Retail net lease could enter rough waters

The sector is getting used to higher interest rates and cap rates, but uncertainty remains.

Net lease investment across the retail sector has been experiencing a rough patch the last couple of years, and it looks like the pain may not be lifted this year. That said, many net lease experts expect to see some stabilization in capitalization rates, which have risen every quarter for the past two years.

There are a handful of culprits behind this collapse after net lease deal volume and transaction values peaked in 2020 and 2021, chief among them were spikes in interest rates from central banks around the world. Though the US Federal Reserve has said interest rate cuts are in the offing in 2024, recent economic data is creating a wall of uncertainty for officials as well as the real estate industry overall.

“The last couple of years have been very tumultuous,” says Matthew Mousavi, managing principal of US retail brokerage SRS Real Estate Partners’ national net lease group. “I’ve noticed optimism building around these rate cuts that are supposedly coming, but it is now cautious optimism.”

Higher for longer

Interest rates and cap rates might be considered a dynamic duo because of the power the two yield together. Rising rates translate to potentially higher returns, but the risk rises as well.

In the global retail market, where there are relatively few pieces of distressed real estate, higher cap rates also have a huge impact on transaction volume and property values as the number of buyers falls. In 2020 and 2021, retail cap rates were at 4-5 percent; today they are at 6 or 7 percent, even approaching as high as 9 percent on some properties in certain subsectors, according to net lease investment brokerage specialist Boulder Group’s first-quarter net lease market report.

Net lease deal volume in the retail sector tumbled by 40 percent to $2.3 billion in Q4 2023, from $3.8 billion in Q4 2022, according to research from global brokerage services firm CBRE. For the full year, the retail sector dove 45 percent. However, market share of net lease transactions for the retail sector edged higher to 28 percent, from 25 percent a year earlier. The industrial sector also saw an increase, while office deals fell, according to CBRE research. When looking just at the single-tenant net lease sector, brokerage firm Colliers reports the share of retail sales was closer to 30 percent for the first half of 2023.

On a global scale across all property sectors, the average cap rate in the net lease sector stood at 6.4 percent in the quarter, 60 basis points higher on a year-on-year basis, notes CBRE’s fourth-quarter net lease market report.

Will Pike, managing director of net lease properties for CBRE, says: “The net lease market outperformed the broader market by our calculation, probably by 1 percentage point. Traditionally speaking, if you look at the overall share of transactions in the marketplace, net lease tends to do better in turbulent times. It’s a safe haven for capital.”

Net lease deals have long produced steady and predictable returns akin to bonds, but with added inflation protection as a result of built-in rent hikes and owning the underlying real estate asset. As a result, investors are often protected from rising costs.

More than cap rates

But cap rates are only one piece of the net lease puzzle in this environment. Tenant creditworthiness and lease terms are weighty as well, particularly at a time when the retail sector is enjoying healthy growth and occupancy rates at many shopping centers and lifestyle malls are sitting comfortably in the low- to mid-90s.

“Occupancy rates are healthy, but the valuations are out of whack,” says Mousavi. “Because we don’t have a lot of distress, you don’t see valuations going down, even though rates have gone up considerably.”

The longer the lease term, the higher the market cap. For example, the median asking cap rate for a 16- to 20-year lease in the casual dining sector stood at 6 percent, according to its report. A lease term of five years or less was at 7.5 percent.

The dollar and drug store sectors were starker, dependent on the brand. For dollar store leases with fewer than three years left, the rates spanned 8.5-9 percent, while in the drug store sector, leases with fewer than five years showed cap rates ranging from 7.75-9.45 percent, according to the Boulder Group.

Market stabilization

There is no such thing as equilibrium in markets. What happens is industry participants get accustomed to what the industry is offering, what is for sale at what price, what might be under water and why, and how to correct it in whatever the current environment is.

“Volumes are down, but deals are
getting done”

Robert Horvath,
Horvath & Tremblay

When industry experts talk about stabilization in this interest-rate environment, they are speaking more of acquiescence, an acceptance that higher interest rates for longer and the overall state of the sector is, as some would say, what it is. Robert Horvath, executive vice-president at Horvath & Tremblay, a Massachusetts-based real estate agency focused on net lease deals, says: “There was an initial shock [around the rapid rise of interest rates] because it moved so quickly, but for many people, it’s the new norm now. Volumes are down, but deals are getting done.”

CBRE’s Pike agrees, and is far from pessimistic about the net lease scene. He notes that his firm still sees “a lot of net lease retail [trading] every day. It’s not all negative by any stretch. We expect a moderately better year than last year. It’s obviously drastically different than three years ago. We had record volume in 2021 and the benchmark rates were 300 basis points lower. That’s a big deal.”

What’s ahead?

Horvath adds: “Everything was selling a couple of years ago. You put a deal out in the market and you had 10 offers on the deal. You pick the buyer and if they didn’t perform, so be it. There was another buyer right behind them. That’s not the case today. There are not a lot of buyers and you have to navigate deals differently.”

Typically, 1031 tax-deferred exchanges drove many net lease deals. That is not the case now because valuations are still high, so those types of deals are harder to get done.

“The buyer pool is down considerably,” says SRS’s Mousavi, noting that the investors who are enjoying this period are all-cash buyers. “They have the pick of the litter.”

As a result, smaller deals, particularly in the $1 million-$5 million range, are getting done.

Horvath explains: “The smaller deals are holding up better from a cap perspective, independent of credit. The smaller the deal, the cap rates have held fairly well because they’re typically not finance transactions. The larger deals independent of the credit have moved more because of the cost of capital.”

For the most part, industry experts expect deal activity in the net lease retail sector to pick up in the second half of the year with or without an interest rate drop, though a pullback in rates would go a long way. But even if they do not come at the pace or degree that buyers and sellers would like, most agree the market is growing.

Still, uncertainty looms. “Where do we go from here,” asks Mousavi. “Is it smooth sailing? Is it flat? Is this the calm before the storm? Or is the storm way behind us?”

Retail’s shining moment

The horizon is bright for well-located retail assets around the world

Though the retail sector stumbled in the early years of the decade, it is having a “moment” now, as some experts say. Vacant spaces in shopping centers, malls and strip centers are getting filled with new concepts as well as expansions from healthy retailers, leaving very few properties in a distressed state.

Ermengarde Jabir, senior economist at Moody’s Analytics, noted in JPMorgan’s 2024 Commercial Real Estate Outlook that the retail sector “is expected to experience steady performance, with unchanging vacancy rates and moderately positive rent growth for neighborhood and community shopping centers.”

Interest rate cuts would go a long way to shaking net lease deals up again, or a glut of distressed properties could get retail transactions moving again.

SRS Real Estate Partners’ Mousavi explains: “Distress might help us and make for a more efficient market. The market is inefficient now because it’s frozen. We’re either in the trough or we’ll be hitting it soon. The longer this drags out, the more risk you have of those who have to refinance in 2025 or 2026. Then we might be in dire straits.”

Though a step up in transaction volumes would surely be welcome, it is not likely to make much of a dent, according to the Boulder Group, at least not initially. “With stability in the capital markets, the expectation from market participants is for increased transaction volume in the second half of 2024,” reads the firm’s report. “However, an increase in transaction volume would be relative as transactions are not expected to be anywhere near the amount in prior peak markets including 2020 and 2021.”