Last year was a sizzling 12 months for the net lease sector of the commercial real estate business. And 2022? So far, it’s been strong, too. But can this year hope to measure up to 2021?
We spoke with Randy Blankstein, president of the Boulder Group in Wilmette, Illinois, about the hot net lease market and what he expects for the rest of the year. Here is what he had to say.
Last year when we spoke, we talked a lot about how strong the nest lease sector was. What is the market like today?
Randy Blankstein: We saw very strong transaction volume last year. The net lease sector was the beneficiary of all that was going on in the world. It represented a stable investment. Net lease generates reliable cash flow. It was all about certainty at a time when none of that existed elsewhere. It is a calm, boring, conservative investment, and people gravitated toward that last year when there was so much uncertainty elsewhere.
There has been what could be a wrench, though, thrown in this, higher inflation and higher interest rates. We are waiting to see how that plays out. It has not changed the supply-and-demand side of the equation. A lot of people think it is a question of time as to when interest rates impact the net lease market. That typically lags a bit. The consensus, though, is that there will be upward pressure on cap rates. But the supply/demand equation is still favorable to sellers. There is not much new product out there, so demand is still high for net lease product, which means it is still an attractive investment option.
Which net lease asset types are most attractive to investors today?
Blankstein: For the most part, there are not a lot of single-tenant office spaces in downtowns. This means that net lease has avoided most of the worst problems you’ve seen in the office sector. Most net lease office space is suburban, single-tenant space, which has outperformed urban. That is a market people are watching closely. There are still ongoing concerns about the office market, so transaction volume in that sector is on the lighter side.
Industrial, though, there seems to be endless demand for. That is the hottest product out there. The fundamentals in this sector are strong, especially here in the Midwest. The supply of industrial space will not catch up to the demand for it this year. There is an overwhelming number of people who have raised money and are dedicated to getting more into industrial. That is a sector that for this year will remain very strong with very little changes in supply. That is probably the sector that will perform the best this year.
The retail sector remains strong on the net lease end of the market. Net lease retail spaces are a lot different from the enclosed malls and strip centers that are having issues today. The 7-11, dollar stores, Walgreens and Home Depots are all performing well. There is still a limited supply in net lease retail. New construction remains dampened from the supply chain issues we are facing. It is still difficult for developers to get enough contractors, not to mention lumber and other materials. Typically, the net lease product that trades is of a newer vintage. There has not been enough new construction to keep that stage of the market so robust. It is a seller’s market, for the most part.
What are the challenges that this sector faces?
Blankstein: The big challenge now is inflation. A lot of leases in this space are long-term leases. Some have minimal rent escalations built into them. Investors are now gravitating toward leases that have more robust escalations. A lot of the drug stores, for example, have fairly flat leases. The worries about inflation are changing some of these deals. Investors want the appropriate discounts applied to a long-term fixed income stream in an environment of inflation and interest-rate challenges. Investors are reevaluating what they want to pay for a fixed income return and they are hyper aware of what the escalations are. It had been a more stable environment for the last 20 years. Inflation and rising interest rates are new headwinds that investors are considering.
What about healthcare assets? Are they in demand today?
Blankstein: No question, there is a lot of demand for healthcare assets, from urgent care facilities and dialysis centers to satellite locations operated by major hospitals. There is a lot of money allocated for healthcare assets. We have an aging population in the United States. Healthcare real estate is a growing sector. Historically, it’s been under-allocated because there haven’t been as many freestanding medical facilities. That is changing. This is a category that investors are excited about.
This asset type was the beneficiary, too, of COVID-19 and all the testing that came with it People went to these non-traditional or smaller-scale locations during the pandemic because they had more of a comfort level with medical care being offered outside of a major hospital campus. Investors have seen this and think this is a good space for investment.
What about the sale-leaseback end of the market? What do you expect from this end of the sector in 2022?
Blankstein: The sale-leaseback market has been rather muted the last few years. With this sector, you are essentially locking in long-term financing. It is more expensive than if you are floating on LIBOR or another line of credit. So sale-leasebacks might not have made a lot of sense the last few years in an environment of low interest rates. What will drive more sale-leaseback activity? An environment of rising interest rates. Locking in fixed-rate financing gets more attractive as rates rise. A lot of the cost-benefit analysis has changed for many corporations where locking in sale-leaseback financing makes more sense. That is the major reason why sale-leaseback activity will increase.
There were fears last year that the federal government might do away with 1031 exchanges. It seems that exchanges are now safe. Are they?
Blankstein: Last year was the most likely year in my lifetime for the elimination of 1031 exchanges. All the events were lining up behind that happening. The Biden administration was working on its Build Back Better package and 1031 exchanges were seen as potential revenue offset. There seemed to be a lot of momentum behind eliminating the 1031 exchange program. But when the specifics of the Build Back Better package got finalized, the elimination of the 1031 exchange program didn’t go through. I’m not as concerned about the program this year, though it is always an ongoing threat. The real estate industry did a good job last year getting the message across about the collateral repercussions of 1031s going away.
The government was trying to paint 1031 exchanges as a tax benefit for high-net-worth individuals, and it is for some. But a lot of other people depend on 1031s, from title companies and lawyers to people with REITs and pensions. Municipalities depend on them. A lot of unforeseen effects were brought to light. Everyone realized getting rid of 1031 exchanges was bad for commercial real estate in general and residential real estate, too.
For the most part, the threat of getting rid of 1031s is behind us. The imminent threat is behind us. The industry does need to stay vigilant, though. Last year was probably the biggest stress test in a long time, and we passed. I think 1031s are here to stay.
Are you optimistic about the near-term future of the net lease industry?
Blankstein: Last year we saw a confluence of events that might have been one-time-only events. We had a worldwide pandemic and people were coming out of it. There were a lot of changes that occurred because of COVID that greatly benefitted net lease. It might be tough to keep the volume of transactions in 2022 at the same level we saw in 2021. We are in an evolving industry. If we continue to see inflation and interest rates rise going forward, sale-leaseback volume will go up. Net lease always plays a part in people’s portfolio. It’s the defensive part, kind of like the bond market. Investors are not trying to hit homeruns with net lease investments. They are playing defense, trying to protect the gains they made in real estate.
We also have an aging population closing in on retirement. Many of them are under-invested in their retirement savings. They are taking a closer look at all kinds of fixed-income alternatives. As this group of retirees are looking at their retirement savings, net lease might be attractive to them. If you want to get rich, you buy vacant land or spec a product with no tenant. You buy a 7-11 or Walgreens if you want to get a fixed income and collect a regular check. That check comes in every month. It is predictable and exactly what people who buy it are looking for.