REAL ESTATE NEWS

Net lease investors are exposed to the challenges of the current economic environment, and the high interest rates that continue to impact the industry.The spread between interest rates and cap rates remains historically low making it challenging for buyers to purchase, merchant developers to build, and tenants to expand.While net lease is considered one of the simplest asset classes to own from a day-to-day perspective, it requires a complex understanding of real estate fundamentals for long-term success.

That's according to Chad Kurz, EVP and managing director of net lease retail at Matthews, who says that while the fundamentals are challenging, the right strategies can help investors uncover opportunities and place capital. Here are three strategies that Kurz says can optimize net lease performance, even in a challenging market.

Look Beyond the Cap Rate
Two different deals with equal cap rates may appear the same, but they rarely carry the same risk or upside potential.

"People look at the cap rate as though the deals have the same amount of risk associated with them, but that is just not true," says Kurz. "Not all cap rates are equal and a good broker or investor knows the difference."

Take two restaurant properties offered for sale; they are in a similar market, with a similar purchase price ($3MM), and a similar cap rate being offered (5.50%).The first property is a small drive-thru only building that can be purchased above replacement cost.It is paying substantially higher rent than market, and operates at a much lower EBITDAR coverage ratio.The second property is paying below market rent; and operating at a much higher EBITDAR coverage ratio.The downside of the first property is substantially higher, and the upside of that property is also substantially lower.It makes no sense that both assets will trade at the same price and the same cap rate, yet they do.As investors analyze deals, it is important to look beyond the cap rate and purchase price, explains Kurz.

Learn from Past Mistakes
Many investors focus on the quality and prestige of the tenant rather than the real estate fundamentals, but the physical asset is more important than the tenant alone.

"Real estate is the ultimate security. Focus on quality real estate that happens to have a lease attached to it, don't focus solely on the lease," says Kurz. "With every net lease asset, the lease will eventually go away and you'll be left with just the real estate. Buyers that don't understand that often don't realize they just purchased an annuity."

Buyers today, individual investors, family offices, DSTs, and large institutional investors, are making the same mistakes they have made in past decades.They purchase property based on the credit of the tenant and the length of the lease with little regard to the actual underlying real estate.As the lease term burns down, the credit of the tenant downgrades, or the tenant reduces rent or vacates, they lose a substantial amount of their initial equity."If anything, the mistakes buyers are making today are worse than in the past," says Kurz."Twenty years ago, a premier credit tenant was at least located on a great corner, even if it was a challenging box to re-use.Today, some of the premier credit tenants are in challenging boxes to re-use, and they're also located in undesirable locations."

Consider Shorter Lease Structures
One of the other concepts buyers don't understand is that higher interest rates and post-Covid inflation have had a major impact on new construction assets.Chad Kurz explains, "higher interest rates mean that developers are building at higher cap rates, and inflation means it's more expensive to build.This has caused rent for new construction properties to be significantly higher than where they were just 5 years ago."

Understanding the nuances of net lease provides owners and brokers great opportunities in today's market to manage their portfolio.

For more insights and thought leadership from Matthews, click here.

Source: GlobeSt/ALM