Inflationary pressures test the net lease sector

Investors seek stability with net lease transaction types able to stand the test of time.

Net leases are attractive for investors eager for stable returns and minimal management responsibilities, while occupiers get a quick boost to their balance sheet by turning their real estate into usable equity. The win-win financial vehicle has seen a once-niche product offering become a staple across all sectors of real estate, but figuring out which deal structure is best can be a challenge.

Sale-leasebacks, build-to-suits and acquisitions offer distinct advantages and considerations shaped by market dynamics and macroeconomic trends. Diving into the details of these structures in the US markets, where net lease transactions are more prevalent, helps investors assess developing trends around the world.

The concept of a sale-leaseback helped pioneer the net lease sector as occupiers sought to unlock capital tied up in real estate.

With the cost of capital remaining elevated, more businesses are seeing the benefit of sale-leasebacks, particularly in sectors like retail, healthcare and industrial, where liquidity can be harder to find on a balance sheet. Rising interest rates created a buyer’s market for sale-leaseback investors across many markets and sectors.

EVgo, an electric vehicle charging station company, just closed on multiple sale-leaseback deals at charging stations in California and New York valued at $27 million. “The sale-leaseback model is a highly effective capital structure that allows EVgo to maintain a nimble position in the market,” says the company’s chief executive officer, Badar Khan.

Amid a pullback in commercial real estate transactions across the board, sale-leaseback investment volume fell by 21 percent to $6.6 billion in 2023, according to research by global brokerage CBRE. However, sale-leaseback deals accounted for 17 percent of all net lease transactions (totaling roughly $38 billion) last year. This is up from 11 percent of 2022 totals and beats the five-year pre-pandemic average of 15 percent.

In a year-end report, CBRE forecasts that net lease investment activity should pick up around mid-year 2024, once economic conditions stabilize.

The long-term nature of the leaseback deal locks in a valuation, meaning the creditworthiness of occupiers is a primary concern for sale-leaseback investors. Sale-leasebacks are often seen as a way to de-lever and improve key creditworthiness metrics. While not inherently bad, such cases deserve scrutiny. Understanding why a potential owner/occupier wants a sale-leaseback and what the business plans to do with the proceeds is key to making any deal work.

Data reflects transactions reported to MSCI Real Assets and may not fully represent total market activity (Source: CBRE Research, MSCI Real Assets)

Tailored solutions

“While sale-leasebacks continue to draw interest in the net lease market, we observe strong fundamentals in the net lease industrial build-to-suit market,” explains Jim Koman, founder and CEO ElmTree Funds, an industrial net lease real estate private equity firm.

“Industrial tenants remain focused on building out their supply chains in response to secular shifts in the consumer market, including e-commerce, reshoring of manufacturing and the shift in US trade from China to Mexico. These trends [have] been significant demand drivers in the net lease industrial market.”

A build-to-suit net lease involves investors financing construction costs, which can impact the viability of build-to-suit deals. Though the deals can be risky and more difficult to execute, demand remains steady, particularly in sectors requiring specialized facilities such as healthcare, logistics and technology.

Build-to-suit data centers are becoming an increasingly large business. Digital Realty and Realty Income have launched a joint venture on two build-to-suit data centers in Northern Virginia. These data centers are fully preleased under a 10-year, triple-net lease anticipated to start in mid-2024, with an initial cash return of 6.9 percent and a stabilized capitalization rate reported in the 5 percent range.

$38bn

Approximate total value of net lease transactions completed in 2023

Occupiers in these sectors are particularly sensitive to the efficiency and functionality of their real estate footprint, demanding custom-built facilities they can maintain some control over. Recently, companies seeking to modernize their operations or enhance supply chain resilience have turned to build-to-suit solutions. Around the globe, supply chain disruptions and material shortages can impact construction timelines and costs, potentially affecting project feasibility.

Unlike a more traditional sale-leaseback deal, most build-to-suits end up costing the landlord liquidity in the short term. Requiring additional upfront capital typically results in higher returns over the long term, creating an attractive opportunity for investors that can line up construction funding.

Acquiring income

Purchasing existing net lease deals may be simple, but in today’s market, making the deals work is proving more difficult. Inflationary pressures lead to a decrease in real yields as the purchasing power of future cashflows diminishes. Investors in turn demand higher initial yields to compensate for the risk of eroding purchasing power, but those types of adjustments are not feasible in most existing lease structures. Net leases often have longer terms, making potential returns even more susceptible to inflationary volatility.

In net lease agreements, periodic rent escalations are standard, often tied to inflation or other economic indicators. However, during periods of rapid inflation, these predetermined escalations may not adequately reflect the true increase in costs. Investors are hesitant to acquire properties with leases that have fixed or below-market rent escalations, as they may not match market conditions in the future.

Rent escalations are secondary to pricing concerns. Valuation uncertainty during inflationary periods erodes investor confidence. When investors are unsure about the accuracy of the property’s valuation, they may hesitate to commit capital. Without a clear understanding of the property’s value, buyers and sellers may have divergent perceptions of a deal’s worth.

“Looking forward into 2024, price discovery in the transaction market persists,” Ryan Albano, president and chief operating officer of diversified net lease industrial REIT Broadstone Net Lease, said on the company’s February earnings call. “Interest rate volatility continues to influence the capital allocation decisions of buyers at a more accelerated pace than the price expectations of sellers, leading to a persistent gap in bid-ask spreads and an overall muted level of completed transactions in the broader market.”

Overall, the net lease sector is a mixed bag. While there is demand for the asset class from investors and tenants looking to make a deal, getting the details right amid a time of uncertainty is proving to be the biggest challenge.

Last year was the slowest for net lease transactions in a decade, despite plenty of interest from both sides of the table. Single-tenant net lease industrial deals continue to dominate, accounting for over 50 percent of volume in the first half of 2023, according to data from global broker Colliers.

Market indicators have net lease executives feeling optimistic that the worst is over. With inflation softening, the Fed has begun to reverse course on rates. How fast that relief arrives will determine the velocity of the net lease sector through 2025, but there are positive signs.

“We believe the narrowing of bid-ask spreads, in conjunction with a more settled outlook for capital markets, has set up a more constructive environment for external growth in 2024, especially through sale-leasebacks,” WP Carey CEO Jason Fox told investors.

Net lease sale-leasebacks, build-to-suits and acquisitions have created new profit centers for dealmakers, but each of these different transaction types are feeling the pressure of broader macroeconomic conditions. In a market with elevated capital costs, build-to-suits and acquisitions will take a back seat to leaseback deals, though pricing discrepancy is holding back substantial deal volume there.

With traditional real estate investment facing strong macroeconomic headwinds, the net lease sector promises investors the safety that many are after.