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Why institutional capital is gravitating toward net leases

With attractive returns and steady cashflow, single-tenant assets are becoming popular for US investors.

Pharmacy chains, such as Walgreens, are popular targets for net lease buyers.

Real estate strategies centered on triple-net leases are attracting an increasing amount of capital from institutional investors in the US.

The Indiana Public Retirement System committed $75 million to Angelo Gordon’s latest Net Lease Realty Fund this month, and in August, the Connecticut Retirement Plans and Trust Funds became the latest US pension to invest $100 million in Oak Street Real Estate Capital’s first open-end net lease vehicle, which aims to be the largest fund to target the space at $2.5 billion.

These recent commitments are part of a broader movement toward net-leased assets by investors seeking safety, reliability and stable returns.

Total net lease investment in the US has scaled from less than $12 billion in 2009 to nearly $70 billion last year, according to a report from CBRE. Institutional capital and equity funds have played an increasingly prominent role in this space, surpassing REITs in total investment in 2015. Institutional acquisitions totaled $25 billion in 2018 and, last quarter, were up 46 percent year over year at $8 billion. They lagged only private buyers, which invested 46.5 percent more than last year at $10.8 billion.

Oak Street estimates there is $7.6 trillion of owner-occupied commercial real estate in the US that could be converted into net leases, according a CRPTF meeting document, so proponents see a long runway for continued growth.

“In an environment where everything feels frothy, in what some investors are calling late or later in the cycle, any strategy that is backed by good credit and can deliver 7 or 8 percent current yield is appealing,” Oak Street chief executive Marc Zahr told PERE.

In triple-net lease agreements, tenants pay taxes, maintenance and insurance costs on a property in addition to rent. Lease durations are long, typically 10 to 20 years, and feature annual rent increases, PERE understands. Funds active in this space tend to focus on ‘mission-critical’ properties owned and occupied by non-real estate companies – pharmacies, insurance companies and service providers, such as auto repair shops. Acquired through a sale-leaseback arrangement, these deals offer short-term liquidity to businesses and stable, long-term revenue for investors.

Oak Street targets investment-grade tenants with its net lease funds. Zahr said the Chicago-based firm will only buy properties that house businesses with BBB-ratings or better because they pose less of a risk for default – a level of security that appealed to CRPTF.

Laurie Martin, chief investment officer of the pension plans, was also drawn to Oak Street’s track record, which spans four previous funds and a separately managed account. Since 2010, the firm has bought 167 net leased properties and sold 158 of them, generating a 32 percent net internal rate of return and 1.5x net equity multiple, according to a memo sent to Connecticut’s treasurer in June.

For its latest vehicle, an open-end core-plus fund, Oak Street is projecting a 7 percent annualized current cash return paid monthly and a 10 percent net IRR over the life of the fund, per the document. Martin wrote that “[t]hese return targets seem to be reasonable and achievable given the current market environment and the total returns – including income – achieved by the firm in prior vehicles.”

Oak Street has raised $1.6 billion for its Net Lease Property Fund. The Pennsylvania State Employees’ Retirement System, Teacher Retirement System of Texas and Teachers’ Retirement System of the State of Illinois have committed $300 million apiece to the vehicle.

Angelo Gordon launched its fourth Net Lease Realty Fund this year and has raised $197 million, according to PERE data. Gordon Whiting, head of net lease real estate at the New York-based firm, declined to comment on the latest vehicle, citing regulatory restrictions. However, he said the series has typically focused on leasebacks to below-investment-grade tenants because of their growth potential. “If you have a less-than-investment-grade tenant and they become investment grade, the value of your investment tends to increase. There are other factors like location, but in general, you will see some type of increase.”

Angelo Gordon’s previous net lease fund, Net Lease Realty III, has achieved one-, three- and five-year net returns of 8.31 percent, 7.77 percent and 7.11 percent, respectively, according to a meeting document from the Kentucky Teachers’ Retirement System. As of 2017, the prior fund, 2010-vintage Net Lease Realty II, had delivered an 8.34 percent IRR, according to a report from the North Carolina State Treasury.

Foreign investors are also active in the net lease space. During the past four years, cross-border acquisitions have averaged $8 billion, a marked jump from the $3 billion averaged between 2011 and 2014, according to CBRE. Investors from Canada, Germany, South Korea, Singapore and China have been particularly active, each accounting for more than $1 billion of capital during the past two years, with most flowing to office or industrial assets.

Though less active than their US counterparts, overseas institutions are showing more interest in net lease funds, sources tell PERE, in part because of the greater diversification they offer over their REIT counterparts. Traditionally, REITs have dominated net lease investing by favoring retail. Listed firms own nearly 16,000 free-standing retail assets, according to Nareit, a trade organization for US REITs. Private funds tend to target a variety of property types. Industrial assets have been particularly popular because of the growth in e-commerce and their operationally critical nature. One example is New Mountain Capital Partners, a New York-based private equity and credit firm, that made its real estate debut with a net lease fund. Focused on logistics warehouses, the vehicle raised $533 million – an oversubscription of $180 million.