PDF Deal Momentum Persists as Investment Spreads Remain Attractive
Disclaimer:
Each quarter, Morgan Stanley research polls our Doug Aronson, along with a select list of net lease brokers around the country, for market cap rate report information.
Deal Momentum Persists as Investment Spreads Remain Attractive
June 2019
April 15, 2019 08:00 PM GMT
Triple Net REIT Roundup | North America
Deal Momentum Persists as Investment Spreads Remain Attractive
MORGAN STANLEY & CO. LLC
Vikram Malhotra
EQUITY ANALYST Vikram.Malhotra@
Kevin Egan
RESEARCH ASSOCIATE Kevin.Egan@
Real Estate Investment Trusts
North America IndustryView
+1 212 761-7064 +1 212 761-5028
In-Line
Our 1Q broker check reveals strong deal momentum as fears of rising debt costs have subsided. Spreads to cost of capital remain attractive, a positive for Overweight STOR. In line with an inverted yield curve, brokers expect price premiums on long lease term assets to increase.
Below we highlight top takes from our Triple Net AlphaWise survey:
1. Deal momentum expected to increase as falling debt costs cause focus to shift away from rate fears. After a strong 2018 for Triple Net deal flow as volumes increased 21.8% over 2017 levels (see Exhibit 1), brokers expect momentum to persist with retail (NIG) having the most positive outlook with large-size portfolios generally the weakest, which we think could bode well for Overweight STOR. The percentage of brokers seeing interest rates as the most important factor impacting deal volume fell to its lowest level since our January '18 survey. As cap rates have remained relatively flat, investment spreads have increased with most brokers expecting bidask spreads to remain unchanged (see Exhibit 6).
2. Calls for cap rate expansion largely absent. After 2.5 years (since the '16 election) of brokers expecting cap rates to rise, calls for cap rate expansion were largely absent from our April '19 survey (see Exhibit 2). Furthermore, in line with an inverted yield curve, a net 19% of brokers expect short lease term cap rates to expand, while a net 12% of brokers expect long term cap rates to tighten (see Exhibit 13).
Exhibit 1: 2018 Triple Net deal volume up 21.8% vs. 2017
levels, driven primarily by Industrial.
Deal Volume in Billions
$70
$60
Office Retail Industrial
$50
$40
$30
$20
$10
$0
Source: Real Capital Analytics.
Note: 2019 data is through February and transaction volumes exclude large portfolio deals announced but not closed and deals under $2.5 million.
Exhibit 2: Calls for cap rate expansion have fallen to their lowest level since the '16 election.
Cap Rate Expectations (N3M) - Net Increase vs Decrease
90% 65% 40% 15% -10%
IG Average NIG Average
Source: AlphaWise, Morgan Stanley Research.
3. New alternative asset Classes for Triple Nets. After our Triple Net day (see Top Takes From Triple Net Day `19) where exploring alternative avenues of growth was a hot topic with management teams noting alternative geographies and alternative asset classes as possible, we decided to ask participating brokers what asset classes they think could be a new asset class and avenue of growth in the net lease sector. Medical was noted as having potential with various property types and uses cited as possibilities as well as fitness, experiential, and data centers (see Monitoring the Triple Net Landscape).
Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision.
For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report.
1
What's changed since our January Broker Survey?
Question Broker View
What's Changed: April vs. January
Deal Pipeline Sentiment - Next 3M
Forward outlook up from last round; most positive for retail (NIG) assets: Higher expectations with an average net reading of +19% vs. +11% last round. The most positive outlook is retail (NIG) assets with large-size portfolios generally weakest.
Impact of interest rates on Deal Volume - Next 3M
Competition Levels
Focus shifts away from rates: 34% of brokers see interest rates as the most important factor impacting deal volume, down from 63% in January. 34% of brokers see supply / demand imbalance as most important, up from 22% in January.
Change in investor interest up during the last three months. Most brokers saw increasing demand across the various investor buckets in recent months. Overall sentiment rose to +24% from +4% in January.
Current Debt Costs
Debt costs down versus January. Brokers see debt costs on current net lease deals at an average of ~4.8%, down ~13bps from our last survey.
Overall Cap Rate Outlook
Calls for cap rate expansion largely absent. About 16% of brokers expect a 10+ bps increase in the coming months while 14% expect a decrease.
Cap Rate Outlook (by lease term)
Premium pricing for long lease term assets expected to increase. Looking forward, a net 19% of brokers expect short lease term assets to see increasing cap rates, while a net 12% expect long lease term assets to see declining cap rates.
Cap Rate Outlook (by tenant credit)
NIG expected to expand slighty while IG expected to contract slightly. Looking forward, expect slight expansion with NIG assets and slight contraction with IG assets.
2
How Robust Are Acquisition Pipelines?
Acquisition deal pipelines remain strong: Triple Net acquisition volumes in 2018 increased 21.8% over 2017 levels, driven primarily by Industrial (+56.1% y/y). Comparing the first two months of 2019 to 2018, Industrial (41% share of transaction volume vs. 52% in 2018) has lost share to Office (37% vs. 31% in 2018) and Retail (21% vs. 17% in 2018).
Heading into 2Q19, brokers expect momentum to increase: The average net positive reading for future deal pipelines this round was +19%, up from last round's +11% reading. We note that this reading is below April 2018 (+31%) and April 2017 (+21%), and brokers appear most positive on Retail (NIG) and Industrial; while large portfolios is the weakest category being the only category with a net negative reading for future deal pipelines (12%). In terms of bid-ask spread, most brokers expect bid-ask spreads to remain relatively unchanged over the next three months.
Exhibit 3: 2018 Triple Net deal volume up 21.8% vs. 2017 levels, driven primarily by Industrial.
Deal Volume in Billions
$70
$60
Office Retail
Industrial
$50
$40
$30
$20
$10
$0
Source: Real Capital Analytics. Note: 2019 data is through February and transaction volumes exclude large portfolio deals announced but not closed and deals under $2.5 million.
Exhibit 4: Broker View on Deal Pipelines (Next 3 Months)
% of respondents
Down 5%+
Up 5%+
Retail (IG)
-9%
Retail (NIG)
-6%
34% 50%
Industrial
-14%
45%
Office
-12%
35%
Mid-size Porfolios
-16%
20%
Large-size Portfolios -24%
12%
-50% -25% 0% 25% 50% 75%
Source: AlphaWise, Morgan Stanley Research.
Exhibit 5: Broker View on Pipeline - Next 3 Months: Large-size portfolios saw greatest deceleration.
View on Pipeline N3M: % Saying Increase vs. Decrease
60%
Jul-17 Oct-17 Jan-18 Apr-18 Jul-18 Oct-18 Jan-19 Apr-19
40%
20%
0%
-20% Retail (IG) Retail (NIG) Industrial
Office
Mid-size Large-size Porfolios Portfolios
Source: AlphaWise, Morgan Stanley Research.
Exhibit 6: Bid-Ask spreads are expected to remain largely unchanged.
Bid-Ask Spread Expectations, Next Three Months
50%
47%
40%
30%
25%
20%
19%
10%
6%
0% Widen
significantly
Widen somewhat
Source: AlphaWise, Morgan Stanley Research.
Remain constant
Narrow somewhat
3%
Narrow significantly
3
Exhibit 7: Focus has shifted away from rates.
What do you expect to have the biggest impact on the volume of deals in the next 3 months?
100%
% Responding Interest Rates
% Responding Supply / Demand Imbalance
% Responding Asset Quality
80%
71% 71% 67%
60%
59%
63%
60%
56% 57%
56%
52% 47%
40% 33%
39% 35%
29%
28% 30%
20% 12%14%10%16%
20% 13%
19% 17%
50% 51% 34%
52%
46% 43% 44%43% 39%
41%
32%
35% 29% 30%
34%
30%
30%
22% 19%20% 22%
33%
28%30%
26%26% 25%
19% 20%
17%
13% 9%
10%12%8%
13% 9%
10%13%
3%
4%
0%
Focus shifts away from interest rates: 34% of brokers see interest rates as the most important factor impacting deal volume in the next three months (down from 63% in our January '19 survey), exceeding asset quality which garnered a 25% share and tying supply / demand imbalance which also garnered 34% (up from 22% in our January '19 survey).
Brokers note increasing demand broadly: Most brokers saw increasing demand on average across the various investor buckets
with Family Offices and Small Investors accelerating the most
Source: AlphaWise, Morgan Stanley Research.
from January levels (+32% and +31%, respectively). We note that
Public REIT interest remained elevated at +13%, with only 6% of
participating brokers noting a decrease in interest. Participating brokers noted that
demand should remain strong with institutional and 1031 exchange investors, and 2Q19
could see high transaction volume due to the recent stability in credit markets.
Furthermore, participating brokers noted that demand should remain strong for A rated
locations in the net lease sector even if a downturn were to occur.
Exhibit 8: Impacts on Deal Volume: Cost of debt and supply / demand imbalance now on par.
Largest Impact on Deal Volume - Next 3 Months
40% 35% 30% 25% 20% 15% 10% 5% 0%
Cost of Debt
Supply / Demand Imbalance
Asset Quality
Corporate Sale/leaseback Market
Source: AlphaWise, Morgan Stanley Research.
Exhibit 9: Investor Interest: Public REITs interest remains strong with only 6% of brokers noting a decrease.
Change In Investor Interest - Last 3 Months
100%
Increased
Stayed Same
Decreased
80%
60%
40%
20%
0% Small 1031 Family
Investors Exchange Offices Buyers
Private REITs
Private Foreign Public Equity Investors REITs
Source: AlphaWise, Morgan Stanley Research.
4
Where Will Cap Rates Go From Here?
Cap rate spreads expanded in 1Q19: Cap rates remained relatively flat in 1Q19 while debt costs pulled back indicating that cap rate spreads have expanded. Cap rates spreads for Office, Industrial, and Retail have expanded YTD by +22bps, +24bps, and +55bps, respectively.
Financing costs decreased relative to January '19 levels, with risk premiums staying constant as the 10 year UST declined: Brokers see interest rates required to finance current net lease deals at an average of 4.8%, down 13bps from our last survey. While the 10 year has declined similarly, risk premiums have remained constant.
Exhibit 10: Cap rate spreads have widened as debt costs have declined.
Exhibit 11: Current Debt Costs (versus last 3 months)
Source: Real Capital Analytics, Thomson Reuters, Morgan Stanley Research. Note data is through August.
Source: AlphaWise, Morgan Stanley Research.
Exhibit 12: NIG assets slightly more likely to see cap rate expansion. Cap Rate Expectations (N3M) - Net Increase vs Decrease
90% 65% 40% 15% -10%
IG Average
NIG Average
Source: AlphaWise, Morgan Stanley Research.
Expectations for rising cap rates down significantly relative to January: Brokers now expect cap rates to remain relatively flat over the next three months down significantly from 53% expecting cap rate expansion in our January survey. 12% of brokers expect overall cap rates to increase by at least 10bps in 2Q19 and 11% expect a decrease, compared to 53% and 1% expecting an increase and decrease in our last survey, respectively. This sentiment is the lowest level seen in at least three years. Brokers see an increase for NIG assets as slightly more likely with a +6% average reading. IG assets have historically had lower expectations of expansion and are now actually expected to tighten with a -3% net reading.
Cap Rates by Remaining Lease Term
Long lease term cap rates expected to tighten while short lease term cap rates expected to expand: 16% of brokers now expect cap rates to expand by 10+bps while 14% expect cap rates to tighten compared to 55% and 0% of brokers calling for cap rates to expand
5
and tighten by 10+bps in our January survey, respectively. In line with an inverted yield curve, brokers expecting short lease term cap rate expansion exceeds those expecting tightening by 19%. For long lease term assets, the percentage of brokers expecting tightening to occur exceeds those expecting expansion by 12%.
Exhibit 13: Cap Rate Outlook (IG Assets) - Next 3 Months
% of respondents
Down 10+ bps
Up 10+ bps
Retail (5-10)
-6%
Retail (11-15)
-9%
Retail (16+)
-16%
Industrial (6-8)
-13%
Industrial (9-11) -22%
Industrial (12+) -36%
Office (7-9)
-5%
Office (10-12)
-5%
Office (13+)
-10%
25% 6% 3%
22% 4%
9% 35%
25% 15%
-50% -25% 0%
Source: AlphaWise, Morgan Stanley Research.
25% 50% 75%
100%
Cap Rates by Tenant Credit
Non-investment grade cap rates expected to widen slightly: Brokers see non-investment grade (NIG) assets as slightly more likely to expand with a net positive reading of +6%, while investment grade (IG) asset cap rates are expected to tighten slightly with a net reading of -3%.
Exhibit 14: Cap Rate Outlook - Next 3 Months
% of respondents
Down 10+ bps
Up 10+ bps
Retail ? IG
-9% 3%
Retail ? NIG Industrial ? IG Industrial ? NIG
-6% -26%
-22%
Office ? IG
Office ? NIG
16%
4%
4% 0%
20% 0%
25%
-50% -25% 0%
Source: AlphaWise, Morgan Stanley Research.
25% 50%
75% 100%
6
Monitoring the Triple Net Landscape
Retail Tenant Health
Tracking tenant health among our Triple Net coverage, we note that all but Sporting Goods (moderate exposure among Triple Nets) and Department Stores (minimal exposure among Triple Nets), have seen positive SS sales growth over the trailing year. Furthermore, we note that STOR (OW) has no exposure to either category. Apart from these two sectors we are also monitoring furniture, which has seen negative YTD sales growth. Looking to YTD results we note that this only includes the months of January and February which have historically been a poor performing months for retail sales given they are right after the holiday season and can be easily impacted by inclement weather. Despite having positive 3.1% one year SS sales growth, Drugstores remain a highly debated sector given AMZN's announced entry into the drug supply chains on June 28th 2018 with its announced acquisition of PillPack (see "Alexa, Refill my RX"), and note O (9.8%), SRC (6.8%), and NNN (1.8%) all have exposure.
Exhibit 15: Triple Net REITs are exposed to retail categories that are seeing relatively strong sales growth.
Source: Company Data, Census, Morgan Stanley Research. Note totals do not sum to 100% as data is not available for other categories.
Coincident with our above analysis, we also asked brokers for their expectations for property types most likely to be impacted by broader retail weakness:
Responses were largely in line with the January survey results, indicating a minimal shift in views on the retail environment over the last three months. Again, brokers noted a demand for medical retail - "Med-Tail" - assets as having grown a lot in terms of interest and is likely to continue.
7
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