2014 SUMMER REpoRt net lease economic report · net lease economic report 2014 SUMMER REpoRt...

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net lease economic report2014 SUMMER REpoRt

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The Federal Reserve has cut its purchasing of distressed assets by 50% year-over-year, leading to upward

movement on Treasury yields. Despite the pressure that rising interest rates present, retail net lease cap rates have

compressed over the time period, dipping below 7% in 2014.

net LeaSe BUoYeD BY StronG InStItUtIonaL IntereStLofty risk-adjusted returns drove investors to well-tenanted net lease assets during the Great Recession. As the economic outlook and real estate markets have strengthened, the demand has remained robust even in the face of the Federal Reserve’s announcement in May 2013 that it would taper its quantitative easing measures. While real estate sales in March 2014 were 5.2% lower year-over-year, transaction volume in the first quarter of 2014 was up 15% over the first quarter of 2013.

Large sale-leaseback transactions have headlined the triple net market in the end of 2013 and first half of 2014. Other institutional investors have increased their exposure to net lease assets as well, seeking higher yields than fixed income securities with a similar risk profile. Recent CMBS transactions have also seen an uptick in single-tenant triple net collateral. More and more, the net lease sector is experiencing a secular shift toward becoming a significant component of general commercial real estate portfolios.


tHe eConomY anD ProPertY InVeStmentReal estate investment has been spurred on by strengthening fundamentals across most property types. First quarter 2014 sales volume increased over 33% over the previous year, hinting at a strong year to come. More promising, only about one in ten deals involved distressed asset pricing, down from the peak of roughly 30% in 2011. Vacancy rates across most asset types have fallen to within 100 basis points of their pre-recession levels. Balance sheet lenders have started taking more risk in commercial mortgage lending and the post-recession CMBS market has consistently cleared new issuances despite a loosening of underwriting standards.

Retail investors have branched out to secondary and tertiary markets seeking yields no longer available in primary markets. Markets with strong demographic drivers and economic growth factors, like Austin, Charlotte, and Denver, posted higher than average pricing gains

The broader US economy has improved with solid gains in the housing and stock markets. The S&P Case-Shiller 20-City Home Price Index is up 12.4% over last year, to levels last seen in 2008. Both the S&P 500 and Dow Jones Industrial Average are at least 150% over their March 2009 lows and have produced multiple all-time highs in the past twelve months. These signs of recovery will likely bring a mixed-bag of implications for the real

estate market. Increases in Treasury yields thus far have been absorbed by a compression of lending spreads, but further expansion of risk-free rates will likely result in upward pressure on capitalization rates.

Stock indices have surged to historic highs since the recession. Soaring corporate profits have not been met with new hiring; rather corporations are using their workforce more efficiently.

The US economy inched forward at an annualized real rate of 0.1% during the first quarter. This represents the worst first quarter performance since the economy contracted by 1.3% in the first quarter 2011.


tHe ConSUmer In tHe eConomYEconomic recovery in the US hinges on healthy consumers. The standard bearer measures of consumer confidence, employment and wages, have been methodically increasing at meager rates. The job market has consistently posted modest gains every month, but currently sits at just 6% over the post-recession lows in 2010. The total non-farm employment in April 2014 sits at its highest level since February 2008, 6.6% over its nadir in February 2010. These levels are within 0.1% of its peak in January 2008. Similarly, retail employment has climbed 6.7% above its trough in December 2009, but remains 1.9% off of its peak in November 2007.

Wages have slowly inched upward as well with January 2014 median weekly wages of $791, roughly 3% higher than previous year. However, the Conference Board Consumer Confidence Index hit a post-recession high of 83.9 in March 2014 and has remained within 3% of this peak in April and May. This is up from a recent low of 72.0 in November 2013, which reflected the general economic upheaval of the US government shutdown.

Employment remains a critical point of weakness for the

economic outlook. More

than five years since the beginning of the financial crisis, the number of Americans gainfully employed remains below its prior peak.

There is little concrete evidence of momentum in job creation. Over the last three years, monthly net gains have improved only slightly.

Job trends aside,

consumer confidence has been lifted by restored home equity and retirement account balances. Real income has been increasing slowly but improving sentiment has seen a reversal of higher savings rates and higher spending.


ConSUmerS anD retaIL aCtIVItYRetail sales have consistently grown since the height of the crisis in 2009. While personal income has fluctuated wildly in response to tax increases in 2013, increased consumer confidence has triggered lower savings rates and increased expenditures. Since 2011, personal income has risen at an annualized rate of 1.4% per annum, while per capita expenditures have increased at an annualized rate of 2.3% per annum.

The growth in sales has been disproportionately weighted towards online retailing. Total e-commerce was estimated at $71.2 billion in the 1st quarter of 2014, up 15% over the 1st quarter of 2013. By comparison, total retail sales only grew 2.4% over the same period. E-commerce represented approximately 10.1% of retail sales in the 1st quarter of 2014 (excluding auto and auto part retailers, food and beverage establishments, and gas stations), up from 9.6% in the 1st quarter of 2013.

In 2013, the renewed surge in the housing market helped acted as a catalyst for growth in home improvement and home furnishing retailers. However, the biggest year-over-year increases in retail sales belong to health and personal care stores which posted 3.9% and 3.1% gains, respectively, over 1st quarter 2013 levels. The biggest losers were sporting goods, hobby, books stores and gas stations which posted -7.8% and -2.8% losses over the same time period. While gas stations sales are likely related to fluctuations in the underlying price of oil, losses by sporting goods, hobby, book/music stores suggests that they are losing a larger portion of their sales to online channels.

Despite the shift towards e-commerce, recent polling suggests that consumers still spend about 60% of their

Taxing sales on the Internet will not

reverse the secular shift

in favor of online commerce. Market leaders including Amazon are pushing aggressively to expand the relevant set of product categories, exploring new technologies and logistics relationships for delivery to consumers.

shopping time at brick-and-mortar stores. Additionally, 40% of consumers found they spent more than originally planned while shopping at brick-and-mortar stores; whereas only 25% of consumers spend more than planned while shopping online. Hoping to cash in on both the convenience of e-commerce and the binge shopping of brick-and-mortar stores, more retailers are producing cross-channel promotions - a trend that is expected to continue in the coming year.

March 2014 Retail Spending-Change from Year EarlierSource: Commerce

All Retail Sales 2.3%Excluding Autos & Parts 1.3%Excluding Autos & Food Service 1.0%Furniture & Home Furnishings 1.2%Electronics & Appliances 1.3%Building Materials & Garden 2.6%Food & Beverage Stores 1.6%Grocery Stores 1.2%Health & Personal Care 4.3%Gas Stations -2.8%Clothing & Accessories -1.0%Sporting Goods, Books, Music -7.8%General Merchandise -0.2%Department Stores -6.1%Online & Non-Retail Stores 15.0%Food & Drinking Establishments 3.1%


InVeStment anD FInanCInGThe commercial real estate industry has thus far absorbed the impact of the tapering of the Federal Reserve’s quantitative easing programs. Treasury yields sharply rose during the so-called “taper tantrum” which normally would pressure property values down and financing costs upward. In practice, however, increased demand from institutional investors and a lack new development have kept property values for net lease retail buoyant. The average net lease retail cap rate was 6.79% in March 2014, with some sectors like banks commanding sub-6% caps. Other tenants have averaged sub-6% cap rates in 2014, including Starbucks, McDonald’s, 7-Eleven and Wawa.

During the recession much of the institutional interest in triple net retail was seen as a flight to quality. While bond yields were extremely low, some non-real estate institutional investors were attracted to triple net lease assets as higher yielding alternatives to corporate bonds. Both of these players are likely to remain active in the sector, now that triple net retail emerging from its perception as an “other” or “alternative” asset class.

Demand in triple net assets has also come from the reemergence of the 1031 exchange market. Dwindling cap rates have forced some investors to chase yield by investing in properties with short lease terms. Others focus on secondary and tertiary markets, having been priced out of primary markets by increased competition.

Lenders have responded to increasing risk-free rates by tightening spreads, softening the impact to borrowers. The renewed demand in commercial real estate has also spurred a loosening of underwriting standards as both balance sheet and conduit lenders are starting to accept more risk. Overall, debt yields have been dropping since 2010.

The health of the triple net sector can be viewed by the

As compared to a year earlier, preliminary estimates for Q4 2013 show marginally higher borrowing costs. However, cap rates and debt

yields were both lower. Borrowers

increased their leverage as underwriting standards eased.


expansion of net lease REIT market. Recently American Realty Capital (NASDAQ: ARCP) merged with Cole Real Estate to form a $21 billion REIT, the largest in the US. Other net lease REITs like Realty Income (NYSE:O) have used the low volatility of cash flow from triple net properties to increase dividends for 19 years and counting.

tranSaCtIon SPotLIGHtThe triple net market in early 2014 is headlined by the $1.5 billion sale-leaseback transaction involving the Red Lobster restaurant brand and ARCP. Red Lobster has been underperforming with 8.8% year-over-year drop in same-restaurant sales in the quarter ending February 23, 2014. Darden Restaurants (NYSE:DRI) announced in December 2013 that it would spin off the ailing chain as a public entity in order to focus on growing chains like LongHorn Steakhouse and other core chains like Olive Garden. However, in May 2014, Darden entered into an agreement to sell the brand for $2.1 billion to private equity fund, Golden Gate Capital. As part of that sale, Golden Gate agreed to sell more than 500 Red Lobster locations to ARCP and enter into a triple net lease at a cap rate of 7.9%. This cap rate is well above the average restaurant cap rate of 7.1% in 2014.

For about 93% of the Red Lobster locations, the initial lease term will be 25 years; the remaining locations are leasehold interests and will have a weighted average initial term of 18.7 years. The leases have contractual rental increases of 2% per annum.


MARKET TRENDS Charts reflect trends through mid-Q4 2013; data points are annual averages

For most of the past 10 years, pharmacies have traded at a slight premium to the broader retail market. In 2013, this premium disappeared and the average pharmacy traded at a slight discount. However, in 2014 thus far, the premium has returned for the average pharmacy.

Bank properties are among the most popular triple net property types in 2014. There is tremendous competition, which brings the average cap rate below 6%. However, it is worth knowing that not all bank branches will see renewals.

By and large, the asset type with the largest discount to the general retail market is dollar stores. However, this discount has shrunk over the past two years and is expected to recede further in 2014 and beyond.

Average restaurant cap rates track the all retail rate, with much volatility in pricing. Established national brands with good financials tend to trade at a premium excluding examples like Red Lobster.

Quick service restaurants have rallied in recent years. The average currently sits at 6.4%, which is only 8 basis points above its level in 2005. Starbucks and McDonald’s lead the way, with each of them averaging sub-6% cap rates

The big box sector continues to lag behind the general market with few potential tenants in the mix for this property type


These casual dining restaurants each average in the low 7% range, near the 7.13% average for the sector.

Walgreens and CVS lead the way while Rite Aid lags behind. This division echos the credit ratings of the companies.

Starbucks leads the pack, with McDonald’s trading at a significant premium to competitor Burger King.

These discount retailers trade at a discount to the broader retail market. However, stronger stores like Dollar Tree which averaged a 7.05% cap rate trades close the all retail rate of 7.01%.

0.00% 2.00% 4.00% 6.00% 8.00%

10.00%

Walgreens CVS Rite Aid

Pharmacy Tenant Cap Rates

0.00%

2.00%

4.00%

6.00%

8.00%

7-Eleven Wawa Circle-K

C-Stores Tenant Cap Rates

0.00%

2.00%

4.00%

6.00%

8.00%

McDonald's Burger King Starbucks

QSR Tenant Cap Rates

4.50%

5.00%

5.50%

6.00%

Bank of America

JP Morgan Chase

Wells Fargo TD Bank

Retail Bank Tenant Cap Rates

6.90%

7.00%

7.10%

7.20%

7.30%

Applebee's IHOP Golden Corral

Casual Dining Tenant Cap Rates

6.50%

7.00%

7.50%

8.00%

8.50%

Dollar General Dollar Tree Family Dollar

Dollar Store Tenant Cap Rates

0.00%

2.00%

4.00%

6.00%

8.00%

Advance Auto Autozone Pep Boys

Automotive Tenant Cap Rates

All of the major banks are trading at extremely low cap rates with JPMorgan Chase edging out the group.

Source: Calkain, Chandan


Dr sam Chandan is Founder and Chief Economist of Chandan Economics and a professor in the associated faculty at the Wharton School of the University of Pennsylvania. Dr. Chandan’s research and market commentary are focussed on commercial real estate capital markets, the structure and regulation of housing finance, and the credit performance of residential and commercial mortgages. He is the editor and co-author of Real Estate Finance, a columnist for the New York Observer and GlobeSt, and co-host of the forthcoming Real Estate Hour on SiriusXM Business Radio.

Dr Chandan is the National Economist of the Real Estate Lenders Association (RELA) and holds advisory and editorial board appointments at the Federal Reserve Bank of Atlanta, the Real Estate Research Institute, the National Center for Seniors Housing, the Commercial Real Estate Finance Council, and Multihousing News. Prior to founding Chandan Economics, Dr. Chandan was Chief Economist at Reis and Global Chief Economist at Real Capital Analytics. He holds a PhD in Applied Economics from the Wharton School and was a doctoral scholar in the Economics Department at Princeton University. He currently teaches Real Estate Investments at Wharton and was a visiting professor in the Economics Department at Dartmouth College.

Jonathan W. Hipp is the Founder, President and CEO of Calkain Companies and is a member of Calkain’s Executive Committee. Calkain is a national, commercial real estate firm which provides brokerage and consulting services for both private and institutional clientele that specializes in assisting Buyers and Sellers with the acquisition and disposition of single and multitenant net lease investment properties. The company is comprised of five divisions specializing in brokerage, advisory, asset management, capital markets and research.

Jonathan is one of the leading experts in Net Lease Investments. With over 25 years of experience in Commercial Real Estate, he manages the overall strategies and growth of Calkain and has successfully completed nearly $3 billion in investments throughout his career. Through his leadership and vision, Calkain has grown to $9 Billion in transactions. Mr. Hipp also serves as a member on the President’s Council of the prestigious invitation-only Real Estate Roundtable. His unique industry expertise is manifested in a well reviewed book he co-authored, The Little Book of Triple Net Lease Investing, which serves as a handbook for investors.

Winston orzechowski is the Research Director of Calkain Companies. He has been instrumental in growing Calkain’s research and web presence to its current position as the preeminent source of research and market data on the net lease industry. Thru outlets like Net Lease Advisor (www.netleaseadvisor.com) he has helped make Calkain’s research some of the most downloaded and viewed industry data on the web. Winston also leads in Calkain’s publishing of numerous reports on the net lease market, including the Calkain & Chandan Net Lease Economic Report, monthly trend reports, broker opinion reports, whitepapers and maintains the weekly Net Lease Insider on Globe Street.

Winston is a graduate George Mason University with a Bachelors Degree in Marketing.

ContaCt

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Copyright © 2013 Calkain Companies, LLC. and Chandan Economics LLC. All rights reserved. All information contained in this report is propri-etary to Calkain Companies and Chandan Economics and is protected by copyright and other intellectual property laws. No part of this report may be copied or otherwise reproduced, further transmitted, redistributed, repackaged, or resold, in whole or in part, by any person or entity, without Calkain Companies or Chandan’s prior express written consent.

Disclaimer. The findings in this report are based solely on the opinions of Calkain Companies and Chandan Economics and the data and ana-lytics available to Calkain Companies and Chandan Econonmics at the time of publication. Neither Calkain Companies, Chandan Economics, its employees, agents, or successors makes any warranties, express or implied, including warranties of merchantability or fitness for a par-ticular purpose, or assumes any legal liability or responsibility for the accuracy and completeness, or usefulness of any information contained in this report or represents that use of this information would not infringe other third party rights. Further, Calkain Companies and Chandan Economics shall not be liable for any direct, indirect, consequential, or inconsequential damages to the user, or any third party arising from use of the information contained herein. In providing this information, Calkain Companies and Chandan Economics do not assume any li-ability as a result of the use or misuse of the information. By your use of this information, you recognize and agree to hold Calkain Companies and Chandan Economics harmless from any liability that may arise as a result of your using this information, materials, products, or services.

CHanDan eConomiCsReseaRCH seRViCesTel. +1 (888) [email protected]

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