Following a robust year of transaction activity in 2019, the flow of new deals is thinning rapidly. Most properties that were under contract for sale in March are still closing. Additionally, buyers that need to line up replacement properties for 1031 exchanges are still active. That pipeline probably will go through the end of the month, says Randy Blankstein, president of net lease investment advisory firm The Boulder Group.

Some continue to look at net lease as a safe place to park capital, adds Camille Renshaw, CEO of B+E, an investment brokerage firm and online trading platform that specializes in net-lease properties and 1031 exchanges. For example, one 1031 buyer’s apartment-property purchase fell through in late March due to COVID-19 uncertainty. Renshaw said the buyer is turning to the net-lease investment market for a replacement. The investor needs to place $10 million from a prior sale to achieve a 1031 exchange and thus avoid paying capital gains taxes. In this case, the buyer is seeking an investment for which the value will hold up if the investor decides to resell when the crisis is over, whether that is two months or two years away, notes Renshaw.

Meanwhile, institutional and REIT buyers have moved to the sidelines relatively quickly in the midst of market uncertainty and falling stock prices. The volume of net-lease retail properties listed for sale dropped 16 percent in first quarter from 3,895 to 3,264, according to a first-quarter research report published by The Boulder Group. Most of that decline occurring during the last two weeks of March.

For-sale listings and transaction volume are expected to drop further in the second quarter as investors wait for the market to stabilize and reassess pricing. However, low financing rates mean there is still a good pricing spread, adds Blankstein. “You can still get a good cash-on-cash yield, and this is a nation looking for yield. So while there is going to be some pricing deterioration, it is not going to be dramatic in the net-lease space,” he said.

Reevaluating risk exposure

Most net lease assets rely on single tenants, so investors understandably are taking hard looks at how individual tenants and categories are likely to withstand COVID-19-related closures and disruption to foot traffic and sales. “The challenge is: How much of a rent headwind do we have here?” said Haendel St. Juste, managing director and senior REITs analyst at Mizuho Securities USA.

Based on liquidity, balance sheets and tenant diversity and credit quality, some net-lease REITs are better positioned to weather cash-flow disruptions. Two REITs holding up better than others are Agree Realty Corp. and Realty Income. Investors appear to have more concerns about companies like STORE Capital and Essential Properties; they have higher shares of small, private-equity backed tenants and traditionally have bought assets at higher cap rates, which suggests higher risk, says St. Juste.

Information on which retailers are or are not paying rent is still becoming clear. As such, the impact on publicly traded REITs likely won’t be disclosed until companies report second-quarter results in July. “It will probably be after second quarter before we have a truer sense of how things are playing out,” says St. Juste.

Essential versus experiential

In some cases, COVID-19 has flipped the table on how investors were valuing categories within the retail net-lease market. Government action to contain the spread of the virus has reemphasized the importance of essential retailers like drug stores, grocery stores and convenience stores. Those types of businesses are open and doing well. That performance likely will keep pressure on low cap rates to stay low. For example, the median asking cap rate for 7-Eleven stores built between 2017 and 2019 averaged 4.97 percent in the first quarter, according to the Boulder Group.

Experiential tenants that were in vogue just a few months ago — such as movie theaters, fitness centers, spas and activities like indoor golf, rock-climbing gyms and laser tag — have closed. “I don’t think this necessarily shifts longer-term strategies in terms of the types of assets and tenants investors are looking to buy, but people might be more aware of the potential risks now that people understand that pandemics can happen,” said Blankstein. It also may impact how those more experiential properties are priced, he adds.

In addition to the essential categories, other needs-based retail — such as auto service and auto parts, pet and veterinary uses — are likely to hold up well under current market pressures, says Renshaw. Big-box stores that blend retail and industrial uses, offering in-store and delivery options, are attractive, such as Whole Foods. Sporting goods stores are likely to be durable, especially those like Bass Pro Shops that already have a strong online platform, she says. “We also really like cannabis. Because they have always had banking issues, some of the debt components that slow down some of our other deals is a non-issue for marijuana and cannabis deals,” she added.

Investors should avoid dismissing property uses categorically and instead should drill down on the strengths of individual companies, Renshaw says. Quick-service restaurants, for example, remains a strong category. However, the ones that are better positioned to hold up are those that not only have drive-thrus but also were generating lots of sales from drive-thru even before the crisis. “It is a matter of looking at the category and the source of income, as well as how they might be impacted by the stimulus package,” she said.