Stabilizing markets will suit net lease strategies

Better interest rate outlooks and burgeoning opportunity in European and Asian markets are boosting interest.

Adjusting to higher interest rates and lower valuations has taken some of the wind out of the sails for net lease markets around the world, but sector participants are optimistic that both investors and corporate real estate owners will warm to the sector.

Compared with the highly developed and competitive market in the US, the number of net lease specialists in Europe is limited, which is a cause for optimism among specialist players there. Meanwhile, the net lease market is not as formalized in the Asia-Pacific region, although sale-leasebacks with triple-net lease terms do exist there.

In addition to increased opportunities in these countries, many investors from European and Asian countries are investing in the more mature US net lease market, with Spain and Singapore contributing a combined 44 percent of cross-border investment in the net lease sector

Still, the US net lease market saw transactions slump in 2023, with volumes down 51 percent to $38 billion, according to research by global brokerage CBRE. The fall in transaction volumes was in line with a 52 percent fall in overall investment volumes across the larger commercial real estate market.

In its first-quarter 2024 market report, the Boulder Group showed higher interest rates continued to suppress transaction volumes, while net lease property supply had increased due to fewer 1031-exchange buyers.

More attractive

Rising cap rates means lower values for corporates seeking to sell their real estate.

Josh Shandell, vice-president at Canadian alternative investment manager Brookfield Asset Management, says: “Higher interest rates have significantly increased the cost of capital for operating companies, making sale-leasebacks relatively more attractive than debt and equity, even at cap rates much wider than where they were a couple of years ago. While M&A volumes, which often influence sale-and-leaseback activity, are lower in this environment, we’re still seeing demand, for example, in order to pay down more expensive debt or fund growth opportunities.”

He adds that, while higher rates also mean elevated borrowing costs for net lease investors, there is still a positive spread over the cost of debt. CBRE research says spreads between the average net lease cap rate and 10-year Treasury yield increased to 234 basis points in the fourth quarter of 2023 from 212bps in the fourth quarter of 2022.

Alistair Calvert, Europe CEO at New York-based real estate investment firm Clarion Partners, says: “Banks have become much more risk averse lately and we have seen a dramatic slowdown in bank lending to the corporate sector, which has left many businesses, especially SMEs without direct access to capital markets, requiring alternative sources of financing.”

Net lease investing offers investors stable, long-term income with a degree of inflation protection thanks to real estate ownership and built-in rent rises, especially if rents are linked to inflation. This appeals to core real estate investors but also fixed-income departments.

“Private credit has generated quite a bit of investor demand recently, so we’re seeing fixed-income investors interested in net lease, which has traditionally been thought of as a real estate sector,” explains Shandell.

While existing net lease investments have suffered in the same way as the wider market due to rising cap rates, “net lease investments have historically outperformed other real estate types during downturns,” adds Calvert.

“The performance of net lease real estate, similar to other private commercial real estate investments, has suffered due to increased interest rates and higher financing costs. Nonetheless, with market capitalization rates having now recalibrated, there exists an opportunity to acquire long, inflation-linked cashflows at attractive entry yields.”

The industrial and logistics sector remains the most popular with net lease investors, accounting for half of all US net lease investments in 2023, according to CBRE, and more than half of the total in Europe, according to MSCI. In the last quarter of 2023, nearly 75 percent of all European net lease transactions were in the industrial and logistics sector.

Retail is also a popular sector, while data centers are widely tipped to be a growing sector of interest to net lease investors and to expansion-hungry cloud companies. The office sector, meanwhile, saw its share of US net lease deals  fall to 23 percent in Q4 2023, down from 32 percent a year earlier, according to CBRE. Hit by the homeworking phenomenon, net lease real estate investment trust WP Carey announced last year that it was exiting the sector, spinning off 59 office properties into a new REIT and selling another 87 assets.

Room to grow

Today, the institutional net lease investment market is mainly a US phenomenon. To illustrate this level of maturity in each market, Calvert says: “In the US there currently exist between 15-20 real estate investment trusts  specialized in net lease real estate. In contrast, Europe has only a handful of specialized net lease investors.”

Larger net lease REITs such as Realty Income and WP Carey invest in the US and Europe, as does Clarion on the real estate private equity side. Meanwhile, European specialists such as Lodge Quai and LeadCrest Capital are taking advantage of a less competitive market where corporates own trillions of euros in real estate but net lease investing is lesser known.

Research from Realty Income shows a total of $5.9 trillion of corporate real estate in developed European markets and a further $2.6 trillion in the UK. Furthermore, with less than 1 percent of this owned by net lease REITs, compared with 5 percent ownership stake across the US, the scale of the opportunity is considerable.

Calvert says: “We see further growth potential in the European net lease market as sale-and-leasebacks become a more established source of financing, and as the higher corporate real estate ownership rates in Europe converge toward the lower ownership rates observed in the US. In an inflationary environment, the fact that most European commercial leases are linked to inflation – compared with fixed increases in the US – is a significant plus, bolstering the appeal of net lease investments in the region.”

While there is a consensus that interest rates have peaked, the Federal Reserve has shown little inclination to begin cutting rates, something hoped for across the real estate spectrum. Meanwhile, a weaker economy in Europe may mean that the European Central Bank is ahead of the Fed when it comes to interest cuts. Even stability, however, at least means more certainty for investors and corporate real estate owners.

“With markets anticipating the commencement of rate cuts in 2024, we believe we are transitioning into a more favorable interest rate environment for net lease investments,” says Calvert, who adds that there is anticipation of an uptick in merger and acquisition activity during 2024. Historically, M&A has been one of the driving forces behind net lease transactions.

Boulder Group president Randy Blankstein says: “With stability in the capital markets, the expectation from market participants is for increased transaction volume in the second half of 2024.

“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.”

Still, any increase in activity would surely be welcome across global property markets.

Asia sees sale leasebacks in fledgling net lease market

Opportunity abounds among APAC’s disparate markets 

While sale-leaseback and triple-net leases are not unknown in the Asia-Pacific region, they are less common than elsewhere in the world, and there is no distinct net lease sector for institutional private equity investment. At least not yet.

Luke Prokuda, head of equity advisory, Australia, at global brokerage services firm JLL, says: “Corporate sale-and-leaseback transactions have been highly prevalent in the Asia-Pacific real estate investment markets for a long period of time. Although activity has slowed, in light of the higher interest rate environment, sale-and-leaseback transactions will continue to remain highly sought after by large global real estate investors seeking access to high quality real estate, underpinned by long-term secure income and backed by strong credit quality corporates.”

Comprehensive data in the fragmented region is hard to come by, but a CBRE report showed $44.4 billion of corporate real estate disposals in 2021, of which only 27 percent came in the form of sale-leaseback deals. The buying parties in sale-leaseback transactions were predominantly core funds and institutional investors, CBRE said. Japan and Australia were the biggest markets for sale-leasebacks transactions.

Andrew Burych, head of East Asia at Brookfield’s real estate group, notes: “In APAC, while you may get long term leases that are akin to triple-net leases, the market is not as developed.”