Widely predicted interest rate cuts will benefit net lease retail, brokers say, but it will take months for deal volumes and cap rates to return to anything like those of the prior go-go years. “It’s pretty easy to make the argument that the recovery is six to 12 months away,” said Boulder Group president Randy Blankstein. “It’s clearly not a 2024 event.”

Against this backdrop, savvier sellers are being more realistic about how much their retail assets can fetch in today’s net lease market, with its high levels of available inventory and smaller pool of 1031 exchange buyers, said Nicholas Kanich, first vice president of investments in Marcus & Millichap’s downtown Chicago office. “When rates were going up a year-and-a-half ago, it was just pencils down,” Kanich said. “Nobody was writing offers or buying or selling anything. Now, people are feeling better because they can see what’s on the horizon. We’re definitely headed in the right direction.”

“Long Year-and-a-Half”

In its national Net Lease Market Report for the second quarter, The Boulder Group reported that median asking cap rates for single-tenant, net lease retail assets had increased from the first quarter by five basis points to 6.47%. The brokerage and advisory firm attributed the change to “elevated interest rates and limited 1031 exchange and institutional buyer activity.” It was the ninth consecutive quarter in which The Boulder Group — which tracks retail sectors like auto, casual dining, quick-service restaurants and dollar stores — had observed cap rate expansion in the net lease market.

The number of retail properties on the net lease market rose to 3,677 in the second quarter, a quarterly increase of 8.1% and a hallmark of sluggish deal flow. “Last year, the market volume [for retail, office and industrial net lease properties] was down 50% across the board, and year-to-date, the market is down 10% from that low level,” Blankstein said. “It has been a very long year-and-a-half for those interested in transaction volume in this space.”

For its part, Equity Retail Brokers’ investor site nnntrends.com reported a 16% year-over-year decline in transaction volume for the second quarter, said principal Ken Yanni. The more than 50 tenants that it tracks include Aldi, Chick-fil-A, Raising Cane’s, Mattress Firm, LA Fitness, Family Dollar Chipotle Mexican Grill and CVS. By comparison, ERB reported a 47% year-over-year decline in transaction volume in the second quarter of 2023 for that same set of net lease retail tenants.

The Fed’s 11 rate hikes since March 2022 came “fast and furious” and “stunned the market,” Yanni noted. The shift led to higher cap rates, lower deal volume and a wider bid-ask spread. “The cost of capital went through the roof for buyers, and the sellers weren’t quick to adjust their pricing expectations,” Yanni said. But like Kanich, the broker sees some sellers adjusting to today’s pricing realities. “Those are the owners who are doing deals today, but others haven’t made that transition yet.”

Flood of Inventory

The higher cost of capital also affects which net lease assets are likeliest to sell. As Blankstein sees it, higher capital costs encourage buyers to steer clear of financing and to pursue smaller deals. “The more you finance, the worse your returns get. It puts a lot of activity in the $3 million-and-under space, where you can buy with cash.”

The trend favors retail, which offers lower price points than single-tenant office and industrial net lease assets. “There are a lot of dollar stores and QSRs out there that are under $3 million,” Blankstein noted. “Those are still cash buyers, and so it’s still an active segment of the market.”

The need to finance larger properties helps explain why there are fewer 1031 exchange buyers targeting assets ranging from $4 million to $10 million, Blankstein added. “We’re missing that middle tier, which in my world is usually drugstores like Walgreens and CVS,” he said. “There’s just a lot less transaction volume there because leveraging those doesn’t make sense right now.”

The slower pace of deals is translating into record levels of unsold inventory, and more net lease retail properties are hitting the market every day. In this environment, even locations of historically favored investment targets can sit unsold. “Before, when you put a Starbucks on the market, you would get interest from buyers all over the country,” Yanni said. But in June, only nine Starbucks deals transacted nationally and 25 new deals came to market. “There are 142 [net lease] Starbucks available right now,” the broker said in late July.

Sellers with unrealistic expectations that leave overpriced assets on the market can add to the inventory pileup and distort perceptions of marketplace demand, Kanich observed. For example, the seller of a property listed at $5.5 million might be told by the broker that the property actually is worth $4.5 million or $4.25 million. “For some owners, the natural response is to say: ‘Well, let’s keep it out there at $5.5 million and just see if anybody shows up,’” Kanich said. Seeing such listings, others with similar properties might then misinterpret these “comps” as viable asking prices for their own assets. “There’s a difference between what’s merely on the market and what has actually transacted,” Kanich said. “On-market comps can be a bit of a mirage for owners.”

Refinancing Clock

The inventory pileup could get worse before it gets better. As Blankstein noted, refinancing deadlines already are starting to come due on the commercial mortgage-backed securities loans that often are employed on larger deals involving the likes of The Home Depot or Walmart.

Those expirations will accelerate for the next six quarters, falling off again in 2027. “We’re certainly going to see more supply added to the market from owners who don’t like their refinancing options or the amount of new equity that will be required to refinance,” Blankstein said. “Higher rates to refinance debt will hurt owners’ returns. They’ll have to make some decisions because CMBS lenders do not work things out with you. You either repay them or go into default.”

Meanwhile, the owners of smaller properties might well find that by next year, traditional banks are no longer willing to grant them extensions, Blankstein said. “Next year, the conversations are going to be a little tougher than they were this year or last year.

The banks will say: ‘Look, it’s time to make a decision regarding this asset.’”

Deals Move Forward

Even with new rounds of rate cuts, clearing all that inventory will be a slow process. In the meantime, brokers said, motivated sellers and discriminating buyers will continue to do net lease retail deals. “We just sold a Walmart in Pennsylvania for a cap rate that was well below what you might expect to see today,” Yanni said. “The 1031 exchange buyer understood that this particular Walmart was in a major retail hub.”

The Walmart also was paying approximately $1 per square foot in rent, Yanni said, which reassured the private investor that buying the property would be low risk. “They understood that they could backfill that space for significantly more money with another tenant.”

In addition to focusing harder on real estate fundamentals, some investors are finding a way forward by going local, Kanich said. “I've seen more buyers that are familiar with, live in or are from that local market,” he explained. “Because buyers are more cautious, they're resorting to what they know. They’re saying: ‘Hey, I want to invest in my backyard because I know the market dynamics and the pros and the cons and I realize exactly what I'm buying here.’”

Earlier this summer, for example, Kanich and Chicago-based Marcus & Millichap investment specialist Mitch Grant sold a Walgreens in Jefferson City, Missouri, for $4.2 million, working on behalf of a Kansas City-based owner. The 1031 exchange buyer was from Jefferson City and had a local broker, as well. “The buyer’s loan came from Missouri Credit Union, which actually was physically adjacent to the property,” Kanich noted, “so they had boots on the ground.”