WPC in the News
‘We’re Bullish On Net Lease Retail’
Investors are flocking to the net lease sector anew as the Fed pauses its rate actions and cap rates stabilize, W. P. Carey’s Michael Fitzgerald told GlobeSt. GlobeSt's Holly Amaya spoke with Fitzgerald at ICSC Las Vegas about the state of retail net lease and what has changed in the sector from last year. In this video, you’ll learn: Why he continues to be bullish on net lease retail, What an increase in cap rates has meant for investment, and How the sector will fare in 2024 and beyond. Watch now An interview with Michael Fitzgerald, W. P. Carey, and Holly Amaya, GlobeSt.com.
Navigating Net Lease Retail
Rising interest rates, increased cap rates, and sluggish deal activity created changes in the retail market over the past couple of years. Indeed, the bid-ask spread left many retail net lease deals stuck in negotiations. “There was a time when buyers and sellers found themselves pretty far apart, trying to find a way to meet in the middle,” says Michael Fitzgerald, executive director and head of US retail at W. P. Carey. “During 2023, we saw volume slowdowns of traditionally marketed sale-leaseback deals, as some sectors experienced 50, 75, or even 80 basis point increases in cap rates.” However, at the start of 2024, Fitzgerald notes that he’s seen a stable flow of developer-fueled deals and a higher demand for liquidity. As the market progresses into 2024 and beyond, understanding its direction can help investors make more strategic decisions. Low vacancy rates, creating new opportunities A recent report found that retail vacancy rates are at their lowest level in two decades, as rents continue to rise. The report compared 390 retail marketers across the United States and found that the national retail vacancy rate sat at just 4%. According to Fitzgerald, low vacancy rates are a positive sign that provides confidence in long-term leases and the ability to quickly replace tenants. “Let’s say a fitness operator signs a 20-year lease,” says Fitzgerald. “If retail vacancies are low, that’s a positive for us if we need to re-tenant, as we can likely replace them with a new tenant at or above the original price without compromising our income stream.” He explains that W. P. Carey typically focuses on finding deals in markets with growing rents, such as Phoenix, versus smaller and less vibrant markets. “When you get into underwriting situations where vacancy rates are low, it often allows us to get more aggressive with the cap rate and other deal terms,” says Fitzgerald. Looking into 2025 and beyond Another factor that could contribute to an uptick in activity is merger and acquisition deals. An increase in M&A typically corresponds to an uptick in sale-leaseback activity, as firms leverage proceeds as part of the capital stack for new acquisitions. Overall, Fitzgerald remains optimistic about the coming months. “I think the retail market will continue to be strong because there’s always compelling fundamental reasons why retailers want to sell their real estate rather than hold it,” says Fitzgerald. He explains that it comes down to retailers not being real estate companies. Businesses can generate better returns for investors by investing in their core competencies, ie. running retail operations, and often find holding onto real estate is a drag on their cash and liquidity. As a result, he predicts continued demand from retailers for creative ways to access that liquidity – such as sale-leasebacks.
How Sale-Leasebacks Help PE Raise Capital in a Tight Market
Funding for growth, refinancing corporate debt, and merger and acquisition activities are top priorities for many private equity firms. A recent PwC report noted that 60% of CEOs plan to make at least one acquisition in the next three years. The report further explains that lower levels of M&A activity during 2023 created “pent-up buyer demand” moving into the current year. However, tapping into capital isn’t always easy when it is locked in assets. “It’s quite inefficient for private equity firms to have capital tied up in real estate assets that aren’t earning for them,” says Tyler Swann, managing director, investments at W. P. Carey. “An alternative is doing a sale-leaseback, which provides a much lower cost of accessing capital than traditional financing methods.” Understanding sale-leasebacks and their advantages can help private equity firms strategically manage growth funding, debt maturities and other capital needs. The advantages of sale-leasebacks With traditional financing strategies such as mortgages, terms are often shorter and exposed to higher market volatility. Accessing capital can also be time-consuming, a challenge for firms that need to move quickly for acquisition deals. That’s not the case with sale-leasebacks, notes Swann. “Sale-leasebacks are very flexible,” says Swann. “The processing time can be as short as 30 to 45 days between the initial call and the actual funding. It’s not unusual for us to get a call from a private equity firm saying, ‘We’re closing on a business in 30 days; can you be there to close with us as acquisition financing?’ And that’s something we can do.” He explains that capital uses also have very few restrictions, with the most common purposes being acquisition financing, dividend payments, and refinancing maturing debt. Misconceptions about sale-leasebacks As private equity firms consider sale-leasebacks, questions often linger regarding who qualifies for this type of financing. Many believe that because their real estate is in a secondary or tertiary market, or their asset doesn’t have a huge value, they won’t qualify. But according to Swann, that’s not necessarily true. “If you have a specialized manufacturing facility in a small market, you may think it won’t qualify because it’s not a high-quality warehouse in a market like Southern California,” says Swann. “Despite where an asset is located, if it’s profitable and contributing to the bottom line of a business, it could be a great candidate for a sale-leaseback.” As the market progresses through 2024, Swann expects sale-leaseback activity to continue upward, partly due to M&A activity and its flexibility to tap into capital quickly. “Every year, sale-leasebacks become a little more accepted in the private equity community as a source of financing,” says W. P. Carey’s Swann. “Ten or 20 years ago, corporate debt was by far the dominant option, but we continue to see an increase in sale-leaseback deals every year.”
Where Will Net Lease Go in 2024?
In 2023, higher debt costs, a looming $2 trillion-plus wave of corporate debt coming due and other economic uncertainty have clouded the CRE outlook. And while the net lease sector, with its low risk and steady income, has weathered recent economic headwinds better than most, it’s not immune. Execution uncertainty was a central theme in 2023, reports Zachary Pasanen, managing director, investments at W. P. Carey. “With the ramp-up in interest rates, buyers and sellers have struggled to meet at a price that made sense,” he says, noting that a lot of deals after the first quarter had repricing challenges or re-trade concerns. In a competitive market, those who rely on debt financing have been constrained by higher rates. Investors, however, are still seeing cap rate expansion within certain sectors. Shifting Rates & Fundamentals With deals more difficult to come by, investors have re-focused on fundamentals. Pasanen notes that, with industrial, this has meant a refocus on rent growth and the assets “criticality.” There remains good demand for industrial assets, but investors should realize the changing fundamentals of the sector: it is no longer the “darling” product, attracting unlimited cheap capital in pursuit of properties requiring lower capex. Pasanen uses the word “retrenchment” for the asset class as people are getting smarter with rent growth projections following their internal modeling. “With the sector still offering a lot of attractive elements, there is no desire to move out of the sector,” he says. “Unlike office, we view industrial, particularly manufacturing, as profit centers: it’s where the widgets are made. We focus on good, underlying fundamentals but also where there’s criticality in the real estate.” The sudden shift in rates has caused a break in investor expectations, Pasanen says, with one-off, syndicators or family offices still pursuing at compressed numbers. Meanwhile, institutional investors are focusing on tenant credits and cap rates at 8% and higher. Outlook Pasanen notes there’s opportunity in sale-leasebacks for companies looking to raise capital. He says W. P. Carey has a successful history here, taking the time to understand a business to ensure they will be a good investment for the long haul. “No one has a perfect crystal ball, but we try our best and we've got a long history of underwriting credits that are sub-investment grade in nature, and we have a good track record in doing so.” Market expectations are leaning toward interest rate cuts in 2024, an outlook reaffirmed by the Fed’s latest announcement on December 13. Smart investors, however, should prepare for all situations and also have contingency plans for a long pause or even a rate hike if inflation kicks up again. With inflation and increasing interest rates making borrowing more expensive, will CFOs and fund managers continue to strategize on how to recalibrate their business and find that new normal? “I think it will actually be a big year in 2024,” he says. “The rise in interest rates happened quickly so if we have a long pause [on rate movement] the deal environment should become more normalized. When the behavioral element settles in we’ll see more normal investment activity.”
Three Ways Real Estate Investors Can Recession-Proof Their Portfolios
Economic experts are continuing to signal that a recession could be on the horizon. A number of factors are contributing to this sentiment, but recent bank failures, tightening credit, interest rate increases and sustained high inflation are among the biggest. To help prepare in case of a downturn, below are three things real estate investors can do to “recession-proof” their portfolios and position their business for long-term success. Prioritize diversification When it comes to portfolio resiliency, diversification is key. Investing in a range of geographies, asset types and industries reduces potential risks tied to individual market volatility. If one particular asset class is more heavily impacted by a recession than others, having a diverse portfolio comprising several asset classes reduces the overall impact. Portfolio diversification also allows investors to allocate capital to where they are seeing the best risk-adjusted returns. This means investors can be nimble and take advantage of unique opportunities should they arise. Focus on mission-critical real estate To be successful in commercial real estate investing, it’s important to focus on properties with strong fundamentals, such as location, size and quality. However, when positioning a portfolio to weather all economic cycles, arguably the most important aspect of a property to focus on is “mission criticality,” or how important the property is to the tenant’s operations. When a property is mission critical, a tenant is more likely to remain in the facility – both in good times and in bad – for the long term. The worst thing that could happen during an economic downturn is to have a portfolio of vacant assets – and therefore limited rent payments – so by focusing on mission criticality, investors can better ensure durable, long-term cash flows. Analyze tenant credit and business Disciplined credit underwriting is critical to long-term portfolio success. Large tenants with a strong underlying credit and revenue history will be better equipped to weather downturns through access to liquidity, or in a worse-case scenario, have the ability to restructure and continue operating in their mission-critical properties. In addition to a tenant’s financials, it’s also important to examine the long-term outlook of the tenant’s business and industry. For instance, a tenant that produces electric car engines may have a better long-term outlook – and therefore be better suited to a long-term lease – than one that produces gas-powered engines given the trend toward electric vehicles. Final thoughts It’s never too late for real estate investors to look at their investment strategies and take steps to enhance their portfolio resiliency. Focusing on long-term stability – through diversification, mission-critical real estate and creditworthy tenants – versus short-term gains will help investors to build portfolios that will carry them through all market cycles.
Where Net Lease is Heading
With financing options restricted by interest rate uncertainty, corporate real estate sellers have been turning to sale-leasebacks. It’s easy to see why: these deals offer liquidity and immediacy. For the net lease sector at large, Tyler Swann, managing director, investments at W. P. Carey, is seeing US deal flow coming almost exclusively from new sale-leasebacks versus acquisitions of existing leases, a change largely driven by the changing capital markets landscape. CRE Psychology Playing Catch-up As interest rates have risen and asset values have fallen, the pricing expectations of sellers have not followed suit. That’s led the market to favor new sale-leasebacks as opposed to investment properties that are acquired from third-party landlords, Swann says. "There's a disconnect between what buyers can realistically pay given current capital markets and what a seller wants,” he says. “It takes time for psychological expectations of sellers to reset and I think we haven't seen that play out just yet, which is why those existing lease deals haven't really been moving or coming to market at all.” New sale-leaseback sellers are more realistic, comparing and choosing the costs of such a deal versus the current cost of capital, especially the added expense of raising debt in the current high interest rate environment. The benefits of the here and now – unlocking their CRE equity means it's "go time" for deals, unlike the often disparate expectations of a third-party landlord seller. Open Opportunity, With Caveats While there are fewer overall opportunities in the net-lease market compared to the last couple of years, there are fewer market challengers due to the more restricted financing options. “Plenty of investors who were very competitive just a couple of years ago, for example, were reliant on CMBS debt and are now no longer nearly as competitive as they used to be,” Swann says. “And that's given us a leg up.” Office demand continues to suffer from uncertainty, mainly from lagging return-to-office efforts and hard-to-figure valuations given the large amounts of vacant and shadow space. On the plus side, Swann views the industrial sector as the most favored by net lease investors, as strong demand post-COVID for logistics facilities persists, with companies building out their supply chains amid a more general move to on-shoring production. Earlier this year, W. P. Carey completed an approximately $468 million, 20-year lease sale-leaseback with Apotex for a portfolio of pharmaceutical manufacturing assets in the greater Toronto area. Swann points out that the combination of sector (industrial), type (new vs. existing lease) and trend (taking advantage of better cost of capital through a sale-leaseback) all led to the deal getting done. “In a lot of ways I think that Apotex deal is a good example of where the market is going,” says Swann.
Why Net Lease Continues to Draw Investors
The net lease retail sector continues to outperform despite changing interest rates, with a growing number of retailers expanding their footprints or developing new properties against a “compelling” cap rate environment. That’s according to Michael Fitzgerald, executive director, head of US Retail, W. P. Carey, who told GlobeSt at ICSC Las Vegas that many retailers are “aggressively expanding” in their markets. “We’ve seen a lot of activity in sale-leaseback and we are bullish on net lease retail,” Fitzgerald says. “The retail sector is enormous – and we’re chasing deals.” Fitzgerald also discusses: The state of retail fundamentals How investors are responding to changing interest rates and economic uncertainty What makes W. P. Carey stand out from its competitors in terms of investment opportunities Watch now An interview with Michael Fitzgerald, W. P. Carey, and Holly Amaya, GlobeSt.com.
Retail's Latest Transformation Has Investors Watching
Retail has been the commercial real estate chameleon, changing and adapting with the times, including the rise of e-commerce and COVID-19. The post-pandemic rebirth of the sector has made major headlines and many retail operators and owners see flying colors. Michael Fitzgerald, executive director and head of US retail investments at W. P. Carey, sees three major trends that sector stakeholders should be watching: the strength of needs-based retail, a development switch favoring sale-leaseback investors and the continued recalibration of buyer-seller expectations. Targets & Tactics “An interesting thing about COVID was how resilient certain areas of retail actually were,” said Fitzgerald. “We saw immediate and sustained growth after that short period of shutdowns.” Non-discretionary, core-good retail including grocery stores and services-based tenants, such as auto services, have been “very strong,” according to Fitzgerald. Low-cost discount stores are a good place to do deals given the economic worries. And family entertainment centers, such as arcades and bowling alleys with full-service restaurants, have seen sustained periods of same-store sales growth and high profitability, benefitting from the post-COVID pent-up consumer demand. “When you’re very flexible, have tons of ability to evaluate business models, take a partnership approach and meet with management teams to understand how they position themselves in the market, you’ll have a lot of good investment options,” said Fitzgerald, who prefers master leases of 15- to 25-year term with escalations every five years. “We can do anything from convenience stores to an automotive service business to grocery and sporting goods. We’re pretty agnostic as to the types of retail we pursue.” Rate Responses As the impact of rising interest rates continues to unfold, Fitzgerald has found that most tenants and retailers are somewhat hesitant to raise their prices so as not to alienate or even “destroy” their customer base. There’s an opportunity to boost profitability, but also a concern about the outcome if companies go down that path and then the economic “switch flips” and customers stop spending. Increased interest rates affect retail development negatively, but Fitzgerald believes a specific shift in that regard that could yield investment opportunity. Retailers planning to grow their footprint have traditionally partnered with merchant developers, but with higher capital costs the latter’s return requirements “have increased significantly” and, in turn, their hiked asking rents have forced retailers to look for alternatives. As a result, retailers are doing more of their own development, whether in-house or through fee developers. “So a lot of these developments will be held on the balance sheet of retail companies, which is good because a lot of companies will likely decide to do sale-leasebacks,” he said. “Given that’s our company’s prime target, we think that’s a good trend to come from the higher rates.” Outlook Fitzgerald maintains that it’s still too early to make a prediction for overall transaction volume in the retail sector in 2023, adding that since last fall cap rate expectations have gone up 45 to 50 basis points in many cases. “What we’re seeing is that retailers that need to grow their footprint and monetize new developments are going to meet the market and are going to do deals,” he said. “If retailers continue to meet the market I think it’ll be a good, active year. If there’s a standoff I think it’s going to be more difficult.”
It's Sale-Leaseback's Time to Shine
The current capital environment has tested the adaptability of many companies, as increasing interest rates have made the cost of capital rise uncomfortably. And while it’s unknown if recent events will calm the Federal Reserve’s zeal for future hikes, some companies are already availing themselves of an alternative capital source: the sale-leaseback. In fact, the transaction type matched its 2019 peak in Q4 of 2021, and there are signs it may not be slowing. Zachary Pasanen, managing director, investments at W. P. Carey, sees two big factors playing into the current interest in sale-leaseback: cheaper cost of capital and extra liquidity during tough times. A Corporate Alternative to Expensive Capital A major concern for corporate real estate holders is reducing the cost of capital for the next several years. As Pasanen notes, while they are “not quite desperate yet, the lag between interest rates and cap rates hadn’t caught up six months ago, but it’s starting to now. Prudent CFOs are looking to maximize capital and a long-term sale-leaseback is a great way to do that.” A sale-leaseback offers a “naturally accretive” alternative funding source. Holders of good, fungible, mission-critical real estate that are willing to sign a long-term lease with market or better rental increases built in will likely find that the underlying rate with which they can monetize those assets is inside the going long-term borrowing rate, according to Pasanen. The 50-year-old REIT’s predominant focus has been on warehousing, specialty manufacturing and food production, but it also delves into the education and retail sectors, the latter ranging from experiential sites to fitness-related products to auto repair locations. “By and large, we’ll look at anything as long as there’s criticality to it, meaning the stuff is made at our subject facilities or there’s a really strong location story to it or rent coverage or just a good real estate fundamental story,” Pasanen says. A Liquidity Solution for Tough Times Another consideration facing corporate real estate owners is having the capital on hand to weather the current economic instability. Rates again become a major problem, especially for companies or properties that might be lower on the credit spectrum. “For companies facing challenges that don’t have the ability to finance at attractive rates it’s a very simple calculus: if your borrowing costs go up that’s going to eat into your profit margins and there are only so many levers you can play with when operating a business,” Pasanen said. “They have to be laser-focused on how to get through this period of instability and unknowns.” Sale-leasebacks appeal here as well, allowing companies to put money back into their core competencies or pay down shorter-term debt that’s gotten more expensive, or perhaps even expand given that acquisition targets may have become cheaper. But Pasanen also notes that W. P. Carey’s sale-leaseback business is not just a capital product for troubled times, whether or not it’s on top of mind for companies and owners. “A sale-leaseback is a good tool in good times and a great tool in really uncertain times,” says Pasanen.