Office
Looking into the Crystal Ball
2023 was undoubtedly a challenging year for the net lease sector. High inflation, rising interest rates and other economic uncertainty caused a notable decrease in overall transaction volume, sparking apprehension about the trajectory of the industry. However, there have been some signs of renewed life in the market. Most experts believe we have hit the interest rate peak and expect cuts to be made in 2024. In addition, dealmakers generally anticipate that the M&A environment will improve given the market has stabilized, which could bring more investment opportunities to the market. While no one has a perfect crystal ball about what the future will hold, there are certainly reasons for optimism in 2024. Here are three net lease market predictions for the year ahead. Boost in net lease deal volume fueled by projected interest rate cuts The U.S. Federal Reserve indicated in its latest summary of economic projections that three cuts may be coming in the year ahead. The cuts are expected to be slow and gradual and will be dependent on the state of the economy, but investors reliant on third-party debt are hoping for a much-needed reduction in borrowing costs to remain competitive. The signaling of rate cuts is positive news for the market as it means interest rates have most likely reached their peak. This should help the market stabilize therefore narrowing the bid-ask spread between buyers and sellers, leading to a more active deal environment in 2024. In addition, many investors who have stood on the sidelines in anticipation that there will be more favorable opportunities down the road are likely to start jumping back into the market in 2024 and new entrants are expected to join in. Uptick in private equity sale-leasebacks as M&A surges The dealmaking environment in 2024 is already off to a better start than 2023. Inflation has declined, interest rates have likely reached their peak and private credit has become more widely available for more kinds of deals, while traditional credit markets are starting to improve. Private equity firms are also sitting on an unprecedented amount of dry powder – $2.59 trillion – with mounting pressures to deploy that capital into new investments. As a result, M&A activity is expected to increase in 2024. Along with an uptick in dealmaking, savvy private equity firms are expected to continue looking for alternative strategies for growth given lingering economic and geopolitical uncertainties. One effective strategy is through the sale-leaseback of their portfolio company real estate, which allows private equity firms to unlock immediate capital to redeploy into other initiatives, such as new acquisitions or portfolio company growth. Typically, when M&A activity surges, sale-leaseback opportunities follow, so more private equity-backed real estate deals will likely emerge in 2024. Pandemic office trends remain while industrial holds steady More than three years since the start of the pandemic, the real estate industry has finally accepted that the office sector will not return to the way it was before – and hybrid- and- remote work models are here to stay. As a result, offices have lost much of their appeal for investors, with transactions declining more than twice as much as any other property sector in 2023. W. P. Carey announced its strategic plan to exit office last year, through the spin-off of 59 office properties into Net Lease Office Properties and an office sale program to dispose of the remaining on-balance sheet assets. This trend is expected to continue into 2024 and some office investors will likely start to look for alternative uses for office assets – such as residential or industrial. Industrial, on the other hand, will continue to perform well into 2024, as re-shoring and nearshoring provide a boost to the sector. While the asset class is showing some signs of softening post-pandemic as the need for robust inventory decreases, the long-term outlook remains positive. Moody’s Analytics CRE forecasts that annual rent growth for warehouse and distribution properties will track at approximately 5-6% per year over the next 10 years, suggesting that the sector has moved on from its huge boom into a steadier state of growth.
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.
A Bumpy Road Ahead, but Reasons for Optimism: Key Takeaways from MIPIM 2023
Last month, 23,000 CRE professionals traveled to Cannes for MIPIM 2023 – Europe’s largest real estate conference. Attendees soaked in the French Riviera sun on La Croisette as they gathered to discuss today’s real estate market and the potential opportunities and challenges that lie ahead. Shakeups and surprises in the financial markets took center stage, but optimism about the future of the commercial real estate market remained. Here were the three biggest topics that dominated the discussion and our perspective on what it means for the future. Financial market turmoil The conference kicked off amidst the largest banking failure in more than a decade with the collapse of Silicon Valley Bank (SVB), followed by the dramatic fall in the stock price of Credit Suisse and the subsequent announcement that UBS would be acquiring the company. The banking sector turmoil became a hot topic of conversation, with delegates divided over the economic impact of these micro-shocks. Some believed the downfall of SVB and Credit Suisse were not a signal for the entire economy, given SVB operated in a very specific ecosystem and Credit Suisse had faced a number of problems going back several years. Others felt it was eerily similar to the bank failures in 2008 and an indication we are moving into a financial crisis. Laser focus on interest rates For some delegates, the outlook off the back of the banking turmoil remained positive, as many thought the banking crisis would help stave off the Central Bank’s appetite for rate increases in their battle against inflation. Ultimately, this proved to be short-lived given the European Central Bank’s decision to raise interest rates across the Eurozone by 0.5 percentage points on March 16 and the Federal Reserve’s move to raise rates by 0.25 percentage points the following week. Interest rates, and the broader discussion concerning the pace of hikes, were topics already in focus long before MIPIM began. However, during the conference, there emerged a growing consensus that we are entering a new stage of the market with higher interest rates likely staying for the foreseeable future and old pricing levels now a thing of the past. Opportunities still available Where to source attractive investment opportunities was another key topic in Cannes. Similar to years prior, logistics led the way with regard to positive investor sentiment. Attendees agreed the fundamentals for the asset class remain strong, although in some markets many pointed out that logistics cap rates were slow to adjust to rising interest rates. Office, on the other hand, has largely fallen out of favor with investors given work-from-home and hybrid schedules remaining in place for many companies. Our perspective If an economic downturn is on our horizon, W. P. Carey is well positioned to weather the storm given we have a 50-year history of operating in all economic cycles. Our portfolio diversification, disciplined underwriting and lease structuring, and our well-positioned balance sheet, make us one of the safest REITs in terms of downside protection. As an all-equity buyer, W. P. Carey also remains well positioned to execute on deals and offer certainty of close given we aren’t reliant on third-party debt financing. For example, we recently announced a cross-border sale-leaseback of an industrial portfolio in Spain and Italy with Siderforgerossi, a leading manufacturer of specialized forged metal components. The facilities represent a significant portion of the company’s manufacturing footprint and are triple-net leased for a term of 25 years with annual rent increases. Despite the bumpy road ahead, I remain optimistic about the future. Rising interest rates make sale-leasebacks a more attractive financing option for corporates on a relative basis, meaning we’ll likely see an influx in opportunities in 2023. We always say that sale-leasebacks are a good tool in good times, but a great tool in uncertain times, and this sentiment couldn’t ring more true than it does today.
Sale-leasebacks Are Back!
The sale-leaseback market is booming. Strong fundamentals including low interest rates, outsized demand for high-quality assets, an active M&A market and significant amounts of capital driven by cheap debt and strong currency make now an opportune time for sellers to execute a sale-leaseback and unlock otherwise illiquid capital tied up in their real estate. According to data from SLB Capital Advisors, sale-leaseback activity increased 17% in Q2 from the previous quarter, reaching $3.6 billion–the second highest in terms of deal volume since before the pandemic in Q4 2019. With interest rates unlikely to rise in the short term and property valuations being pushed higher as new investors enter the sale-leaseback market, we expect this high level of activity to continue into 2022. However, within the broader sale-leaseback market, each core property type–industrial, office and retail–faces unique headwinds and tailwinds, presenting new challenges and opportunities across each. Here’s how we think each will fare in 2022. The Industrial Surge The industrial real estate market continues to be one of the strongest sectors fueled by tailwinds related to the growth of e-commerce, including increased inventory requirements and record-low vacancy rates. These strong fundamentals mean that investor demand for industrial sale-leasebacks will only increase, particularly as new entrants enter the market. We are already seeing the effects of this–but as more entrants enter, the imbalance between the product available and demand for assets will continue to widen, driving prices higher and cap rates lower–even in traditionally non-core industrial markets. In addition, a lag in new development due to increased material and labor costs will keep real estate valuations for existing assets high. As a result, we don’t see the industrial market slowing any time soon–creating immense opportunity for sellers to maximize the value of their real estate through a sale-leaseback. Growing Office Optimism While office has certainly been a dark horse in the real estate market due to lockdowns and work-from-home mandates, there’s some optimism on the horizon going into 2022. Several big tech companies such as Google, Facebook and Amazon, have made investments in NYC office space this year, sparking early signs of recovery in the sector. In addition, Sun Belt markets such as Texas and Florida–where many urbanites migrated during the pandemic–are seeing an increase in demand for offices supported predominantly by the small and mid-size businesses located in those regions. For potential sellers, these are all positive signs and suggest that investor demand for certain office assets will rise in 2022, particularly for high-quality properties in strong markets leased to investment-grade tenants. Retail's Road to Recovery Similar to the office market, retail is seeing a recovery from COVID-19 pandemic lows. Retail foot traffic and sales continue to increase, but the rise of e-commerce has certainly left a lasting impact on the industry as a whole, as most retailers are now implementing hybrid store models which include both brick-and-mortar stores and online distribution. In the next few years, many retailers will likely reevaluate their portfolios in terms of number of stores, location and use–and many may downsize as online orders become a greater proportion of their sales. As a result, the overall level of occupied retail space will likely shrink, meaning the market will favor corporate sellers and tenants. In addition, we expect investor demand for essential retail such as grocery and quick-service-restaurants will remain strong in 2022, as those sectors have demonstrated exceptional resiliency during the pandemic and resulting economic downturn. We’ll likely also see an increase in volume of retail sale-leasebacks in Europe, particularly for those essential assets, as US-based investors expand into new markets to take advantage of different costs of capital. What's Next Overall, the outlook for sale-leasebacks remains positive across all three core property types, with 2021 shaping up to potentially be a record year for deal volume. As long as the market fundamentals remain strong, corporate sellers pursuing a sale-leaseback will be able to secure high valuations for their real estate assets while locking in current low rates for the long term. Working with an experienced sale-leaseback investor such as W. P. Carey ensures sellers unlock 100% fair market value of their assets–which can be reinvested into growth initiatives–and also provides a long-term capital partner that can support future real estate needs.