Jul 9, 2015

By Jennifer Duell Popovec

Demand for newly-constructed net lease assets is fierce, and these assets are commanding a pricing premium in the net lease space due to their scarcity. However, as retailers execute their expansion plans, experts anticipate more new retail net lease properties to become available.

“Retail growth is fueled by consumer demand, and we are seeing retailers respond to that demand by announcing new store growth, redevelopment of outdated concepts and launching new store formats,” says Lanie Rea, director of research for Stan Johnson Co.” In the coming quarters, we expect to see these announcements translate into greater amounts of square footage under construction.”

Cap rates for newer construction assets have decreased over the recent years as the supply of these assets has been limited when compared to demand across the net lease sector, according to Randy Blankstein, president of The Boulder Group. For example, recently constructed Walgreens properties were asking cap rates at 5.4 percent in the second quarter of 2014 and today these same properties are asking cap rates of 5 percent.
Construction levels below normal

Over the last three years, the single-tenant retail sector has had on average 24 million sq. ft. under construction at any given time. Currently, development levels are noticeably below that average amount, reporting just over 15 million sq. ft. under construction, according to Rea. Of that total, tenants have committed to more than 10.8 million sq. ft.

During first quarter 2015, the market delivered 7.8 million sq. ft. of new retail space, which is on par with quarterly totals reported over the last 12 months. However, Rea expects 2015 to break the delivery trend seen in the last few years.

“Retailers have announced new locations and concepts in new markets, and are actively developing, some at a more robust pace than others,” Rea says. “As the year continues, we expect to see under construction levels rise, and quarterly deliveries to outpace levels reported during first quarter 2015.”

Looking at across the United States, there doesn’t appear to be a significant draw to any one particular region for new retail net lease construction. The Southeast currently leads the nation in square footage under construction, with nearly 4 million sq. ft. currently under development. However, the remaining regions are still boasting healthy levels upwards of 2.5 to 3.5 million sq. ft. each, with the exception of the West region.

Rea notes that construction levels in this region dropped from a recent high of 5.8 million sq. ft. in mid-2013 to the current 1.8 million sq. ft. The vast majority of this West region retail development, not surprisingly, is occurring in California (1.1 million sq. ft.), but even there a slow-down has occurred.

“All signs point to this being a short-lived slow-down, as retailers remain eager to boost market share in growing geographies, expand their newest concepts, and tap into new or underserved markets across the U.S.,” Rea adds.
Select tenants expanding

Within the retail industry, the sectors that are rapidly expanding include dollar and discount stores, drugstores, grocery stores and restaurants. Dollar General, Dunkin Donuts, Starbucks, Walgreens, and Chick-fil-A are actively developing new units.

“Supply in the last few years has been constrained, but this dynamic should shift over the next few years as construction levels continue their rebound from recession lows,” Rea says. “As retailers with attractive credit commit to long-term leases in newly constructed prime locations, those investors seeking strong investment opportunities should have more options to choose from as retailers expand across the nation.”

According to Blankstein, the majority of new construction net lease product today is focused on smaller tenants—those under 20,000 and outlots. The development pipeline for larger footprint big-box stores has slowed as these tenants have slowed their expansion plans.

However, a notable exception is Walmart. The chain is expanding its Walmart Neighborhood Market concept and plans to build around 450 stores over the next couple years. A large percentage of those are net lease properties, Blankstein notes.
Cap rate compression for new construction

Cap rates in the second quarter of 2015 for the single-tenant net lease retail sector remained unchanged at their historic low rate of 6.4 percent, according to The Boulder Group. The firm reported that overall supply of net lease assets was up over 21 percent in the second quarter, with retail assets leading all sectors at 23 percent.

“Even with an increased supply and compressed cap rate levels, bidding for net lease assets has been favorable to sellers,” Blankstein notes, adding that recently constructed Dollar General, PNC Bank and O’Reilly Auto Parts properties experienced cap rate compression of 12, 30 and 12 basis points, respectively, in the second quarter. “As limited opportunities exist for new construction and long-term leased properties to investment grade tenants when compared to the investor demand, these assets are commanding the highest prices.”

—Elaine Misonzhnik