From SoCal Real Estate’s November 2018 issue:
What to know about pricing and cap rates
By Carrie Rossenfeld
As coastal markets become too hot for many single-tenant net-lease investors to gain a foothold, these investors have been expanding their radius to markets like the Inland Empire. But as the market gains more visibility, cap rates for these properties have compressed, and prices have heated up, reducing ROI in many cases.
Corona del Mar, California–based Hanley Investment Group (HIG) is a nationally recognized real estate brokerage and advisory firm specializing in retail property sales. In 18 months prior to August 2018, HIG was one of the most active brokerage companies in the sale of single-tenant and multi-tenant pads in California, including the Inland Empire. SoCal Real Estate sat down for a chat with HIG’s EVP Bill Asher and VP Jeff Lefko to discuss the rise of the single-tenant net-lease market in the Inland Empire, where they see it heading, and how investors should approach the market.
SoCal Real Estate: What do you see happening with sale prices and cap rates for single-tenant net-lease properties in the Inland Empire?
Lefko: Cap rates for single-tenant net-leased retail properties on long-term leases in the Inland Empire have remained relatively consistent and have actually compressed over the last 12 months, according to data from CoStar Group.
Between August 2017 and July 2018, the average cap rate for net-leased single-tenant properties priced below $5 million on long-term leases (10 years or more) with national or franchise tenants was 4.86 percent. The average cap rate between August 2016 and July 2017 was 5.01 percent, marking a 3 percent compression. Transaction volume for single-tenant sales increased this year from 27 in 2016-17 to 34 in 2017-18, which translates to a 25 percent year-to-year increase. The rise in transaction velocity has been a combination of sellers being more decisive about their disposition strategies and an increase in the supply of new-construction properties that were built to be sold.
Asher: Although cap rates have compressed over the last 12 months, signs are pointing to pricing slowly softening in the next six to 12 months due to rising interest rates. It’s noteworthy in 2018 that overall sales cycles of single-tenant investments are taking longer than in previous years as buyers are proceeding with more caution and patience in their purchasing strategies.
Which factors are influencing what’s happening with these fundamentals?
Asher: Rising interest rates will have the largest impact on future pricing. In one of the Federal Reserve’s most recent statements, U.S. economic growth was characterized as “strong” for the first time since 2006. In a previous June statement, the economic growth was described as “rising at a solid rate.” As anticipated, the central bank raised rates at the end of September with intentions for one more rate increase this year (December). Borrowing costs have been steady for most of 2018, but the Federal Reserve’s view of economic strength (i.e., record-low unemployment levels) are major factors toward the upward pressure on future retail cap rates.
Lefko: On a more general level, investors are continuing to be attracted to Internet-resistant, daily-needs retail that cannot be replicated or replaced by e-commerce. Daily-needs retail is not as threatened as was perceived last year. Internet sales are enhancing total sales for daily-needs retailers — not threatening them. Cap rates have compressed for single-tenant net-leased properties with a service-based national tenant.
Where do you see sale prices and cap rates heading in this market for this product type over the next year or two?
Asher: Single-tenant net-leased investments priced under $5 million will continue to have the biggest buyer pool, most demand, and the largest transaction velocity in the next two years. The single-tenant net-leased category is less dependent on financing as a large portion of properties are acquired all-cash. The single-tenant net-leased category will remain a safe haven for passive investors because of its typically solid fundamentals: pad locations at signalized intersections, new long-term leases to corporate tenants, and minimal or no management responsibilities. Single-tenant net-leased pricing will be the last retail asset class to adjust compared to other categories in retail moving ahead.
Lefko: Large single-tenant properties and multi-tenant net-leased properties that are more dependent on financing will see cap rates slowly start to increase over the next two years. This will have the biggest impact on net-lease developers who are already facing the challenge of escalating land values coupled with all-time high constructions costs. It has become more difficult for a developer to make new projects pencil. Over the last year, developers of multi-tenant retail have exercised more caution when looking at potential development opportunities that could have an impact on the future supply of new-construction multi-tenant retail.
How should investors in these properties approach the market, especially since it’s so competitive?
Lefko: Upon finding a property that matches their criteria, prospective buyers need to be ready to move quickly with offers that have a timely contingency period. Many single-tenant net-leased properties are being marketed before the tenant is even open for business. Prospective buyers need to be open to structuring a rent credit or holdback for properties where the tenant is not open for business or even a scenario where the property is still under construction. Many developers are exploring pre-selling properties with a forward commitment from a buyer. This can create a win-win solution as the seller is able to mitigate the cap rate risk by locking in a non-contingent offer ahead of the completion of construction, while the buyer can enjoy a better-than-market cap rate for taking the risk that they would have already incurred if it was a traditional sale.
Asher: The majority of the single-tenant net-leased transactions under $5 million do not have a financing contingency. Prospective buyers that do need to obtain third-party financing should be organized and have a lender already selected before submitting a letter of intent so that they can be competitive with other potential buyers that do not have financing contingencies or are prepared to transact all cash.
What else should our readers know about the Inland Empire market?
Lefko: The Inland Empire has continued to be a top-performing market, experiencing the fastest job-growth rate in California, with more than 425,000 new jobs since 2011 including 44,700 new jobs between Q2 2017 and Q2 2018 (according to C&W MarketBeat Q2 2018). As e-commerce continues to grow at a national level, so too do the Inland Empire’s industrial hubs and logistic warehouses that benefit from the proximity to major urban cities. The Inland Empire has over 20 million square feet of industrial space under construction and a market vacancy of only 4.1 percent, which is significantly below the national average of approximately 7.4 percent. The ports of Los Angeles and Long Beach are experiencing record freight volumes, which have fueled an increase of trade- and transportation-related jobs in the Inland Empire. The Inland Empire’s 2017 job-growth rate of 3.49 percent outpaced California’s urban and tech regions including Los Angeles, Orange County, and Silicon Valley, which historically have experienced the largest job gains when the economy is growing.
Asher: With job creation comes an increase in demand in the local housing market. In a market that has previously experienced little housing growth, median prices for single-family homes in the Inland Empire grew by 9 percent between 2016 and 2017, a level faster than San Diego County (7.8 percent), Los Angeles County (6.6 percent), and Orange County (6.4 percent) (according to UCR Today). Home developers have the expectation that the housing market will see consistent growth in the foreseeable future. One example is Brookfield Residential’s focus on New Haven, a 2,200-home community that is part of the Ontario Ranch Master Plan. New Haven ranked sixth in the entire state of California in sales of masterplan homes with 214 closings (according to July 2018 RCLCO Survey), of which half were sold to millennials.