Competitors Attack Single-Tenant Market with Varying Tactics

Buyers from across the spectrum of private and public entities have stepped up their investments in single-tenant net leased properties recently - each employing unique strategies to capitalize on the opportunities they see in current and future market conditions.

In this Part 3 of CoStar's 4-part series on the single-tenant investment market, we examine the strategies of three major players that encapsulate the varying approaches used by investors in the single-tenant market, and some of the pitfalls.

[To read the other reports in this 4-part series on the single-tenant, net leased property market, please see: Part 1: Single-Tenant Property Sales Surge To Record Numbers.
Part 2: Cheap Money Fueling Net Lease Market.
Part 3: Competitors Attack Single-Tenant Market with Varying Tactics.
Part 4: Niche Targets Spreading the Playing Field in Single-Tenant Arena. ]

Realty Income Corp. in Escondido, CA, is a publicly traded REIT on the New York Stock Exchange that bills itself as the 'Monthly Dividend Company.' The REIT is shooting for $850 million of investments this year.

Cole Capital in Phoenix, AZ, operates a series of public non-traded REITs and has raised more than $3.5 billion in the last two years primarily for net leased investments.

AEI Capital Corp., in St. Paul, MN, is somewhat of a granddaddy in the business as it has been developing, buying and selling net leased properties for more than 35 years.

Realty Income: Friendly's Proves Credit Tenants Aren't Always Trouble Free

During the third quarter of 2011, Realty Income Corp. invested $462 million in 89 properties across 15 states. All the properties are 100% leased to nine tenants in seven different industries, with an initial average lease yield of 8.1%.

That level of investment surpassed what the company did in the first half of the year, when it invested $364.2 million in 36 new properties and properties under development. During that first six months, the company sold just $5 million in properties.

Overall, Realty Income expects that its real estate portfolio acquisitions will exceed $850 million during 2011, slightly more than the high end of its previously estimated acquisition volume range of $600 million to $800 million for the year. Realty Income said its initial average contractual lease yield on its investments made during 2011, should be approximately 8%.

In late September, the company raised $214.2 million in a public stock offering. It was the third time it had gone to market this year, once with another stock offering and once with a bond offering. The first two offerings brought in $450.2 million. The firm said it plans to use its most recent proceeds to pay down some of its acquisition debt.

In terms of investment strategy, Realty Income shoots for industry diversification in its portfolio. As of June 30, the company owned 2,523 properties in 37 different industries and 131 multiple unit tenants in 49 states.

"The industry exposures are moving around a bit and we remain very diversified," Realty Income CEO Tom Lewis said in his company's second quarter earnings conference call. "Convenience stores remain our largest at 19% of rent, and that's net down about 90 basis points from last quarter."

"Restaurants continue to come down as we've been working on that for the past couple of years. It's down to about 17.5% of revenue. That's down 140 basis points from last quarter and about 440 basis points over the last four, five quarters, and we think that will continue," Lewis said.

"Beyond that, theaters is our next largest industry at 7.8%, and then the only other categories that really come in over 5% are automotive tire stores at 6.3%, beverages at 5.7%, and child day care at 5.4%. Interestingly I would note that 5.4% I think child care was 50% of the portfolio when we became public [company] a number of years ago."

Diversification not only by industry but also by tenant is key to Realty Income, as formerly credit tenants have been randomly disappearing through bankruptcy and downsizing, victims of the Great Recession and weak recovery.

Case in point, Friendly's Ice Cream, one of Realty Income's tenants, which this month filed for voluntary reorganization under Chapter 11 Federal Bankruptcy Laws. Friendly's leases 121 properties from Realty Income that, as of Sept. 30, 2011, represented 3.6% of its rental revenue.

In its bankruptcy filing, Friendly's rejected the leases on 15 of those properties, representing approximately $1.3 million annualized rent. Those properties are now available for re-lease to other tenants.

Realty Income characterized the reorganization of any one of its 135 tenants to be a "normal course of business" event. Since it went public in 1994, 23 of Realty Income's tenants have make similar filings. Historically, Realty Income has retained a significant portion of the tenant's pre-filing rent, the company said.

Further, Realty Income said it believes that the majority of the properties it leases to Friendly's are "profitable stores" for the Friendly's restaurant chain. As such, the company anticipates that the majority of the properties should remain under lease, and that any stores vacated as a result of the filing will not have a material impact on its operations, or on its ability to pay and increase the amount of the monthly dividend.

Going forward, Realty Income estimates that 2011 funds from operations (FFO) per share should increase in a range of from 7.7% to 8.2% over 2010 FFO per share. In 2012, it estimates FFO will increase of 4.5% to 7.1% over 2011 estimates. Those projections include the anticipated impact of the Friendly's Ice Cream bankruptcy filing. In addition, Realty Income has included the potential impact of one or more of its other tenants, equating to 5% of its portfolio rents, filing similar reorganizations during 2012.

While Realty Income has not been a seller of property thus far, CEO Lewis said that could change next year with a portfolio that has now grown to more than $4 billion.

"We have a project underway to go through the portfolio and look at each of the properties and rate them 1 through 2,500," Lewis said. "We're going to marry that with the tenant review and take a look at - as we look forward 5, 10 years, given we've had 30 years of declining interest rates and we are almost at zero, how we deal with the tenants relative to their operations."

"Those two [efforts] will lead us probably in the next year and year after to work on some portfolio sales," he added. "But I still believe that acquiring property will be responsible for our growth primarily in the next three, four years."

Cole Capital: $2 Billion in Deals in 2011 and Counting to $3 Billion

Cole Capital has been the dominant buyer in the single-tenant market for almost two years, industry players say. Investors CoStar talked to in this series bumped up against Cole in deals across the country. Enough so, that they said they believe prices are increasing from Cole's demand alone.

Cole has aggressivly pursued net lease deals in the retail property sector, but has occassionally stepped outside that preferred arena to make single-tenant office and industrial, as well as multi-tenant retail investments, due to lack of yield in alternative investments, John Bacon, vice president marketing - real estate of Cole Real Estate Investments, told CoStar.

"On the single-tenant retail side, we have closed on nearly $1 billion of acquisitions through the end of September, and we have approximately $250 million under letter of intent or under contract," Bacon said. "In terms of single-tenant office and industrial, we've closed more than $500 million of transactions and have more than $325 million of deals under letter of intent or under contract."

"We've also closed nearly $450 million of multi-tenant retail deals so far this year," he said. "Overall, we are targeting $3 billion of acquisitions for 2011 and we are approximately two-thirds of the way there."

"Cole's foundation was built on discount and value-oriented retail tenants because of their 'necessity' based business models and earnings endurance, even through recessions," Bacon said. "This has been expanded to include strategic corporate assets in the office and industrial sector - especially corporate headquarters and strategic warehouse and distribution facilities. We will also invest in power centers and grocery anchored centers that have multiple national or regional anchor tenants contributing the majority of the center's revenue."

Bacon said Cole is seeing competition mainly among individual investors seeking investment opportunities within a lower price range.

"They may not have the resources to buy a shopping center or an office building at higher price points, but they can buy a Walgreens, CVS or Tractor Supply because the deal size is within their budget or 1031 exchange requirement," Bacon said.

"Regarding single-tenant office and industrial product, supply is up considerably from a year ago," Bacon said. "Competition has increased with more institutional, REIT and private funds chasing these transactions as well. We continue to see an ample supply of product and have even noticed an increase in sale-leaseback opportunities."

On the single-tenant retail supply side, Bacon said Cole has started to see less available product in the market as a result of the slowdown in the economy and a dearth of new development. While some retailers are beginning to ramp up their expansion efforts, the impact from those efforts aren't expected to hit the market for a year or two.

Cole has raised a staggering of money in the last two years - maybe more than almost anyone else in the market.

Its Cole Credit Property Trust III REIT has raised more than $3.5 billion since it started acquiring properties in 2009. It is a sharing-selling juggernaut and has recorded several months of bringing in more $100 million, including the past month, according to its registration filing at the Securities & Exchange Commission.

As of June 30, Cole III's investment portfolio consisted of 539 wholly owned properties in 42 states, comprising 23.4 million gross rentable square feet. As of June 30, it had five tenants that made up 32% of its gross annualized rental revenue: Walgreens drug stores, Albertson's grocery, Microsoft, CVS drug stores and Apollo Group education.

Specialty retail properties made up 14% of its gross annualized rent; drug stores represented 13%, grocery stores 12% and almost one in five of its properties were in Texas.

Cole III has nine properties under contract to close this month valued at $61.6 million, the largest of which is a Whole Foods Market in Reno, NV, valued at $18.3 million.

Like Realty Income, Cole's investment strategy is to hold each property for an extended period, generally in excess of five years. Based on its start in 2009, that means any significant sales are likely another three to four years out.

AEI Capital: With No Debt Purchases, Comes No Worries About Rising Interest Rates

Since 1975, AEI Capital Corp. and its affiliates have organized 17 public and 17 private net lease property investment programs. Unlike Realty Income and Cole Capital, which raise hundreds of millions per offering, AEI keeps its offerings small to control growth. The total amounts raised in its public programs have ranged from $5 million to $24 million. Its private offerings have ranged from $1.4 million to $57.4 million.

Last month, though, AEI stepped it up a bit and filed registration papers for its 35th program: AEI Core Property Income Trust, which will be a non-traded REIT, is looking to raise about $300 million on a best-efforts basis over a two-year period.

With smaller offerings comes less pressure to acquire properties, Robert Johnson, president and CEO of AEI Capital told CoStar, and added that he has questions about the mass purchases and debt ratios of some of his competitors.

AEI's acquisition activity doesn't even come close to some of the other players in the market today. In its 36 years, AEI's corporate net lease property funds have acquired about 300 properties in 37 different states.

To avoid the lease-up risks associated with value-add or opportunistic real estate, all AEI properties are fully leased to creditworthy national and regional companies prior to purchase, Johnson said.

Uniquely, AEI buys its properties using all cash, with no mortgage debt, allowing its investors to avoid the risk of interest rate fluctuations associated with debt financing.

"To guard against the negative effects of swings in interest rates, we try, wherever possible, to be the first owner of these types of properties (our due diligence, our lease, not someone's defective deal), co-developing them when we can," Johnson said. "That way, we can often 'save' the developer's profit margin of 5% to-20%. That provides an additional buffer of economic protection against valuation changes when interest rates shift."

"Additionally, because our funds are relatively small (our current public REIT offering is 'only' $300-million) and, usually, structured as limited partnerships, we can actively buy/sell properties up and down the interest rate curve," he said. "That has the potential to add alpha returns for our investors and flattens out the valuation peaks and valleys that unavoidably occur with moves in interest rates."

While creditworthy tenants offer investors a more secure predictable income stream, like anything else, they don't come risk-free.

"When the primary lease term expires with a major credit tenant (say Staples) in the property, that tenant often has the landlord over the barrel with respect to lease term renewals," Johnson said. "Investment fund sponsors, which are some of the largest investors right now, will say that they have renewal options in their leases that contain specified rental increases. Sorry. It doesn't work that way."

"Renewal options work primarily to the benefit of the tenant. All tenants attempt to negotiate their renewal options when the time arrives."

To overcome that obstacle, Johnson said individual site analysis is of critical importance in net lease investment.

"Investors making 'bulk' purchases today are potentially facing some surprises when their 10-year leases mature," Johnson said.

In addition, Johnson said AEI tries to stay away from flat leases, such as Walgreen's, where rents may not escalate for 35 to 40 years.

AEI differentiates itself, too, in that it is an active buyer and developer - as well as an active seller.

Through December 2010, AEI's public funds had purchased 243 properties in 35 states for $434.9 million. They had sold 133 entire properties and had completed 556 tenant-in-common sales, involving 66 properties. Its private funds had purchased 74 properties in 24 states for $175.5 million and sold 13 entire properties and had completed 120 tenant-in-common sales, involving 21 properties.

Johnson added that AEI has taken 20 of its programs full-cycle.

AEI Core Property Income Trust, its newest fund in formation, intends to stick to the same strategy.

[To read the other reports in this 4-part series on the single-tenant, net leased property market, please see: Part 1: Single-Tenant Property Sales Surge To Record Numbers.
Part 2: Cheap Money Fueling Net Lease Market.
Part 3: Competitors Attack Single-Tenant Market with Varying Tactics.
Part 4: Niche Targets Spreading the Playing Field in Single-Tenant Arena. ]

Bulk up? Stay slim? Splurge while market is there? What's the best strategy?

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