generic assets, adaptable to change of use. All European net lease assets have CPI protection built in, which gives them good inflation protection.” 

He believes there is no question that interest in sale and leaseback net lease real estate will increase substantially as bank financing becomes tighter. “Net leases typically outperform in a downturn because of their strong cashflow,” he says. “When most of your projected return in an asset comes from income rather than realized value on exit, then with commercial real estate valuations falling, these are circumstances when net leases will stand out.”

Louis Simon Ferland, CEO of Boreal IM, a pan-European industrial real estate manager, is particularly optimistic about net leases in logistics. He says: “Until recently, corporates were easily able to borrow on warehouses with cap rates of 3.5-5 percent… which made it a very competitive area. Fortunately, that is now changing. Now the opportunities are considerable. Some companies are over-indebted and need to pay down their debts fast. Because logistics overall is a very liquid asset class at present, it is very likely to be the sector in which companies seek to raise cash on real estate.”

In other European sectors, net lease investors are proceeding with caution. At Newcore Capital Management, a specialist real estate investment manager focusing on social infrastructure assets in the UK, chief executive Hugo Llewelyn says: “Net lease means sharing operational risk. The changing economic circumstances mean that tenant quality is more important than ever. Rising interest rates make us more demanding with a net lease. We probably now want a higher return, and we want less hassle. 

“For example, we have invested in student housing. In the past we might have been prepared to lease to the students directly, but in this high interest rate environment we would prefer to have an arrangement where we lease the building to the university, and they take on a lot of the more granular tenant work and deal with the students directly instead.”

The effect of falling inflation

One thing US and European investors agree on is that a fall in inflation would help the sector. 

Ferland notes that “in theory the period of opportunities should come to an end… but this time it will not happen quickly as a lot of banks have significant troubled real estate assets on their books, they are likely to take some time before they come back into markets to offer financing.”

Meanwhile, Steingold observes that net leases are long-term and high duration, meaning they are very interest rate sensitive. “Any small change in interest rates leads to big changes in value,” he says. “If your chosen economic scenario is one where inflation is brought back under control, then there is certainly a strong argument that the net lease sector is attractive at present, provided you understand the idiosyncratic nature of the credit risk and can mitigate it with diversification.”

There is reason to be bullish on the future of net leases in Europe. Calvert notes European corporate disposals, a proxy for net lease investment, have doubled over the last decade (2012-21) and remained elevated in 2022, at €26 billion, despite the slowdown in capital markets.

The addressable European net lease market is large, partly reflecting the fact that in Europe, corporate ownership of real estate is more prevalent than in the US. Europe’s commercial real estate ownership rate is around 65 percent versus an estimated 50 percent – or lower – in the US.