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Despite interest rates rising, if only modestly and the current commercial real estate cyde seemingly plateauing, sentiment remains largely bullish for the net lease sector. This is the consensus that comes through in the responses to NREI’s first survey of the net lease real estate sector, which was conducted in February.

Existing sentiments
Sentiments are rapidly shifting as to where we are in the commercial real estate cycle.
In our 2015 research surveys on various property types, the majority of respondents said we were in the recovery or expansion phase of the cycle. In this most recent survey, 42 percent of respondents say we’re now at the peak of the cycle. Only 36 percent believe we are in the expansion or recovery phase. That said, only four percent of respondents said we are in the recession phase and just seven percent said we are at the trough. An additional 11 percent said they were unsure what phase of the cycle we are currently in.
Responses to our survey indicate a big appetite for net lease properties. Only 7 percent of respondents said there is too much supply on the market for investment. Overall, 36 percent said there is the “right amount,” 35 percent said there is “too little” and 21 percent said they were unsure.
Respondents estimate current cap rates for net lease properties to be at about 6.0 percent. In the coming year, respondents expect cap rates to stay the same. Just under half of respondents (48 percent) said cap rates would remain flat. An additional 42 percent said cap rates should increase. Meanwhile, just 11 percent of respondents said cap rates will decrease. (The percentages add up to more than 100 percent due to rounding.)
In terms of money chasing deals, 52 percent of respondents said they would characterize the availability of equity in the net lease sector as unchanged from a year ago. An additional 28 percent said equity capital is more widely available, while only eight percent said it is less available.
Sentiments were similar on the debt side of the equation. There, 48 percent said the availability of debt is unchanged from a year ago. Meanwhile, 32 percent said it is more widely available and 10 percent said it is less available.
On the development front, 36 percent of respondents said there is the “right amount” of development. Another 35 percent said there is “too little,” while only 10 percent said there is “too much.” Another 19 percent said they were unsure.

Challenges and opportunities
As part of the survey, we asked respondents to write about what they saw as the biggest changes in the space from 12 months ago and what they saw as the biggest opportunities and challenges for the net lease sector. Many insights emerged from these responses.
Many respondents wrote in about cap rate compression being a big theme in the past year. But some see that trend as having run its course.
“Cap rate compression has ended for all but newly constructed assets, leased to highest credit rated tenants, in 24/7 markets where there is competition from international investors,” one respondent wrote.
Another prevalent theme was that demand for assets continues to outstrip supply and that there is a lack of new quality product entering the market.
On the opportunities front, investors today may look to acquire, “short-term leases with strong credit rated tenants who have a demonstrated track record of strong unit-level performance,” one respondent wrote. “These assets can be purchased at much higher yields than new construction, but the risk of losing a tenant that has strong sales is minimal. Smart investors know they can bank on long-term tenant commitment.”
Another respondent sees opportunity on the development side of the equation. “We are a developer with an emphasis in STNL retail,” they wrote. “The biggest opportunity for us is getting linked up with all of the different types of retailers that are expanding.
When it comes to concerns, the overwhelming tone of the responses pointed to macroeconomic factors, whether it was interest rates, being unsure of how legislation might affect capital markets or the overall state of the economy. “I’m afraid we are at or near the peak of the economy and lease rates have increased over the past five years,” one respondent wrote.
Another worried about what macro factors might portend in terms of institutional demand for net lease properties. The respondent pointed to a brief drop in demand from those buyers in 2015 and wondered if it would happen again in 2016.
“I think this is less likely to happen now that it seems less certain the Fed will increase rates again this year, but it’s still a concern as institutional buyers represent almost one-third of all net lease transactions in a given year,” they wrote.

The rise of medical office
Respondents to the survey work across the spectrum of net lease property types. The most prevalent net lease property type identified was “miscellaneous retail” (49 percent). That was followed by restaurants/fast food (44 percent), office (42 percent), medical office/health care (41 percent), industrial (39 percent), bank/financial (34 percent), drugstores (33 percent), convenience store/discount (31 percent), grocery stores (25 percent), auto (24 percent), government (16 percent) and fitness (15 percent).
In terms of those property types, respondents ranked medical office/healthcare as having the best outloook, giving it a score of 3.9 on scale of 1 to 5. That was followed by industrial (3.7), grocery, convenience store/discount and drugstores (all at 3.6). But, generally, the outlook for all net lease property types was fairly consistent. Every sub-sector ranked between 3.9 and 3.1.
Those results roughly match what respondents said were the property types in the greatest demand. Both drugstore and medical office/healthcare scored 40 percent on that question. Those two subsectors were followed by restaurants/fast food (34 percent), industrial (24 percent), grocery stores (23 percent) and convenience stores/discount (17 percent). Auto and fitness tied for the lowest score at 6 percent each.
A lot of these medical facilities, including specialty surgery centers, urgent care clinics, dialysis clinics, plasma centers and oncology centers, are being introduced to the market to offer greater accessibility and increase the delivery of services to consumers.
“There certainly has been escalating deal flow over the past several years as a lot of these facilities have been developed and delivered to the market,” says Alan L. Pontius, senior vice president in the commercial property group of brokerage firm Marcus & Millichap.
Cap rates in the single-tenant net lease medical sector compressed in the third quarter of 2015, with the median asking cap rate declining 22 basis points to 6.5 percent. Cap rates on medical net lease properties are now slightly lower than in the broader net least market, where they currently average 6.65 percent, according to a third quarter report from The Boulder Group, a Northbrook, Ill.-based investment real estate services firm specializing in single-tenant net lease market properties.
That cap rate compression can be attributed to strong investor demand, which is being fueled by a number of factors. Buyers are attracted to the positive outlook for the healthcare sector due to the anticipated needs of an aging baby boomer population. In addition, most medical-related net leases feature rental escalations and credit tenant lease guarantees.
Urgent care properties are seeing the highest level of buyer demand, which is why the sector is trading for the lowest cap rates at 6.3 percent, compared to 6.6 for dialysis clinics and 6.68 percent for general medical buildings.
“People really like the urgent care space,” says Randy Blankstein, president of The Boulder Group.
Investors think there is a giant need for urgent care clinics, and because the sector is still in the early stage of growth, most of the projects that have been developed have been in very strong, primary locations, he adds.
Throughout 2015 there has been continued cap rate compression in medical net lease assets, predominantly in properties with longer terms. According to Pontius, cap rates have compressed by a little over 100 basis points in the past year for medical net lease properties with terms of 10 to 15 years or longer, while cap rates on deals with lease terms of 5 to 10 years have remained relatively flat. In addition, properties with premium locations, credit tenants and longer terms are seeing cap rates dip below 5 percent, he adds.

The Wal-Mart effect
Recent data suggests that the Walmart Neighborhood Market chain is driving down cap rates on net-leased big-box stores. An influx of new units in the fourth quarter of 2015 helped tighten cap rates in the sector by 63 basis points, according to an assessment by The Boulder Group. Net lease cap rates tightened by 25 basis points between the fourth quarter of 2014 and the fourth quarter of 2015.
It meant that for the first time since 2010 the big-box sector was priced at a premium to the entire retail net lease market, according to the research firm. And the sector owed much of its success to Walmart Neighborhood Markets. Store count increased by 200 percent in the fourth quarter, compared with the previous year, and the median asking cap rate for Walmart Neighborhood Market stores was 5.10 percent.
“The influx of Walmart Neighborhood Markets into the supply made up almost one quarter of the overall big-box market,” says John Feeney, director of research at The Boulder Group. “It really brought it down a lot over the past year. Walmart Neighborhood Markets is the one major, long-term new construction tenant out there, which is why their cap rate is so much lower than the others.”
Walmart’s influence on the sector doesn’t seem like it will wane anytime soon. There were 645 store locations in operation as of June 2015, according to data from Moody’s Investors Service. In its 2015 annual report, Wal-Mart said it expects to increase the count by between 240 and 270 units in fiscal 2016.
Of course, Walmart stores were not the only engine that powered net lease agreements in the fourth quarter and drove cap rates down. Hobby Lobby, the arts and crafts retail chain based in Oklahoma City, Okla., backfills a lot of existing space that other retailers vacate so that it can take advantage of lower rents.
Lifetime Fitness, LA Fitness, Lowe’s and PetSmart are among the companies that closed on big-box single tenant transactions in 2015.

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