What the Latest Rate Cuts Mean for the Net Lease Sector
As the Fed cuts rates, investors are re-evaluating their strategies. Here’s what it means for the net lease sector.
The persistent high cost of capital, along with the fact that large amounts of corporate debt are set to mature, have been ongoing challenges for investors. The Fed’s recent rate cut – the first in over four years – leaves many speculating how investors will fare.
“Impacts from these changes will take some time to see,” says Zachary Pasanen, managing director, investments, at W. P. Carey. “I don’t necessarily believe we’ll experience a rush of investment overnight. Everyone is still in the process of figuring out what the environment will look like, and there are also geopolitical situations at play.”
Cap Rates and Market Sentiment
Pasanen suggests a positive outlook for the net lease sector, noting that while volumes are down compared to the previous year, the sector’s resilience remains.
He explains that net lease investments function similarly to bond instruments, and with rates being cut, he doesn’t believe the risk profile changes that dramatically.
“I think the risk paradigm is still very much in that 7%-8% cap range,” says Pasanen, noting that while conditions may eventually spur more net lease activity, it won’t take place immediately.
He also cautions that investors should not get too caught up in “rate cut mania” and risk comprising spread. Focusing on fundamentals and maintaining a disciplined investment approach remain as important as ever.
Relaxed Interest Rates and the Financing Landscape
Funding business growth and quickly accessing capital have left many corporates looking for alternatives to traditional financing. With the Fed’s recent rate cut, Pasanen believes that sale-leasebacks will continue to be an attractive option. He further notes that while there have been pockets of “stress” in the market, these aren’t the same as “distress.”
“Many lenders were willing to accommodate borrowers and work with them,” says Pasanen. “This group made it through this past year and is saying, ‘Okay, I’ve extended the maturity of my debt and identified some dislocation among acquisition targets, and now might be a good time to raise capital and grow my business.’”
However, as these businesses return to banks to raise more capital, financial institutions may have reached a limit in how much they can help, a scenario where sale-leasebacks can be beneficial.
“W. P. Carey has been in business for over 50 years,” says Pasanen. “We’ve been through numerous market cycles and have a lot of capital to deploy. As the market recalibrates, we’ll continue to do what we do best – work with corporate owners to unlock the value of their real estate through sale-leasebacks.”
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Keeping Up with Industrial in a ‘Wildcard’ Year
Uncertainty around interest rates, slowed transactional volumes, and a future of unknowns has left investors in the industrial sector watching trends closely. “This year has been a bit of a wildcard,” says Jason Patterson, senior vice president of investments at W. P. Carey. “People constantly speculate about what the future holds regarding interest rates, and we also saw a bit of softening on the lease demand side at the end of 2023.” As uncertainty persists, understanding a few key trends can help the industrial sector track what’s next as it moves closer to a new normal. Cost of Capital Challenges Persist As 2024 began, forecasts predicted multiple interest rate cuts; however, the Fed has held rates unchanged to date. Recently, it adjusted the previous forecast from three expected rate cuts in 2024 to one, against the backdrop of persistent inflationary concerns. Volatility around rates has also led to investor hesitancy in making long-term commitments, further impacting transaction volumes. “There is also a long and continuous trend toward e-commerce,” says Patterson. “In the near term, there has been a bit of volatility due to overbuilding in certain markets, and there is a bit more vacancy that needs to be absorbed. These shorter blips are relative to what seems to be a long-term trend toward higher value in industrial real estate.” Despite ongoing challenges, opportunities still exist for the industrial market, and understanding some existing tailwinds can help investors capitalize on these. Shift to Onshoring Onshoring is a continued tailwind for the industrial sector, especially on the manufacturing side according to Patterson. “It seems there is bipartisan agreement around a movement to onshore, as sentiments trend toward increased American manufacturing.” Upticks in high-tech chip manufacturing and transitioning the auto fleet to electric are also drivers of long-term industrial demand, says Patterson. While electric cars accounted for only 2% of vehicles in 2018, that number jumped to roughly 18% of all vehicles sold in 2023. A push toward more sustainable vehicle technologies could further drive long-term industrial demand, but Patterson cautions that continued growth could depend on the outcome of the election. Strategic Positioning and Access to Capital When operating in a market with many unknowns, a good place to start is focusing on what’s within your control, suggests Patterson. “Factors such as interest rates are out of the hands of most folks,” says Patterson. “We focus on sticking to our competitive advantage, which is underwriting sub-investment-grade long-term lease opportunities.” Agility is also key, as is working with partners who can support the market’s need for increased flexibility. According to Patterson, “This is a time when having a reputation for strong performance and access to capital is very valuable. At W. P. Carey, we are well positioned to execute with significant liquidity and capital, enabling us to be nimble in the current environment.”
What’s Next for Net Lease?
The effect of rising interest rates registers in many ways around the real estate world, but perhaps the starkest impact can be seen in the investment volume differential in one of CRE’s most popular sectors. Net lease investment volume decreased roughly 35% year over year in the third quarter, according to Jason Patterson of W. P. Carey. The VP of investments at one of the largest diversified net lease REITs notes the Fed’s impact on market players has been far-reaching. “Net lease volume prior to the Fed moves had been near or at record levels so the run-up in rates certainly impacted people getting on the same page with the value of real estate or what they were willing to commit to on a cap rate basis,” Patterson said. “A high level of volatility in a space where people are making long-term investments is not the ideal environment.” A Debt Market in Disarray Call it a pause, a disconnect, or total debt market disarray, 2022 has brought major headwinds to a CRE industry and net lease sector that have gotten accustomed to cheap capital. Yet, Patterson reports still seeing a lot of attractive opportunities in the market. “Private equity-backed sellers or tenants continue to use sale-leasebacks as an attractive form of unlocking tied-up capital in their acquisitions, a counter-inflationary move that in some cases has been beneficial to us,” he said. “They’re viewing it more and more as a regular, very attractive component of the capital stack, which I think is good from a broad industry perspective.” Unencumbered by rising capital costs, equity investors have certainly found more room to work within the net lease market “The current environment favors people in a high certainty or all-cash type of capital structure like W. P. Carey,” Patterson said. “We’ve seen increased focus on certainty of close as levered buyers signed up for deals maybe in the early part of the summer and then with rising debt costs their assumptions didn’t pan out. You see deals come back to market as more investors have to reevaluate pricing in this period of volatility.” 2023 Outlook Citing the first half 2022 industrial deal volume exceeding more than 50% of the STNL market, Patterson forecasts that industrial product will continue to be a very attractive investment target. He added though that not all industrial product types are created or viewed equally. “Rather than just lump everything into broad industrial, we’re looking for real estate that is extremely critical to operations for our tenants,” he said. “Maybe we’re willing to give up a little bit in terms of fungibility for increased certainty that tenants are going to renew and keep paying rent for the long term. Asset classes such as cold storage and food production are extremely important to users and they don’t have a ton of alternative options available.” A $75 million sale-leaseback W. P. Carey completed in the second quarter embodies the above trends. The 25-year net lease for six mission-critical specialty manufacturing facilities totaling approximately 1.1 million square feet in three countries is backed by private equity. “There continue to be more and more deals getting done with private equity sponsorship, and we’d expect that to largely continue in 2023,” Patterson said. “The trend, a positive one for the industry, really is private equity ownership looking toward sale-leasebacks.”
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.