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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   July 2014

Net-Lease Strategies: Know the Signals

With the right window of opportunity, knowledge and decisiveness help reap rich investment returns

Net-Lease Strategies: Know the Signals

With the economy largely back on track, interest in net-lease investments appears to be at an all-time high. Cap rates are being realized at unheard-of levels. For commercial real estate investors, it is imperative to have a proper exit strategy in place, depending on their properties or portfolios.

Countless owners and investors acquired net-lease assets though the last real estate cycle. Many, however, now find themselves with aging properties in an improving  economy — a circumstance that may translate to a signal to sell. How can commercial mortgage originators assist investors in this respect?

In order to effectively assist investors in maximizing the profitability of their portfolios, commercial mortgage professionals should understand three key net-lease investment tactics:

  • Know the market
  • Have a strategy
  • Know when to sell

Let’s take a closer look at the ins and outs of each.

Know the market

Market conditions have continued to improve throughout the last six months. This past year was a transition point where profits were substantial, the stock market soared to its greatest heights since 1997 and unemployment rates were down all over the country.

More people had jobs, which resulted in more disposable income. This had a positive impact on consumer spending. In the retail net-lease world, consumer confidence is everything. Many analysts believe the national economy will continue to grow through this year and beyond.

But with economic growth, the commercial real estate market is challenged by the likelihood of rising interest rates and their eventual impact on investments. If interest rates rise, as is expected, access to financing will be more expensive. 

As of this past May, the 10-year treasury yield rate hovered in the 2.5 percent range, but according to JPMorgan Chase & Co., 10-year treasury yields could rise as high as 5 percent in 2018. Assuming an average 250-basis-point spread for commercial real estate, this would mean that financing rates in 2018 could rise as high as 7.5 percent. And if interest rates were to increase to estimated levels in the next few years, they will put upward pressure on cap rates, reducing the overall value of investments.

Have a strategy

National individual net worth has increased, on average, to unprecedented levels. A result of this is that an increasing number of private investors are concerned about long-term stability.

Many commercial real estate owners and investors, if asked to define their exit strategy for their investments, would likely say, “I have a buy-and-hold strategy.” That is fine for an acquisition strategy, but it’s not an ideal long-term process for maximizing profitability over time.

With a buy-and-hold approach, before owners realize it, they find themselves with, for example, a property that has aged 10 years, which creates concerns about tenant renewal and other financial uncertainty amidst changing market conditions. Also, as net worth increases, more private investors end up acquiring diverse portfolios. It is not uncommon for an investor to own, say, a Walgreens, an Advance Auto Parts, a Starbucks and a McDonalds. If each property varies in terms of cap rate, remaining term and location, it is imperative to have an ongoing process in place for each to monitor performance to identify when it’s the best time to sell.

When an investor employs a buy-and-hold strategy on a given property, eventually capital expenditures are likely to be necessary in order to retain a demanding tenant or one with changing needs. If the timing of these expenditures is not taken into consideration in advance, the investor’s strategy becomes reactive rather than proactive.

Finally, when investors leverage a particular property, which many have (and many more will likely do, based on current interest rates), as soon as the note is signed, part of their exit strategy has already been determined for them. Investors who are unprepared may find themselves surprised that their portfolio has not performed as well as expected, depending on the market at the time the note comes due.

The buy-and-hold strategy generally works for large institutions over the long term because they are adept at pruning underperforming and aging properties or those that don’t meet their core requirements. For private investors, on the other hand, it is a must to identify a point in time to consolidate, refinance or sell their portfolios in their entirety.

Know when to sell

When you and your investor clients believe cap rates are as low as they are going to get, given that interest rates are likely to rise substantially over the next few years, it is time to consider putting a property or properties on the market.

When investor interest is high and interest rates are rising, it may well be time to sell, even for investors who own just a single property. At this point, there are a few key preparatory steps when the decision to sell is made.

Realistically assess the current value of the properties, given market conditions. Find experts that deal exclusively in net-lease assets and solicit their guidance and assessment of the properties.

Determine which properties in the portfolio cause the most concern. The reasons for concern may be because of remaining lease terms, gross revenues, capital expenditures, loan terms or a combination of all of the previous factors. In any case, identify the fat to be trimmed.

Determine the likely impact of the sale on the portfolio. For example, this could mean protecting an investment from tax consequences with a 1031 exchange, an installment sale, a charitable trust or a gifting of real estate.

Once you and your investor clients have made the sometimes-difficult decision to sell, don’t look back. With the improvement in the economy and other positive indicators, the future of net-lease commercial real estate looks very bright. Being prepared and having a strategy to reap these benefits is the key to maximizing investment returns.  •

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