Essential Net-Lease Assets Offer Appeal in Pandemic

Widespread orders to stay at home and close businesses during the coronavirus pandemic are signaling potential doom for retail properties that house restaurants, salons, sellers of soft goods and other shops considered non-essential in many states.

Retail sales dropped 16.4% month over month in April, exceeding the previous month's record 8.3% drop, according to data from the Census Bureau. In April, the value of malls and strip retail properties plunged 20% and 15%, respectively, according to Green Street Advisors, a commercial real estate research firm based in Newport Beach, Calif.

However, certain retail categories in the net-lease sector that have remained open are proving their worth. Owners of single-tenant buildings housing Walgreens, CVS, McDonald's, Dollar General, Trader Joe's, Chick-fil-A, 7-Eleven and other operators deemed essential have largely continued to receive rent. In fact, San Diego, Calif.-based Realty Income, a real estate investment trust (REIT) that owns net-lease properties, said that it received almost all of the rent due in April from essential retailers, which make up 37% of its portfolio's rental revenue.

Investment demand is typically high for these assets in any economic environment, and right now they are one of the few properties trading hands as most buyers have headed to the sidelines, observers say. CoStar News recently reported that investors across the country bought more than 300 single-tenant properties since mid-March when the first cities and states started shutting down, according to data from the company.

“Investors know that essential assets are still open and paying rent, and they can see how many of these companies are doing on Wall Street," said Randy Blankstein, president of the Boulder Group, a net-lease brokerage based in Chicago. “There's going to be a flight to quality, and investors will be willing to pay a bigger premium for safety."

Often referred to as a “bond wrapped in real estate," net-lease properties require tenants to pay the ongoing expenses of the property, including maintenance, real estate taxes and insurance. In addition to essential retailers, tenants in the net-lease space include fast casual restaurants, oil and lube shops, childcare centers, bank branches, and Walmart and Target stores. Tenants typically lease the properties for 10 to 15 years and provide stable annual income at yields ranging from 4% to more than 7%, depending on the property and location.

The steady income and hands-off features are attractive to a range of investors, from individuals rotating out of labor-intensive apartments as they near or enter retirement, to multi billion-dollar REITs. Similarly, investors often pull money from the equity markets and buy net-lease assets for diversification during turbulent times, net lease experts say.

The lack of decent fixed-income yields in the low interest rate environment over the last several years has driven more investors into net-lease assets. Consequently, buyers have been willing to pay more for properties across the board, regardless of the category or whether corporations with investment-grade credit or franchisees backed the leases, Blankstein said.

The pandemic is now exposing some of those net-lease assets and others that were supposed to be e-commerce resistant as more risky. That's especially true of casual restaurants and movie theaters. Not only are they operating at a lesser capacity or completely closed, but the era of social distancing has created a lot of uncertainty about how eager consumers will be to return to the venues in the coming months.

“Even as bad as the financial markets were in 2008 and 2009, it amazed me how many people were still going out to eat and to movies," said Jonathan Hipp, a principal with property brokerage Avison Young in Washington, D.C., who is the head of the firm's U.S. Net Lease Group. “Obviously, that's not the case today. Everyone now is trying to figure out what retail, restaurant and entertainment operators are going to do to survive."

While Green Street Advisors estimated that net lease properties had lost 8% of their value in April, net-lease experts anticipate that buildings housing essential retailers will come out of the pandemic in decent shape. Median capitalization rates for newer Walgreens and CVS stores ranged from 5.15% to 5.7% in the first quarter, and cap rates for newer 7-Eleven properties hovered around 5%, according to the Boulder Group. Observers expect those rates to hold steady or even decline in the coming months as investors ratchet up demand for the essential category properties.

The same expectations hold true for dollar store capitalization rates, which on a median basis ranged from 6.75% to 7.9% for newer properties. Tulsa, Okla.-based net-lease brokerage Stan Johnson Co. is marketing 40 Dollar General stores and is seeing brisk interest from buyers of individual assets and portfolio investors, said Joey Odom, a regional director and partner in the firm's Atlanta office. His team has facilitated 25 letters of intent for property sales in the last 30 days, and most have either been for Dollar Generals or grocery assets, he added. CoStar data shows more than 80 Dollar General stores have sold since mid-March.

“In a frothy market, dollar stores can be overlooked by investors," Odom said. “But buyers of them over the last few years are looking pretty smart right now because they aren't getting requests for rent reduction."