B+E Net Lease Outlook 2023

B+E Net Lease Outlook 2023

Spike in for-sale inventory fuels robust transaction market heading into 2023

The single-tenant net lease (STNL) market continues to be a bright spot amid the broader commercial real estate investment sales market. While other sectors are battling headwinds that are slowing deal-making, the STNL sector posted huge transaction volume in Q4, and B+E is anticipating that momentum will carry over into the first quarter of 2023. 

A surge in new listings coming to market is providing fresh inventory for prospective buyers and fueling robust sales activity. B+E research shows that for-sale inventory in the STNL sector has been steadily building this year, including a nearly 140% jump compared to the prior between Q3 and Q4, according to B+E’s Q4 Net Lease Cap Rate Report.

However, market realities are tempering enthusiasm somewhat as buyers and sellers are still dealing with pricing adjustments amid ongoing Fed rate hikes, as well as the uncertainty of a potential recession ahead in 2023. “We are forecasting a choppy year with sales likely to be more weighted in Q1 and Q4, similar to 2022,” notes B+E CEO and Co-founder Camille Renshaw. Transactions are likely to slow during the summer before picking up again, as investors will be motivated to deploy capital before year-end, adds Renshaw.

Understanding the STNL market in 2023 will be key to helping both buyers and sellers navigate price changes amidst challenges the year will bring. The increased inventory on the market is allowing B+E to capture more data than ever on real-time market activity. “When you want to know how to price an asset, whether it’s a Mr. Clean Car Wash or a Walmart, it’s really difficult to pinpoint market pricing when you only have two active listings,” says Renshaw. “But when you have 20 on the market, or in the case of a Walgreens where there are nearly 300 on the market, that data provides greater depth of insight for buyers and sellers.” 

Growing for-sale inventory

Analyzing that data starts with digging into factors that are contributing to a spike in supply, as well as the underlying dynamics of pricing and cap rate trends and how long properties are sitting on the market. Certainly, some of the excess inventory is due to a bid-ask gap. Many properties that came to the market in the spring of 2022 or before, ahead of rising interest rates, haven’t updated pricing to reflect the current market. Those that remain aggressively priced have been slower to move and have contributed to properties hanging on the market. 

In addition to the “normal” influx of new listings, with owners choosing to sell for a variety of reasons, there are sellers who see now as an ideal time to sell before assets potentially reprice lower. “Many sub-$5 million transactions continue to close at early 2022 pricing. So there is still a chance to close at below market cap rates of 4% or 5%,” says Renshaw. Developers that have relied on short-term, floating debt also are motivated to sell as their project financing has become more expensive along with rising interest rates. “We’ve seen a number of developers trying to sell out of properties they own, even if it means selling at breakeven, in order to get a clean financial slate in this new market paradigm,” says Renshaw.

It’s also important to note that the increase in supply isn’t entirely across the board. Some categories, such as banks and grocers, have remained relatively flat, whereas other sectors have seen big spikes of 50 to 60% and higher. For example, the number of convenience stores jumped 56% to 333 in Q4, and car washes have more than doubled quarter-over-quarter from 77 to 159. 

Dissecting buyer demand

There’s good news for sellers in 2023, as there continues to be a healthy appetite for STNL assets from a diverse set of buyer demands, and preferences are nuanced within the buyer pool depending on the type of investor. 

“Private buyers are still pretty active. Although not as active as they were a year ago, they were driving a majority of transaction activity in Q4,” says Renshaw. Some private buyers are driven by factors outside the market, such as generational wealth considerations or estate planning. Tax considerations, such as 1031 exchanges or bonus depreciation needs, also drive the private buyer. Regardless of where interest rates or cap rates are relative to historic markets, many investors are highly motivated by tax strategy and need to execute quickly. 

Highly motivated buyers are willing to be aggressive on pricing, even in the rising rate environment. For example, B+E put a NNN Taco Bell in Winter Springs, Fl. under contract in early December that closed in the last week of 2022. The older prototype had 23 years remaining on the ground lease and sold at a 4% cap rate to a private buyer in an all-cash transaction. 

On the larger end of the spectrum, institutional buyers raised capital in 2022 and need to get that capital out. Some large institutions also are repositioning portfolios. They’re selling properties at peak pricing then reinvesting those proceeds at higher cap rates that are more accretive to their portfolio. Increasingly, B+E is seeing that institutions buy assets larger than $5 million in size at cap rates of 7% or higher.

The small to mid-sized funds that sit between the larger institutions and private buyers are under pressure in the current market. In some instances, they feel the need to give on pricing in order to deploy capital. “We do have a lot of divergent motivations among buyers and sellers, which is contributing to choppy pricing,” says Renshaw. “By end of year 2023, we should see this pricing even out as increases to the treasury rate slow and more stable trends follow.” 

What’s hot in 2023

Heading into the new year, pent-up capital is aimed at the STNL sector. The top 10 STNL REITs alone have roughly $10+ billion combined to place in 2023. On the private side wealth needs to be invested, and STNL is very attractive as a risk-averse category of real estate. Demand for net lease assets also tends to spike when there is turmoil in markets, and that is B+E’s expectation for 2023. 

The Sunbelt states, particularly high-growth markets such as Florida, Texas, and Tennessee, are going to continue to be hot spots for demand. Capital is also chasing some favored property types. Early learning centers have been more attractive as they are trading with an average cap rate that’s above the current debt constant – in the 6s. KinderCares are popular and typically command some of the best pricing, with current asking cap rates averaging 5.6% as of Q4. For the smaller price point buyer, Dollar Stores remain very attractive. 

Despite the feeding frenzy for industrial assets, there remain few buying opportunities. Distribution facilities had the largest inventory with 62 assets on the market in Q4, followed by manufacturing at 28 and warehouse at 22. “Great assets will continue to come to the market, but this segment will be a tough place to find deals given the strong demand that exists,” says Renshaw. 

The car wash sector is another area to watch as its popularity and acceptance in the STNL market has grown over the past couple of years,  similar to where QSRs were 20 years ago. Operations are now more automated with new equipment that offers the opportunity for bonus depreciation. More private equity firms are entering the space as operators, creating stronger tenant credit profiles.  The combined progress in the car wash sector is very attractive for STNL investors. 

In short, buyers and sellers are starting 2023 with a significant delta in pricing expectations, but by Q4 this gap will narrow, generating stronger deal velocity once more. Asset type, the caliber of the tenant, the tenant’s inflation-adjusted profit margins, the property’s inflation-adjusted expense factors such as insurance and property taxes, and the debt service coverage ratios demanded by banks will all influence pricing and vary deal by deal over the year.  For property sales that rely less on debt, cap rates will not move up as much as those dependent on debt.