Net leases are becoming real estate’s bond replacement

As retail and office sectors trend toward volatility, the steady returns of sale-and-leaseback strategies are becoming attractive fixed-income substitutes.

Although transaction volumes have been lower during the pandemic, net lease strategies have been finding outsized success.

Earlier this month, Apollo Global Management led a group of investors in acquiring a $5.5 billion portfolio of properties in Abu Dhabi on one such contract. Fellow private equity giant KKR is pursuing a similar strategy in Japan.

Deals like this are propping up investment volumes for the private real estate sector. In the US, sale-and-leaseback arrangements accounted for a record 20.2 percent of commercial real estate transactions last quarter, according to a report by CBRE, nearly double the long-term average.

The environment is ideal for triple-net lease acquisitions. Companies languishing under the economic strains of the pandemic can sell their underlying real estate to generate much-needed liquidity. Real estate investors, for their part, get something almost as hard to come by: bond-like returns.

Real estate’s primary appeal to institutional capital since the global financial crisis has been as an alternative to fixed-income instruments. With central banks set to hold benchmark interest rates near zero for the foreseeable future, the need for reliable yields has only increased during the covid-19 era.

Yet, at the same time, traditionally structured real estate deals are trending more toward the cyclical fluctuation of stock markets than the steady income flow of bonds. This is most evident in the two longstanding pillars of core real estate: office and retail. The rise of flexible offices and e-commerce have upended the long-term leasing models that made these assets so attractive to investors. The relative ease with which people adjusted to working and shopping primarily from home has only made matters worse for the property types.

As Paul Kennedy, managing director of JPMorgan Asset Management, put it in a recent commentary for sister title PERE, investors seeking “high-quality, stable income may have to focus on an increasingly narrow subset of the office and retail sectors and rely more heavily on logistics”. That is already playing out in the net lease market, where industrial properties accounted for 48 percent of transactions last quarter, up from 34 percent the year prior, according to CBRE. Retail and office, meanwhile, lost 3.3 and 10.6 percent of their market shares, respectively.

A successful sale-and-leaseback strategy is an extension of the seller-tenant’s creditworthiness, which can offset broader market volatilities. In retail, for example, managers can cherry pick successful businesses – such as fast food restaurants, drug store chains and auto repair shops – backed by strong parent companies and avoid rolling the dice on turnover-prone shopping centres.

Institutional managers have also shown a greater willingness to invest in non-traditional markets on a net-lease basis. An example of this is Apollo in Abu Dhabi, which is more often a source of investment capital than a destination. For 24 years of income from a reliable tenant – the Abu Dhabi National Oil Company – the arrangement seems well worth any location risk. For its part, ADNOC gets an immediate injection of $2.7 billion to bolster it through a lull in petroleum demand.

KKR’s Japanese playbook is similar. It will source deals from railway companies, manufacturers and other corporations with large, underutilised property holdings. In the US, sale-and-leasebacks have played a larger role in the market since 2016, a trajectory that tracks closely to the rise of industrial net leases.

So long as investors remain starved for steady income-producing assets and companies stay equally in need of capital, look for net lease strategies to continue having their day in the sun.

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