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A strong investor appetite for net lease properties has been pushing sales volumes higher in recent years. But limited supply of deals may impact that velocity in 2014.

One of the biggest hurdles to achieving higher sales in the net lease market is limited supply of acquisition opportunities.

“We are several years into a development-challenged market for new product, and that is putting a limit on supply and therefore limiting transaction volume,” says Randy Blankstein, president of The Boulder Group, a Northbrook, Ill.-based investment firm specializing in single tenant net lease deals.

The total volume of net lease sales across all property types reached nearly $44.8 billion in 2013 – up about 24 percent compared to the $36.2 billion in sales recorded in 2012, according to Real Capital Analytics (RCA), a New York City-based research firm. Retail net lease sales alone accounted for $13.9 billion in 2013. The consensus is that $13.9 billion in retail sales is attainable an level for this year, notes Blankstein. “But, I’m not sure that the growth is going to continue as far as transaction volume is concerned. I think it is more of a plateau year,” he adds.

Although demand remains robust, sales growth may stall due to lack of available supply of quality assets and the run-up in pricing. Net lease properties have been selling for top dollar.

“We have a number of market conditions that are causing pricing to improve significantly and cap rates to compress,” says Bill Rose, national director of the retail group and the net leased properties group with real estate services firm Marcus & Millichap.

A key factor driving prices higher is basic supply and demand economics. Investors continue to have a strong appetite for net lease properties, while new retail development is still well below traditional levels. An estimated 41.5 million sq. ft. of new retail space was completed in 2013, which is a fraction of new construction that was occurring pre-recession, when annual levels were closer to 200,000 million sq. ft., according to Marcus & Millichap. “That, combined with falling vacancy rates, is creating a very ripe environment for very, very favorable pricing in the net lease space,” says Rose.

Flat-lining

Cap rates have been falling since 2010. Every time cap rates dropped it brought a new group of sellers to the market, which helped boost supply. However, the Boulder Group is predicting that cap rates will remain relatively flat this year. They are already hovering near peak levels for top properties. In addition, if interest rates move slightly higher this year, as many anticipate, it could push cap rates higher as well. In the fourth quarter, average asking cap rates for industrial properties climbed up by 15 basis points. Cap rates on retail assets increased 17 basis points and cap rates on office properties increased 30 basis points, according to the Boulder Group.

Some fear that flat pricing won’t give owners the added incentive to dispose of properties. More people are holding onto their assets and also choosing to refinance, because for many owners interest rates are still below where they were when they initially bought the property, notes Blankstein. That being said, there continues to be a voracious appetite for investment grade credit properties in major metros with very long, 20-year leases. Those properties could be the exception, experiencing further cap rate compression going forward. For example, an Aldi store in Addison, Ill. with a 15-year lease sold in December for a 5.8 percent cap rate, according to the Boulder Group.

Conventional thinking in the industry is that a rise in interest rates might diminish the appetite for net lease properties. However, considering the lack of better investment opportunities that may not be the case, adds Rose. Treasuries remain low, and investors continue to be drawn to the safety of owning a brick-and-mortar building compared to buying stock in a market that has been on a five-year bull run, he says.

The competition and limited supply is also prompting buyers to adjust their acquisition criteria to include second tier product with lower credit ratings, locations in secondary metros and shorter term leases. There is a greater supply of those types of assets on the market. “When people say there is a shortage of product, what they are really saying is that there is a shortage of the exact thing they want to buy,” says Blankstein. Even a lot of the institutional buyers are now willing to look at deals that have shorter-term leases, but are still backed by investment grade credits and well-located real estate. “I think that is probably the trend of the year as people start to look at shorter-term leases to hit acquisition targets,” Blankstein adds.

This article was republished with permission from National Real Estate Investor.