Three key trends in the net lease sector

The stability net lease offers in a time of high inflation is just one reason the strategy's time has come.

The net lease property investment market saw a continued slowdown in new transactions last year as investors assessed the lasting impacts of rising inflation and higher-for-longer interest rates, but market indicators are showing why demand is climbing for net leased real estate as an asset class.

Cap rates in the single-tenant net lease (STNL) sector are continuing to rebound across all three major property types of office, retail and industrial, according to a report from the Boulder Group, a net lease investment real estate brokerage firm based in Chicago.

In the well-established US net lease market, one popular net lease involves a property occupied by a sole corporate user. These STNLs can result from a sale-leaseback transaction or a build-to-suit deal, and often involve real estate that occupiers feel is important to the continued operation of their business. Such deals are particularly prevalent in the logistics and retail sectors.

The US net lease retail sector saw a 7 basis-point increase in asking cap rates from Q4 2023 to Q1 2024, but at 6.42 percent, that beat the 6.64 percent overall national average cap rate on asking prices across property types. Office cap rates climbed 5 basis points to 7.6 percent in the first quarter, while industrial rose 2 basis points over the previous quarter to 7.02 percent.

Randy Blankstein, president of the Boulder Group, wrote in an April post on LinkedIn that: “Cap rates in the first quarter of 2024 represented the highest levels since 2014 for single-tenant retail properties. However, cap rates for single-tenant retail and industrial assets remain lower than their 20-year historical average by approximately 40 basis points. Elevated interest rates continue to impact transaction volume, which is lower than prior years.”

International commercial real estate brokerage Colliers, looking at sales numbers for the second half of 2023, notes that volatile capital markets have led to constricted sales volume in STNL sales, resulting in the lowest totals since 2012. The firm notes in its year-end report released last quarter that one reason for this is the 10-year Treasury yield peaked around 5 percent in October while the Fed held its announcement to pivot rates until December, “resulting in restricted lending and a pullback in activity.”

Higher US Treasury yields resulted in higher cap rates for net lease properties, averaging 6.4 percent at the end of 2023, according to global brokerage CBRE.

The net lease sector has long been seen as a haven for investment dollars, benefitting from stable, bond-like risk and return compared to traditional property ownership, with additional down-side protection through contractual rent increases and long-term leases. However, appetite has waned as transaction volumes continued to fall amid dropping valuations in recent years, according to CBRE.

However, net lease does not exist in a vacuum, and these same macroeconomic market drivers are impacting all commercial real estate deals.

Net lease investment volume in the US fell by 45 percent year-on-year in Q4 2023 to $8.3 billion, according to CBRE research. By comparison, total commercial real estate investment volume fell by a similar 44 percent to $81.2 billion over the same period. For full-year 2023, net lease investment volume fell by 51 percent from 2022 totals to $38 billion, while total commercial real estate volume fell by 52 percent over the previous year to $348.4 billion in 2023.

Demand for net lease industrial properties remains robust, while investors around the world are shying away from the office sector amid changes in demand. However, retail sales in the net lease sector are outperforming than the overall retail property market, according to Colliers.

That is in-part attributed to the large number of available retail properties in the market. As a long-time favorite asset class in the net lease investment strategy, especially among popular single-tenant, triple-net transactions, retail properties currently make up more than 3,400 of the 4,500 current net lease properties on the US market in the first quarter, as tracked by the Boulder Group, which found that net lease retail properties with the largest supply – dollar stores and drug stores – continue to experience the greatest cap rate expansion.

Beyond the current statistical headlines associated with net lease investment, executives speaking to PERE about the sector have highlighted the following key trends.

1Stability and diversification in net lease investments

Net lease investments continue to offer stability for investors, making them attractive to a wide range of investors seeking consistent income streams and risk mitigation, as well as diversification.

According to David Grazioli of US Realty Advisors, a real estate investment and asset management firm focused on sale-leaseback and build-to-suit transactions in the US, net lease investments provide a “sleep well at night” risk profile.

Unlike other real estate classes that are subject to market dynamics and occupancy fluctuations, net leases offer fixed income with minimal exposure to these variables by way of the durability and predictability of income from long-term lease contracts where tenants are responsible for property expenses and capex.

Net lease investments are suitable core allocations due to their consistent income across operationally critical assets, especially in the cases of sale-leaseback and build-to-suit transactions. These assets offer reduced downside risk and an inflation hedge through long-term leases with escalating rents. Net lease investments can serve as essential building blocks in diversified income portfolios.

Such investments appeal to various investor types, including high-net-worth individuals and institutions seeking diversification away from traditional market volatility.

Net leases provide tax-advantaged income and attractive real yields, especially in these current inflationary environments. For institutions aiming to meet benchmark returns beyond the conventional 60/40 rule, net lease investments offer compelling diversification benefits and upside potential.

2Emerging opportunities in European, APAC markets

While trailing the more mature net lease markets in the US, the sector is gaining popularity in European and Asia-Pacific markets, which present compelling opportunities driven by rising demand for alternative finance, M&A activities and favorable property-yield environments.

Cap rates in Q1 represented the highest levels since 2014 for single-tenant retail properties

Randy Blankstein
Boulder Group

The untapped nature of the European and Asia-Pacific net lease markets has created a less crowded space with significant opportunity for specialist investors. The demand for alternative finance from corporates, coupled with more supportive interest rate environments, makes net lease investments particularly appealing to pension funds and insurance companies seeking income-generating assets.

Certain European and Asian markets like Germany, Poland, Japan and Australia do have well-established sale-and-leaseback markets facilitating net lease investments, while net lease transactions are less prevalent in other countries.  In many markets throughout the European and Asia-Pacific regions, industrial manufacturing, logistics and in-demand retail are preferred sectors due to their stable income profiles.

The pricing environment for European net lease transactions has become more attractive with rising real estate yields and increasing rents, while Asian markets are seeing increased demand for sale-leaseback transactions as investors seek access to high-quality real estate and secure income.

3Market dynamics impacting net lease strategies

Net lease strategies are evolving to meet changing macroeconomic and market conditions, emphasizing stability, inflation protection and strategic property acquisitions.

The evolution of net lease investments from niche to mainstream has been driven by increased investor demand for inflation-proof assets amidst market volatility. Sale-leaseback transactions in particular are designed to provide stable, risk-adjusted returns while freeing up capital for occupiers.

Net lease strategies are adapting to current economic trends, with longer lease terms becoming the norm while rent escalations tied to inflation are aimed at hedging against losses. Owner-occupiers are increasingly exploring sale-leaseback transactions to unlock capital and pay down expensive debt while freeing up the equity locked in their real estate and maintaining some control of their assets, making net lease investments more attractive than traditional corporate financing methods.

Net lease investments offer stability, inflation protection and diversification benefits across global markets amid changing headwinds. As the demand for alternative finance and income-generating assets rises, net lease investments present compelling opportunities for investors to build diversified portfolios with stable, long-term returns.

Current market dynamics, including rising cap rates, the cost of capital and a shortage of buyers, belie a promising outlook for net lease investment strategies should interest rates fall in the year ahead.