With a recession around the corner and inflation likely to be stickier than originally expected, defensive real estate strategies focused on long, secure, inflation-linked income hold greater appeal to investors in today’s market environment.
Net lease is one such strategy, with transactions typically involving the acquisition of “mission critical” corporate real estate, usually via sale and leaseback or build-to-suit structures. Such assets are typically let long-term on triple net leases, protecting landlords from increases in property-related expenses.
Since its founding in 2006, Clarion Partners Europe has closed approximately €2.1 billion of net lease transactions across seven jurisdictions in Europe. But CPE expects net lease transactions to make up an increasing portion of its acquisition volume for the foreseeable future. As we examine below, investing in net lease assets in Europe has particular merits at this point in the economic and property cycle.
Alternative financing to banks and bonds
Economic uncertainty, financial market volatility and rising interest rates are all contributing to restrict the amount, and increase the cost, of debt financing available to corporate occupiers. Bank credit standards tightened during previous downturns and a recent ECB survey suggests this may be the case this time around as well.
Bond financing may also prove less attractive for corporates due to rising interest rates, as demonstrated by the sharp reduction in high-yield bond issuance since the beginning of the year.
In this environment, corporate occupiers may be more likely to monetize their real estate portfolios to generate liquidity. Anecdotally, Clarion Partners has observed a substantial increase in interest in S&LBs from corporate occupiers over the last few months.
While the mainstream commercial property sectors of offices, industrial and retail have traditionally accounted for the bulk of S&LBs, the rise of “alternatives” such as life-science and data centers has widened the pool of investable assets and, with it, the size of the opportunity. Corporate disposals more than doubled across the EMEA from 2012 to 2021, reaching a post-GFC high of €29.2 billion across 670 disposals during 2021, according to JLL’s Raising Capital from Corporate Real Estate report. Clarion Partners expects the European S&LB market to grow faster in the coming years as corporates consider alternative forms of financing to bank loans and bond issuance in a lower-liquidity environment.
One key advantage of net lease investments for investors stems from the fact that the majority of returns tend to come from contractual income and contractual CPI. Returns are therefore typically more stable and predictable. Net lease/long income strategies have also generally tended to outperform the wider market during downturns as returns are less dependent on estimated recovery value growth, development gains or exit yield compression. For all the above-mentioned reasons, net lease investments have the potential to generate an attractive risk-adjusted return, specifically in the current uncertain and volatile market environment.
Finally, net lease assets tend to benefit from an inflation hedge provided by European commercial leases through CPI indexation, which provides downside protection in inflationary environments. Leveraging with fixed-rate debt results in locking in an inflation multiplier effect. Longer-term inflation expectations in Europe have increased substantially since the reopening of European economies and general conclusion of lockdowns. European 5-year inflation swaps stood at 2.7 percent at the end of October 2022, higher than pre-GFC levels when the economy was firing on all cylinders.
Now more than ever, net lease investments benefit from numerous tailwinds. These tailwinds stem from capital market illiquidity, growing demand for liquidity from corporates and high inflation. Moreover, net lease can temper return volatility in a turbulent market. For all these reasons, European net lease strategies can provide attractive risk-return investment opportunities, especially in times of elevated macro-economic uncertainty. Investors looking to recession- and inflation-proof their portfolios should take note.