Lodge Quai: The time is ripe for net lease

A confluence of positive drivers means there has never been a better time for European net lease investment, say Lodge Quai’s Thomas Reckers and David Leshnick.

This article is sponsored by Lodge Quai

The net lease market in Europe is relatively untapped compared with the much larger and more mature US market. However, this means a less crowded space with a bigger opportunity set for specialist investors such as Lodge Quai, which has been investing in European net lease since its founding in 2013. Thomas Reckers, portfolio manager, net lease investments, and David Leshnick, vice-president, net lease investments, explain why now is the time to invest in the sector.

What makes now a good time for European net lease investment?

Thomas Reckers: There are a combination of factors that place net lease investment across Europe in a sweet spot. There is rising demand for alternative finance from corporates and companies are seeking to sell and lease back their highest quality and most strategic assets to attract capital and to maintain long-term occupational control.

From an investor’s perspective, current capital market dynamics make this an opportune time to buy, with higher real estate cap rates providing a comfortable spread to financing costs. Furthermore, long-term net leases provide the right sort of income-generating and inflation-linked investment profile demanded by a range of investors, including pension funds and insurance companies.

What is driving demand for sale-leasebacks from the corporate side?

David Leshnick

David Leshnick: The sources of demand are twofold. Firstly, as the macroeconomic environment improves, M&A volumes are rising. Private equity firms have high levels of dry powder and investment-grade corporates have near record high levels of cash holdings. Both factors drive M&A activity, which is a good source of deals for us as private equity companies look to free up cash from portfolio companies by selling their real estate to net lease investors.

Secondly, the higher-for-longer interest rate environment will put pressure on companies that have higher floating rate liabilities or near-term debt maturities. We see ourselves as a form of alternative finance, and so we benefit from many of the tailwinds from which the wider private credit market benefits, especially as traditional bank financing becomes less readily available or accessible.

Are there particular markets or sectors which are better for net lease investors? 

Thomas Reckers

TR: There are opportunities across Europe; however, there are markets where net lease investing works better than others. Germany, the UK and the Netherlands have well-established sale-leaseback markets. Some other countries, for example France, are more difficult due to their local legal framework or accepted market lease practices.

Regarding sectors, we focus on two areas: industrial/logistics and non-discretionary retail, such as grocery or DIY stores. While our cost of capital can be too high for prime logistics markets, we see many compelling opportunities in the light industrial, production and manufacturing sectors. Germany and Italy are the largest manufacturing nations in Europe, while Poland’s share of manufacturing has been growing.

What is the pricing environment for net lease transactions?

DL: Pricing today is a lot more attractive than it was 12 to 24 months ago. Real estate yields are following the movement in interest rates, albeit with a six- to 12-month lag, which varies from market to market; pricing shifted faster in the UK than Germany. We are seeing prime logistics yields in some markets moving out to about 5 percent, from 3.0-3.5 percent. At the same time, rents are increasing, which is accounted for in index-linked sale-leaseback structures. So, from our perspective, this product offers a valuable credit-oriented, inflation-linked income structure along with the downside protection of owning the real estate.

TR: We have not typically focused on investment-grade tenants, but pricing in this space has become more appealing. In some markets, we have seen cap rates for these deals moving out by 200 basis points. That is why we see a great opportunity to deploy capital that did not exist three or four years ago. We expect over the next few years that interest rates will normalize again, although not back to near zero levels, and this should feed through to lower cap rates, serving to drive real estate valuations up again.

Why is Europe fertile ground for net lease investors?

DL: The key attraction is that the net lease market in Europe is very much untapped, compared with the US. The amount of European corporate-owned real estate is estimated at €4 trillion to €5 trillion, which is approximately twice what it is in the US, so there is a lot more potential here. There is also less competition in Europe, as the net lease market is less developed, whereas in the US net lease is a commoditized product with a deep pool of investors.

For us, that means less specialist European competition. There are some net lease REITs investing globally, but they tend to target larger assets and give us room to aggregate institution-grade portfolios in the lower and middle markets. Looking ahead, we are targeting lot sizes of €10 million to €40 million. Pricing is better in Europe as its harder to get positive leverage in the US given where interest rates and industrial cap rates are currently.

TR: Where the US does have an advantage is financing, the focus being more on the credit of the tenant and the diversification of the portfolio. In Europe, it takes more time to get financing, and there is a greater focus from the lender on the real estate. So we are facing something of an ongoing education process with the banks.

What financing is typically employed by net lease investors?

TR: Financing is generally done on an asset-by-asset basis. It is non-recourse debt, around 50 percent LTV and with as little amortization as possible, ideally interest only, as our funds are structured to make recurring distributions to our LPs. Of course, typically debt is fixed for four to five years, but then thanks to indexation, the cashflow distributed increases every year. Due to inflation over the last few years, we have benefited from strong rental rises in our portfolio.

How important is the balance of real estate and credit skills/knowledge in net lease investing?

TR: The blend of real estate and credit is a key differentiator for net lease; you could say that we are only in the real estate game if we make a bad credit decision! If we do our underwriting correctly and the corporate keeps the lights on, then by the very nature of the investment strategy we have little to do with the real estate.

We spend a lot of time underwriting the real estate, how strategic the asset is to the tenant, as that will have some impact on residual value and alternative use. Generally, due to the specialized nature of the assets, it is a question of alternative user rather than use.

What length of lease do net lease investors look for?

DL: Typically, we are looking for anything above 15 years. For manufacturing and industrial assets, one would typically see a longer lease term, but for logistics it might be shorter. Ideally, we are looking for assets which are so strategic to the company that they will take 20-year leases, with no intention of leaving the asset.

How can sustainability be enhanced in these investments?

TR: We take a vigorous approach to asset selection and tenant engagement to future-proof our assets, with a focus on energy efficiency, reduced water consumption, waste management and biodiversity. We employ green lease provisions providing that tenants report energy use and encourage tenants to seek ESG ratings, such as BREEAM, as this improves the liquidity of the asset. We see tenants being more open to green leases and capex on ESG measures, although they typically favor measures with a short payback period.

What is driving investor demand for net lease funds?

TR: A lot of investors compare our strategy to corporate bonds, and so, as a comparison, a BBB European corporate bond is probably trading at a little over 5 percent, whereas we are typically acquiring assets at 7-9 percent initial yields. Beyond the current pricing advantage, we offer inflation protection through increasing annual rents, and there is a lot of downside protection from asset ownership.

There are plenty of examples of corporate bondholders taking a haircut when a company runs into difficulty, whereas leases on strategic assets are protected from restructuring and of course, if needed, identifying a new tenant would help to secure full recovery of the equity. These elements add to make net lease real estate attractive to investors.

A net lease investment is fundamentally an income product, and we target an 8 percent annualized distribution yield and a low- to mid-teens IRR, which is compelling in the current market. There is growing demand for stable, inflation-linked income for investors across the board.

We are in discussions with pension funds and insurance companies who are facing growing liabilities and a difficult underwriting environment. The product allows them to effectively diversify both their fixed income and real estate portfolios while still providing attractive, risk-adjusted returns.

What is the typical hold period and exit strategy for net lease assets?

DL: I think we are a little unusual in Europe because we have successfully exited net lease investments. We are in the business of crystallizing profits for investors in closed-ended funds, rather than being long-term holders of assets like REITs. A key consideration for us is to be able to exit with 10 years remaining on the lease, because assets with longer leases offer more liquidity. Sometimes, our tenants like to buy back the real estate, which demonstrates how strategic the assets are to them.