October 19, 2011

News: National

Niche Targets Spread the Playing Field in Single-Tenant Arena

Written by Mark Heschmeyer: mheschmeyer@costar.com

Emerging Trends in Single Tenant Deals Expand Investment Range to AAA and Distress; (Part 4 of a 4-Part Series)

As the feeding frenzy developed in single tenant property sales over the past four months and competition for deals heated up, investors invariably began hunting for twists and niches in search of a better deal. In this report, we present the investment strategies shared by several active single-tenant investors, and how they the expect the market to change going forward.

Tim Marshall, principal of TM 1031 Exchange Inc. in Santa Monica, CA, pulls out an email he received from an investor earlier this month that he says aptly illustrates the changed mindset among investors: "I purchased a new Walgreen's earlier in the year at a 7.25% cap rate and am not interested in further drug stores as I want to diversify and not be too deep into any one segment. I'd be interested in more information from A or better credits like Verizon and the federal government. (Would need to negotiate a better deal, as 6% is not overly enticing). Not interested in a 1031...just a cash purchase for the right opportunity. I have been a muni bond investor for many years, but don't like the yields and the credits are not as good as they used to be... thus my interest in high quality long-term leases with strong tenants and in good locations (ultimate security)."

Marshall said this one client isn't alone in his thinking.

"We have seen significant interest in 'A' quality industrial properties. Strategically located facilities with strong credit tenants, attractive lease terms and financing are seen as a safe, long-term haven by a number of larger investors," Marshall said. "Properties with weak tenants, less desirable locations or deficient lease terms are struggling along with the rest of the market. We attribute this to a natural response to the uncertainties in the economic environment. Today, investors are seeking as much certainty and liquidity as possible." Even with attractive debt available for quality properties, Marshall said that over 75% of closed transactions at his firm to date have been for all cash. "We attribute this to the large cash reserves many investors have maintained through the current economic cycle and an aversion to the inherent risk associated with leverage," he added. In this Part 4 of our 4-part series on the single-tenant net lease investment market, we look at a few other of the emerging plays within the segment.

Like Marshall, Winston Orzechowski, research director at Calkain Companies Inc. in Reston, VA, said he also is seeing the segment spread out to both ends of the market, with increased spending at both valuefocused and more affluent stores.

"Dollar stores continue to be very popular. But, now, even higher end stores such as Neiman Marcus are seeing more spending," Orzechowski said. "Government tenants are very attractive in either downtown or suburban areas. However, urban areas are more highly valued due to high barriers of entry and proximity to public transit. Larger government leases usually have their "Non Appropriation of Funds Clause" stricken - guaranteeing the investor a bond like income stream. Industrial government sites are often secure facilities, with restricted access and high value tenants improvements such as SCIF (Secure Compartmentalized Information Facility). Anything inside the beltway is golden." At the other end of the spectrum, investors also are targeting distressed, zero-cash flow properties. "Real estate investors are also utilizing net lease assets in distressed situations," added Orzechowski. "As an example, we recently completed a complex 1031 transaction involving two zero-cash-flow, net lease properties occupied by CVS."

In this case, the purchaser had a debt obligation of approximately $22 million that needed to be replaced with the purchase of new assets. Purchasing highly leveraged, zero-cash flow CVS properties allowed the LLC to complete a 1031 tax deferred exchange, meeting its debt obligation with minimal equity contribution while enabling it to defer taxes and re-invest in passive real estate. Gerald A. Klassen, research analyst at the Real Estate Center at Texas A&M University in College Station, TX, said he believes the best investment plays going forward for the next eight years will be to find tenants that serve the needs of frugal customers.

"We are in the early stages of household deleveraging," Klassen said. "Households will either cut spending to pay down more debt or they will default on their debt and keep spending. Both outcomes have serious implications for the economy. It is still too early to make assumptions about future trends in consumer spending."

"This year the first of the Boomers is turning 65 and the largest consuming segment in the economy is entering a period of secular earnings decline," Klassen said. "Depending on how you classify the Echo Boomers, they are still eight years away from turning 40 and entering their strongest earning years. So we may be headed for an air pocket in consumer spending for the next eight years." To play on a common warning in the investment industry: Past consumption doesn't necessarily predict future spending.

Ken Wimberly, managing director of Noble Crest Property Group, a Member of KW Commercial in Arlington, TX, said that the same trends Klassen point out are giving a boost to single-tenant medical office buildings transactions.

"Health care will always be a priority and we expect consumer spending on health care to increase as the baby boomer generation continues to age," Wimberly said. John Bacon, vice president marketing - real estate of Cole Real Estate Investments in Phoenix said they are seeing more interest in sale-leaseback deals within the single-tenant segment. "So far this year, we are seeing a growing number of sale-leaseback opportunities in the market, with both creditworthy and non-creditworthy companies," Bacon said. "One reason is that interest rates are low and tenants can lock in their occupancy costs for the long-term at the low end of the real estate cycle when rents are lower."

"Other companies are looking at expansion as we come out of the recession, and sale-leasebacks provide companies access to capital," Bacon added. "When M&A activity picks up, companies will use the saleleaseback as part of acquisition financing. Non-creditworthy companies can use sale-leasebacks to gain access to capital that might be unavailable or cost-prohibitive via traditional financing methods."

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