Lodge Quai: Europe’s net lease pioneers

This article is sponsored by Lodge Quai

Lodge Quai takes its name from its two founders, Cabot Lodge and Daniel Quai, who founded the business in 2013. They have more than 60 years of joint investment experience in the net lease market in the US and Europe, while the firm also invests in private equity real estate and real estate debt, mainly in Europe. 

Geographically, the firm is interested in sale and leaseback deals across the UK and Europe. 

In terms of industry sectors, it is currently investing in automotive, last-mile logistics, internet resilient industries and “essential retail” – meaning food or DIY.  In terms of asset classes, this tends to be existing or build-to-suit (BTS) manufacturing and production facilities.

Thomas Reckers joined the firm in 2017 and is Lodge Quai’s net lease portfolio manager. He believes the current macroeconomic backdrop provides an opportunity for a step change in the European market for net leases, as corporates increasingly confront a tighter environment for traditional forms of corporate finance and come to understand the benefits of sale-leaseback (SLB) financing.

What are the benefits to investors in net lease transactions?

From an investor perspective, SLB transactions provide exposure to three main benefits.

First, you have stable, predictable and index-linked, bond-type cashflows from high quality corporate tenants. Long term leases of 15 years or more are triple-net, where all costs of occupation (eg taxes, insurance, maintenance) are with the tenant rather than the landlord, such that rent typically equals NOI. Most leases carry built-in increases in line with an inflation index.

Second, you get an asset-backed investment, as the real estate is owned by the landlord, which provides investors the ability not only to capture real estate upside but also to manage downside risk in case of a tenant default. Then third, the yield premium and margin spread can be captured by investors given the non-liquid nature of owning the real estate versus owning a corporate bond of the same or similar credit with similar maturity as the term of the lease. 

What about the benefits of net leases from the corporate point of view?

I think there are three significant benefits from the corporate perspective.

Sometimes a company owns an asset which it really doesn’t want to sell, but at the same time it wishes to access the capital trapped in it. A SLB can unlock 100 percent of the value of a property compared to say only 50 percent that would be available with a normal commercial mortgage, and there is no repayment requirement as with a mortgage at the end of the term.

Secondly, there is the question of operational control of the asset. Compared to bank financing, a SLB does not come with complex and punitive covenants or LTV clauses.

The corporate user continues to occupy and control the property as if it were still the owner and there is no disruptive movement of employees. In a triple-net lease, all the costs of owning, occupying and maintaining the asset remain with the tenant, so the seller in a SLB, who then becomes the tenant, considers a SLB an alternative form of financing as there is no change to their day-to-day operations in the asset.

Finally, a SLB is a very long-term arrangement. The leases typically last 20 years or longer so it amortizes the longest-term asset with the longest-term financing.

Given these advantages, why is it that the market in Europe for net leases remains so small?

There are some legal and cultural barriers that still exist in Europe. For example, in France and Germany, the landlord typically has responsibility for the roof and structure, and therefore a triple-net lease, which is common in the US, is more difficult to implement without structural enhancements.

On the sell side, we believe European treasury functions are coming to realize the benefits of SLB financing, but it takes time. Up until 10 years ago, Metro, the large German cash and carry retailer, had not sold a property. Now they use SLBs routinely and it is rare they continue to own their real estate, office included. 

Because SLB is a hybrid concept where conceptually returns are very credit-driven, from the investor’s perspective it is often difficult to know how to allocate a net lease in their portfolio. Is it a bond or credit investment or is it a real estate investment?

Managers who confuse net leases with credit often then have difficulty in getting their minds around the kind of granular detail that is necessary to ensure a net lease works well. We spend a lot of time understanding the credit of the tenant and how ‘mission critical’ an individual asset is to the business itself, what barriers to entry exist to protect the operations in the asset and consider if the tenant had financial difficulties, can it carry out the same activity easily in another asset.

The underdeveloped nature of the market also becomes a barrier in itself; the European net lease market is simply not as sophisticated as in the US. One of our brokers said to me that if she had a deal in Germany, she would have only a handful of potential investors to talk to, whereas in the US she might have 50. There is just not sufficient depth in the market at the moment so there needs to be more of an education process with investors and owner/occupiers on the benefits of SLB.

Are there other differences between the US and Europe that hold others back?

In Europe, historical real estate transaction data is not as readily available as it is in the US, and local country nuances need to be considered. 

A lot of our time is spent underwriting and understanding our downside risk. I would also say owner-occupiers in Europe are more interested in having control of the process as there is more of an emotional attachment to the real estate.

That can mean the due diligence process is much more challenging in Europe than it is in the US, where it is essentially commoditized. There, a deal can be closed in a couple of weeks, whereas in Europe it will need at least three or four months.

US listed net lease REITs investing in Europe have access to cheap debt financing via the US bond/CMBS market. By contrast, European mortgage lenders are often concerned about the limited alternative use of the assets and prefer more generic logistic or retail assets rather than ‘mission-critical’ bespoke assets. 

However, one attractive consequence of all this is that Europe is much less crowded, offering significant opportunities, especially in the current macroeconomic circumstances.

What is it about current macroeconomic conditions that is creating opportunities?

It is all driven by the rise in interest rates. Three or four years ago, we would speak to corporates about undertaking a sale and leaseback at 6 percent cap rate, only for the corporate to say its bank could offer 2 or 3 percent. Rising rates and the reduction in bank financing are both helping change that.

This trend can also be observed for listed corporate debt in Europe. Average coupons for non-investment grade bonds bottomed out at around 3 percent about five years ago. In 2023, these bonds are now issued with average coupons above 6 percent.

This is opening up new areas of the market. There has always been a lot of interest from private equity owners, which tend to have less emotional attachment to real estate.

The same is not true of many of the family businesses across Europe, where they tend to prefer to own the real estate in which they operate. Historically this has deterred them from looking at sale and leaseback. The current market conditions are changing that.

What is the scale of the opportunity that this unlocks for the longer-term development of the European net lease market?

Just consider the size of the publicly listed net lease market in Europe compared to that in the US. Whereas there are 12 major US net lease REITs, in Europe there are only two.

Overall, the size of the US listed net lease market is some $150 billion, whereas in Europe it is only $5 billion, yet the untapped market of corporate-owned real estate in Europe is arguably four times the size of the US. Based on estimates, around 65 percent of European commercial real estate is owner-occupied which compares to 10 percent in the US.

This indicates the scale of the opportunity. Add into that the considerable private real estate market, and it is clear that the European market could be a multiple of its current size.

We are well placed as European experts. It is simply not a crowded market and whilst it might be tempting for the larger US managers to play in our market, the existing managers are protected by some barriers to entry. 

The multiple different legal frameworks require an existing network of contacts so having legal and technical relationships and experience in Spain or Germany for example takes time to develop and understand.

Will the increasingly stringent ESG regulations hold back European development?

No, definitely not. There is obviously increasing regulation across Europe seeking to improve the energy performance of real estate, but different sectors are affected differently, and we are fortunate in that we have no exposure to non-essential retail or offices, two of the sectors where issues are getting the most publicity. 

However, we do have older industrial assets, as ESG can help us “future proof” these assets in partnership with the long-term occupier, who is our tenant.

Moreover, we very much have an active approach to ESG issues, and we seek to put green leases in place with all our tenants. We believe it is important to embrace ESG not least because it is going to become increasingly vital in terms of liquidity. In five or 10 years’ time, it will be crucial to undertake the necessary refurbishment to make an asset ESG compliant as we wouldn’t want to be involved in an ESG-stranded asset.

We are therefore putting considerable effort into understanding the current state of all our assets and what capital expenditure might be necessary. The current high energy costs are focusing our tenants’ minds in this area.

The green leases we are putting in place will monitor the energy use of a property and encourage the installation of LED lighting, better insulation, solar panels and the like. Our lease provisions expect tenants to pay for ESG upgrades, another benefit of triple-net lease structures.

Overall, we believe we are at an inflection point in the market and the opportunity set is considerable. Net lease financing provides an excellent opportunity for investors and companies alike, and we have experience in providing that important intermediation between single-tenant corporate real estate buyers and sellers.

Do you try to influence what the corporate does with the capital raised?

We don’t like companies to pay themselves a dividend but prefer that the proceeds are used to pay down debt, to undertake mergers and acquisitions, or, most especially, for capex investment. Companies often have a lot of their money tied up in real estate, and a SLB arrangement allows them to put that capital to better use than owning real property.

Typically, they understand their own business much better than they will understand the real estate market. Therefore, the capital can be directed to where it will get superior returns.

For private equity investors, it provides an arbitrage between what they pay for portfolio investments versus the multiple on where they can sell their real property. This spread between private equity and real estate multiples is particularly attractive now compared to previous years.