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The fastest growing sector among real estate investors is the net lease market. Yes, good old boring single-tenant, investment-grade buildings.

With the upside pretty much capped, it never garnered too much attention outside of 1031 exchange investors and stodgy institutions. However, that has changed dramatically. With bond yields at record lows over the past three years, net lease buildings have gained favor as alternatives to fixed-income investments by providing steady returns while maintaining low risk.

The latest net lease conference in New York City (held by RealShare) drew over 400 real estate professionals. One of the interesting statistics outlined at the conference was that in the last year, $23.5 billion in liquidity events occurred among non-listed REITs, with $47 billion of non-listed REITs for sale.  Like with many areas of real estate, once an investment product comes into favor, the herd rushes in and cap rates compress dramatically. A sampling of recent transactions, provided by Real Capital Analytics, a New York City-based research firm, is as follows:

A Walgreens in Los Angeles sold for $13.6 million at a cap rate of 5.3 percent. A McDonald’s in Melville, N.Y. sold for $3.025 million at a cap rate of 4.4 percent. A Dollar General in Inglewood, Calif. sold for $3.525 million at a cap rate of 6.3 percent. A Firestone in Baltimore, Md. sold for $3.8 million at a cap rate of 6.8 percent.

Part of 2013’s cap rate compression coincided with the drop in Treasury rates. But even as Treasury rates perked up in early 2014, cap rates have actually moved down. REITs that specialize in net lease investing used to have the “pick of the litter,” but competition has caused them to alter their risk profiles. Walgreen’s and CVS portfolios, which used to trade in the 7 percent rage, are now trading in the mid-5s.  To maintain a yield in the 7’s, today’s investors are forced to go for sub-investment grade properties, into tertiary markets, to buildings with shorter-term leases, or maybe assets that are all of those things!

Dollar General opened 600 new stores and Family Dollar opened 500 new stores in 2013. They are both rated BBB- by S & P and are thus investment grade. A year ago, a typical Dollar General store was selling at approximately 8 percent. That figure is now around 6.25 percent. You have to ask yourself: is that enough yield to entice you to buy a building with a borderline investment-grade tenant in a tertiary location on a 10-year lease?  If the tenant leaves after 10 years or goes bust in the meantime, can the store be re-leased?

Fighting for deals

Let’s use WP Carey, one of the largest net lease REITs with an enterprise value of more than $15 billion, as an example of just how competitive the landscape has become.

In March of 2014, WP Carey raised $500 million in senior unsecured notes. Those notes priced at 4.64 percent. Meanwhile, the company’s common stock yielded 5.9 percent as of Apr. 3, 2014. Using those metrics, WP Carey can’t possibly buy Walgreens or CVS portfolio’s in the mid-5’s. So what have they been buying? On Apr. 1, they paid $158 million for the bank headquarters of Bank Pekao in Warsaw, Poland. Before this transaction, 21 percent of WP Carey’s holdings were located outside the U.S., with concentrations in France and Germany. With the Warsaw acquisition, the REIT now have over a quarter of its holdings overseas. As for lease maturities, the average tenant only has eight years remaining across the entire portfolio. And investment grade? Only 31 percent of the properties in the WP Carey portfolio are occupied by investment-grade tenants. In order to maintain their dividends, REITs like WP Carey are having to be more creative and go a little further out on the risk spectrum.

One other factor causing cap rates to compress is the lack of supply. ARC Properties Trust, one of the largest net lease owners, commented that their portfolio used to include 30 percent development and 70 percent acquisitions, but now those percentages are reversed. So while all of these investors want in on the net lease product, who is left to sell? There will always be new Dollar General stores being built, but what else can satisfy the insatiable appetite of net lease investors?

Sale/leasebacks are one untapped area. The old 1980’s concept of companies using sale/leasebacks as a form of cheap financing will be coming back when interest rates inevitably rise. CFOs have been sanguine in their abilities to raise funds in the credit markets. When either that spigot gets turned off or these CFOs see the compression in cap rates for net leases, they will inevitably turn to the net lease market with sale/leasebacks. Going back to WP Carey, on Apr. 3, the REIT paid $43 million for a new building in Chandler, Ariz. with a 10-year lease to QBE Holdings, an Australia-based global insurer.

This type of transaction is an indicator of things to come in the net lease market as investors look for alternatives to the typical Walgreens and Dollar General-type transactions. In fact, Savills, LLC has the exclusive listing on a 249,000-sq.-ft. office building in downtown Phoenix net-leased to investment-grade Freeport-McMoran for 10 years. Investor interest, particularly from overseas bidders, has exceeded all expectations.

One last thing to consider is financing. TIAA-CREF financed $1 billion in net lease properties in 2013.  This insurance giant only wants the highest quality properties in its portfolio. The rest of the lending universe is fragmented, with hundreds of lenders taking a small percentage of the market. To aggressively finance a Dollar General in mid-America, a mortgage broker has to dig deep to find a regional lender who wants to bet on the location. While that financing remains plentiful at the moment, interest rate spikes and “black swan” credit scares could cause lenders to pull back on their leverage, causing a subsequent increase in cap rates.

The sky is not falling. The net lease market remains hot and should continue to be so. The aforementioned facts simply illustrate potential warning signs—and how the landscape can possibly change in the near future.

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