The net lease sector has provided a haven for investor dollars during even the most challenging of economies. But today? That is changing.
High interest rates and persistent inflation has caused investors to pause, even when they are considering net lease assets. Sellers and buyers are still adjusting to today’s new market, and so far? No one is budging and deals aren’t getting done.
Midwest Real Estate News spoke with Randy Blankstein, a net lease expert and president of the Boulder Group in Wilmette, Illinois, about the sluggish net lease market. Here is what he had to say.
Let’s start with the big question: How have higher interest rates impacted sales in the net lease space?
Randy Blankstein: Volume was down significantly in the first quarter of the year. This is the result of two things. First, interest rates and inflation have hurt. And last year the first quarter was a historically strong one. Activity in the first quarter of last year was abnormally high. Now we have gone abnormally low in the first quarter of this year. Until the Fed is done raising rates, we can expect volume to remain down. During times of uncertainty, the path of least resistance is to move to the sidelines.
The net lease sector has long been considered a safe investment. Isn’t that a plus today?
Blankstein: The net lease sector is under pressure for the same reason that the bond market is under pressure. Net lease has always been a conservative investment. It’s been safe. Net lease investments don’t have a lot of upside or a ton of downside. When interest rates and inflation go up, though, you can’t adjust the rents enough to keep up, so the value of net lease properties goes down. When you can get short-term bonds on 4.5% and 5%, it doesn’t make sense to pay the same cap rate on real estate. People want a greater spread when bond yields are high.
Cap rates are going up, but people want them to go up even higher. Sellers aren’t always catching up with the interest rate environment. There is a group of people who think that interest rates will hopefully stop going up and start to move down again next year. Why should they sell in the middle of this tightening curve? There is a large group of owners who would rather not sell their net lease properties in this current environment.
There is a belief that the Fed might be winding down its hiking of interest rates. How much of a boon would that be to net lease sales activity?
Blankstein: That’d be good news if it happens. The Fed might be signaling that it will move this way. We might be close to the end of the hikes. But that doesn’t mean that interest rates will necessarily go down. And we don’t even know for certain that the Fed won’t raise rates again.
The Fed could pause their hikes but then raise interest rates again later. Just because they stop raising rates for now, doesn’t mean we are at the end yet. When the Fed does stop raising rates and pauses their increases for a long time, then I think it will have a positive impact on the net lease market. But we’re not there yet. Most people I talk to are saying to forget what the Fed says and instead watch what inflation does. When inflation is below 3%, they tell me, let us know. That’s when they’ll get active again in the net lease market.
Even in today’s challenging economic environment, are their net lease asset types that are attracting investor dollars?
Blankstein: There is less competition today. In times like this, you’ll see a flight to quality. In net lease, that means assets with longer leases and investment-grade tenants in major metropolitan areas. Investors have the chance to buy those at better prices than they could in the past. Assets that are selling at lower prices, under $4 million, are more attractive for investors today, too. This is an interesting time to buy some of the higher-quality assets. It is an interesting time to be a buyer if you are looking to buy something of quality.
Are investors especially skittish today?
Blankstein: The problem is, people are looking at the headlines today. When you see commercial real estate in the news today, what do you see? You see a lot of negative headlines about the struggles of downtown office buildings. That is the most challenged sector in commercial real estate and the most visible. The struggles of office buildings make headlines. That causes people to think that commercial real estate is perhaps in worse shape than they envisioned. If you think commercial real estate is only core urban office buildings, then commercial real estate in your view isn’t strong today. People who look past that one sector, though, get a better sense of things.
The key question out there, which no one has an answer to, is were the last few years an aberration and are we reverting to the mean? Is this the new normal? Or is the new normal somewhere between what we saw the last two years and what we are seeing today? I am in the camp that this is probably the new normal and people must adjust to it. People bought properties at more aggressive pricing during the last few years and aren’t anxious to realize losses or break even when they sell. That has put us in an adjustment period.
How long will this adjustment period last?
Blankstein: No one knows the answer to that. But people will have to adjust. They can’t sit on the sidelines forever. Sellers will have to sell eventually. If you sell a property and you only break even or you lose money on the deal? Your track record is now less stellar than it was. People are not anxious to put break-evens or losses on their track records. It’s a tough realization. It’s an adjustment, but it’s a painful one.
How about the sale-leaseback side of the industry? How is that niche performing?
Blankstein: Sale-leaseback business hasn’t expanded to the extent that people believed it would, myself included. It had been hard to do sale-leaseback transactions the last few years because you could borrow on a floating rate cheaply. Now that short-term rates are up, and continuing to go up, there should be more interest from investors in sale-leaseback deals. The cost of capital has gone up. Suddenly, doing a sale-leaseback becomes more viable. I think the volume of sale-leaseback deals should be up in the second half of the year.
That being said, sale-leaseback volume has been well below where it was before. It is surprising that volume hasn’t gone up yet. Everyone is taking a look, but they are still on the sidelines. I’m not sure how long that is going to last. People’s initial reaction today is to play wait-and-see. Ultimately, though, you have to make decisions. Corporations are like individuals, you have to adjust and adapt over time. I am confident that sale-leaseback deals will become more viable in an environment of rising rates. You are taking interest-rate risk out of the equation when you do a sale-leaseback. I am optimistic that the increase in sale-leaseback transactions will happen. We just haven’t seen it to the extent that we thought we’d see it.
What is the state of the 1031 Exchange market?
Blankstein: The 1031 market faced the most serious political threat that it ever had in 2021. You had the presidency, House and Senate all under the control of the Democrats. They viewed 1031 Exchanges as something that benefited the wealthier people in the country. The timing was right for politicians to either eliminate or tweak the way 1031 Exchanges worked. But it never happened. Now, with a divided Congress, that is essentially dead. Those two sides won’t likely agree on anything. No one is talking about 1031 limitations or the elimination of 1031 Exchanges at this point.
As for today? 1031 volume is down, too.
What are your predictions for the rest of the year? Do you think sales activity in the net lease sector will finally increase?
Blankstein: There are certain events that people have delayed. There are a lot of loan expirations coming in the second half of the year. That will force people to either reduce their cash flow by refinancing or to sell. They must make a decision one way or the other. It’s easy to have lenders kick that decision down the road for three or six months. But lenders will only do that for so long. In the second half of the year, these owners will have to make a decision. People are optimistic about next year. It is a presidential election year. The Fed usually doesn’t fight people in a presidential election year. They will do what is necessary this year, but probably back off in 2024.
This is a transaction-driven business. You can put yourself on the sidelines for a while. But in the long term, people are looking for you to invest capital and earn a return. You have to choose a direction at some point. People will be more motivated to close deals in the second half of this year. Volume will be up in the second half of the year but will be down from last year overall because volume has been down so much in the first and second quarters of the year. I expect us to rebuild a bit and be better than today. It’s just an adjustment period, and adjustments take time.
