Pricier debt and signs of stress

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Good morning. Net lease investors face a challenging environment of tougher lending conditions as buyers and sellers continue to disagree on valuations. Compelling value-add features—such as top-credit tenants and healthy rent escalations—are often key to successfully completed acquisitions.

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Net Lease Investors Press Pause as Price Discovery Gets Tougher

Net lease investors are finding it difficult to execute acquisitions in today's market due to a tightening lending environment, decreased transaction activity, and pricing discrepancies. The challenge for many investors lies in trying to accurately price assets that fit their criteria.

Setting the scene: Net lease sales volumes have been in decline for two years, and net lease retail/office that previously traded well is struggling. As interest rates went up, transactions went down. This year, the situation is no different.

By the numbers: Net lease retail properties on the market fell by more than 8.6% in Q1 2023, and net lease office properties declined by 1.48%. Sales volumes also declined between 30–40% YoY in Q1 2023. LTVs on loans for net lease acquisitions have dropped by an average of 10% since last year, and interest rates on retail loans have also risen to 6% from 5.25–5.5% last year, with office and industrial cap rates near or at 7%. Net lease investment sales also fell 25% last year compared to 2021, as investors remain cautious in a turbulent environment.

Fewer deals to be found: Investing has become increasingly difficult due to a diminishing group of potential buyers and investors, including those involved in 1031 exchanges. The Fundamental Income Net Lease Real Estate Index has experienced a year-over-year decline of 18%, while the total returns on the Fundamental Income Net Lease Real Estate ETF (NETLX) dropped 15% over the same period.

Investment opportunities: Despite the market's decline, investors with deep pockets can still find investment opportunities, as seen with ElmTree Funds’ Q1 2022 total of $800M in net lease acquisitions. Meanwhile, REIT Agree Realty Corp (ADC) is estimated to have reached $1B in acquisitions in Q1 2023 by taking advantage of several opportunities in the merchant builder space as institutional sellers are forced to adjust their pricing expectations.

Higher rent escalations: Investors are focusing on credit tenant ratings and looking for short-term rent escalation on the higher end, according to Joey Agree. Properties with rent escalations of 3.0% or more built into their leases are attractive to ElmTree Funds' net lease private equity firm. Deals that close—like the sale of a quick-service restaurant by Northmarq featuring a great location, good tenant credit, and 10% rent escalations every five years—are few and far between.

➥ THE TAKEAWAY

Pickier and trickier: Net lease investors are facing challenges when it comes to acquiring properties. These challenges arise from several factors such as stricter lending requirements, a slowdown in property trades, and a gap between buyer and seller expectations. As a result, investors are becoming more selective and are focusing on assets that feature top credit tenants and long leases with rent escalations. Deals that do end up closing tend to have highly sought-after features like good locations and special attributes.

At the same time: The number of net lease retail properties on the market is declining, and pricing accuracy challenges are causing some investors to forgo attractive buying opportunities. Despite these difficulties, well-funded buyers are still able to find attractive investment options. Some are targeting industrial net lease acquisitions, while others are looking to buy and redevelop existing properties.

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