Archives for November 2021

The decline in profitability will make restaurant companies less attractive as mergers and acquisition targets.

Restaurants are facing shrinking margins with higher food, fuel, labor and transportation costs, according to a report from the Restaurant Finance group at Mitsubishi UFJ Financial Group.

The rise in labor costs comes from a number of post-pandemic factors including the increased difficulty in drawing new workers and retaining existing ones in a labor market that is demanding higher wages and being more selective in choosing employers, says Nick Cole, head of restaurant finance for the firm.

The decline in profitability will make restaurant companies less attractive as mergers and acquisition targets in the first quarter of next year, MUFG is predicting. The M&A pullback should be significant unless there is an improvement in margins, Cole asserts.

He attributes the recent M&A boom in the restaurant industry⁠—especially in the quick-service sector⁠—in part to the generational transfer of businesses.

Supply chain interruptions and worker scarcity among commodity producers and transporters have added to the cost woes of the eateries, says Quinn Hall, the leader of loan underwriting and portfolio management for the MUFG Restaurant Finance Group.

To attract workers, Hall says restaurants will have to spend more on health benefits as well as wages and offer flexible work schedules.

With the problems with margins, he says banks are continuing to accept a higher leverage profile among borrowers and offer loose amortization, pricing and covenant terms which will become more stringent in 2022 if interest rates rise and borrowing costs grow—and certain businesses may experience credit downgrades.

The trend to more off-premises dining that started during the pandemic and continues is spurring a retooling of restaurant real estate to allow for more drive-through and digital pick-up lanes while deemphasizing dining-room space to lower dependence on in-restaurant business, Brian Geraghty, Head of Loan Originations at MUFG adds.

“Over the long run, we believe you’ll see restaurants shrinking in size to reflect smaller onsite patronage but better built to support off-premises business,” Geraghty says.

Marcus & Millichap is predicting labor shortages and wage increases will continue to be headwinds but then should abate a bit in 2022.

Recovery of restaurants, and other businesses hit hard during the pandemic will be bumpy, but Marcus & Millichap Senior Vice President and National Director Research Services John Chang noted multi-tenant retail vacancy rates only increased by 90 basis points to 6.6% and current absorption should continue into next year.

Source: “Restaurants Face Shrinking Margins As Food, Labor Costs Increase“

Months after Albuquerque officials hammered out land-use provisions for the budding recreational marijuana industry, Bernalillo County is ready to do the same.

Leaders are now weighing a proposed zoning code update that outlines where businesses can grow and sell cannabis within the county’s unincorporated areas. The County Commission voted Tuesday to introduce and publish the proposed rules, and could make a final decision as early as Dec. 14.

“It’s something brand new, and we want to see how close to right we get it the first time,” Commission Chairwoman Charlene Pyskoty said during Tuesday’s meeting, adding that leaders always have the option to make future changes.

County zoning administrator Nicholas Hamm told the commission the pending proposal aims to “treat cannabis like any other product in the county.” For example, it permits recreational sales in most commercial zones, as long as the shops are at least 300 feet away from schools and day cares.

“If a zone allows for a special type activity for another type of product, this ordinance will allow a similar cannabis activity to occur in that zone,” Hamm said.

The county’s proposal also permits outdoor commercial cannabis cultivation in agricultural zones, though it does set limits based on property size. Commercial growers can use only 25% of lots 1 acre or smaller, but up to 75% of sites larger than 5 acres. Any growing beyond those caps must take place indoors.

Commissioner Debbie O’Malley said she hoped the county also could create a permit for cannabis processing on agricultural sites as a way to help smaller operators stay competitive in the market, though Commissioner Steven Michael Quezada said the county must consider the effect on surrounding neighborhoods and businesses.

“We want (cannabis businesses) to be harmonious with everybody else, but the plain fact of this industry is it has an odor, and we’re going to have to really look at what we bring forward when we’re looking at manufacturing, processing and growing,” he said.

The rules also address cannabis consumption.

They would ban outdoor cannabis smoking at licensed businesses, restricting smoking to indoor spaces with proper ventilation.

The proposed regulations permit medical cannabis consumption in more zones than recreational consumption – a distinction one local cannabis industry advocate said makes little sense.

“Why are we restigmatizing this?” New Mexico Cannabis Chamber of Commerce Executive Director Ben Lewinger said in a Journal interview.”We’re talking about something legal for adults over 21.”

Lewinger also disagrees with the outdoor smoking prohibition and some other proposed provisions. He said his organization would make formal comments to the commission prior to its final vote, but that the current proposal is more reasonable than he’s seen in some other jurisdictions.

“The approach Bernalillo County is taking seems less prohibitive than that in other counties, which is good. Kudos for that,” he said. “(But) we still have some work to do.”

The county’s rules would apply only to unincorporated parts of Bernalillo County, such as the South Valley and East Mountains.

Albuquerque has already established zoning rules for recreational cannabis operations inside city limits – a process that sparked some debate over the summer.

Albuquerque Mayor Tim Keller wanted to stop new marijuana shops from opening in certain areas – including along much of Central Avenue – and also proposed specific standards related to cannabis shop operating hours and signage. The City Council mostly rejected the attempt to regulate cannabis differently than other businesses, though it did pass a rule that addressed density concerns by making new shops go through a public hearing to open within 600 feet of another cannabis retailer.

Source: “Bernalillo County Weighs Cannabis Regulations“

The lack of rent escalations in drugstore leases could be a problem in an inflationary environment. But the story is more complex than that.

When Walgreens announced last month that it planned to close several stores in downtown San Francisco because of safety and security issues—shoplifting, in particular—city leaders pushed back. After expressing doubt that crime drove Walgreens to make the decision, they suggested instead that the locations were underperforming due to the chain’s aggressive expansion in the city and cannibalization of its own stores.

Meanwhile, a small but vocal group of industry observers contends that Walgreens’ move to shutter stores indicates that the company’s finances are in a precarious state and insists that the decision had nothing to do with San Francisco or shoplifting.

Wall Street hasn’t paid much, if any, attention to the debate. Shares of Walgreens Boots Alliance are trading at $49.10, up 31.6 percent year-over-year.

Likewise, net lease investors seem to be unfazed by the hullabaloo. In fact, they’re far more concerned about increasing inflation and its impact on their real estate portfolios.

“There are no red flags for either Walgreens or CVS,” says Alex Sharrin, managing director with JLL Capital Markets. “Both companies are viewed very favorably by the marketplace.”

State of net lease

During the third quarter, more than $20 billion in net lease properties traded, making it the sixth strongest quarter on record, according to research from brokerage firm Stan Johnson Co. Retail properties accounted for $3.1 billion of the total.

“Market activity is frenetic,” says Camille Renshaw, CEO of B+E Net Lease, another investment brokerage firm that specializes in the sector. “There’s definitely more buyer demand than available properties.”

Yet, Renshaw acknowledges that investor interest in drugstores could diminish, depending on inflation. Though commercial real estate is widely considered a hedge against inflation, the lack of rent escalations in drugstore leases often makes them less attractive.

Because inflation hasn’t been a major concern for the past several years, investors were happy to park their money in drugstores and feel secure in the long-term leases with fixed rent and strong credit.

But these flat rents matter in today’s inflationary environment, where investors need to adjust rents every year to keep up with inflation. Over the past year, the Consumer Price Index (CPI) rose by 6.2 percent.

“Drugstores offer great credit and great locations, but buyers are very nervous about the flat rents,” Renshaw says. “That’s one of the enduring problems for private and institutional buyers—that drugstore rents don’t track with the CPI.”

The lure of rent escalations is enticing many drugstore investors to look at other kinds of retail assets or even switch to industrial. “They’re not used to getting annual rent escalations, and they’re just blown away. It’s a huge differentiator for retailers such as Walmart and Target, as well as industrial properties,” Renshaw adds.

Alex Sharrin, managing director with JLL Capital Markets, says he and his team are seeing drugstore landlords selling off their assets because they’re worried that in-place lease economics will not provide a hedge against inflation. “Some investors feel that if inflation happens and interest rates go up, their cash flow will be in a bind,” he notes.

Not just essential retail

Though the outlook for drugstores looked murky as recently as two years ago due to online pharmacies and insurance plans that require mail-order prescription drug services, most of those fears have been allayed. The pandemic proved that drugstores can serve a purpose beyond filling prescriptions, says Jon Hipp, principal and head of the U.S. net lease group with real estate services firm Avison Young.

He points to the chains’ efforts to find innovative ways to deliver a holistic healthcare experience to consumers through its clinics and its expansion into primary care. Walgreens, for example, recently announced plans to acquire VillageMD for $5.2 billion, while CVS Health is looking to hire primary care physicians to serve consumers beyond its Minute Clinic and HealthHub stores, according to the chain’s new CEO Karen Lynch.

Hipp’s team is currently marketing a CVS HealthHub Pharmacy in Wayne, N.J. (part of the New York MSA) for a 5 percent cap rate. The chain has operated out of this location for 40 years and recently inked a long-term lease extension.

Because drugstores are considered “essential” businesses—not just essential retail—most net lease landlords haven’t had to deal with any rent interruptions that many owners experienced with other retail tenants, says Randy Blankstein, president of net lease brokerage firm The Boulder Group.

“Transaction velocity in the sector has picked up in a big way, leading to the compressed cap rate environment,” Blankstein says.

Historic low cap rates

Strong demand for drugstores has pushed cap rates to their lowest level ever. In the third quarter of 2021, cap rates decreased to 5.8 percent, a 59 basis points decrease from the previous year, according to The Boulder Group’s Net Lease Drugstore Report.

“If you asked most market participants 18 to 24 months ago, no one would have guessed cap rates dropping to this level,” Blankstein notes.

While all three tenants within the sector provide investors with guaranteed corporate leases, there are differences in the credit profiles. CVS and Walgreens share an identical investment grade rating from Standard & Poor’s of BBB.

Rite Aid carries a non-investment grade rating of B-, which is the primary reason for the cap rate discount of 225 and 200 basis points compared to CVS and Walgreens, according to The Boulder Group.

The firm recently closed on a Rite Aid Pharmacy in suburban Cleveland with five years left on its lease renewal option and another seven-year lease renewal option period remaining. The 13,000-sq.-ft. drugstore sold to a private investor for $2.5 million.

“I remember in 2006 to 2007, during the last peak in the market, a CVS or Walgreens trading at a cap rate of 5.75 to 6.0 was considered a record,” says Brandon Duff, managing director and partner in Stan Johnson Co.’s Chicago office. “Today, cap rates for that same property are in the 4.5 to 5.0 range—100 to 150 basis points more aggressive. Considering the lack of supply, I expect this to continue into 2022, so long as interest rates remain low.”

For example, earlier this month, Stan Johnson Co.’s Zach Harris brokered the sale of two net lease CVS properties in Houston. Both properties sold to separate private investors at 4.5 percent cap rates. Both were constructed in 2019 as part of CVS’ national expansion

Construction pipeline limits supply

Increased demand and transaction volume for drugstores last year created a supply issue in 2021, according to The Boulder Group. As of the third quarter of 2021, the supply of single-tenant drugstores had decreased by roughly 20 percent compared to the previous year. All three major tenants within the drugstore sector—Walgreens, CVS and RiteAid—experienced decreases in supply ranging from 14 percent to 26 percent.

As of early November, there were 201 Walgreens on the market—a slightly elevated total from the 180 or so that’s been the norm for most of the year, according to B+E, which tracks available properties in real time.

There were 121 CVS stores on the market, which is in line with average. However, Renshaw expects more CVS stores to become available now that the chain has completed its recent expansion plans.

Notably, the supply of drug stores with long-term leases remains low compared to historical standards, mainly due to the lack of new store development. For the second straight year, the median remaining lease term for the drug store sector was less than 10 years, according to The Boulder Group.

“New construction is slow,” Duff notes, adding that both Walgreens and CVS have completed their expansion plans and are now focused on optimizing their typical store square footage and utilizing less space.

The limited development pipeline of new stores for all three chains means that the majority of long-term net lease investment opportunity will come from the “blend and extend” of existing leases or larger portfolios of sale leasebacks, according to Blankstein.

Many of today’s drugstore sellers are private investors or investment funds that acquired drugstore properties from about 2010 to 2018, according to Duff. They’re selling now—while there’s still lease term remaining that is accretive to the value via a disposition—to take advantage of the cap rate compression.

Even drugstores with short-term leases aren’t lingering on the market for long. For example, JLL Capital Markets recently closed on the sale of two drugstores in Southern California, a Rite-Aid in Riverside County that traded for $8.4 million and a Walgreens in Orange County that garnered $1,000 per sq. ft. for a total of $11.3 million.

“Investors are attracted to the recession resistance and durability of pharmacies, as well as their strong locations on outparcels and hard corners,” says JLL Managing Director Gleb Lvovich, who brokered the deal along with Director Daniel Tyner. “Our team was able to sell through short lease terms and flat rents by highlighting the real estate value and the strength of each site. At the end of the day, while credit is important, investors are attracted to strong real estate.”

Priced out of the market

With the exception of larger portfolio deals, private and 1031 investors account for the vast majority of net lease drugstore buyers today. In 2021, more than 75 percent of the single-tenant drug store transactions were acquired by private and 1031 exchange buyers, according to The Boulder Group.

Exchange buyers and individual private investors have always been a major buyer pool for drugstore properties. However, over the trailing 12 months, they’ve comprised an even greater percentage of the buyer pool when compared to the previous 10 years, Duff notes.

“Because cap rates have compressed to historically low levels, many of the other buyer profiles (REITs, investment funds, etc.) that have typically been active buyers of drugstore properties have been priced out of the market,” he says.

He and other market insider expect that private investors, including 1031 investors, will continue to be the most active buyers of net lease drugstores. Even in an inflationary environment, hard-corner locations and well-known names attract buyers. Not to mention that both Walgreens and CVS provide unit level sales reporting—something that other retailers are not required to do—thereby creating an additional layer of comfort and certainty for investors, Duff adds.

Source: “Will Inflation Erase the Demand for Net Lease Drugstores?”

 

 

Recent real estate industry research supports the notion that real estate assets provide some protection in inflationary periods.

Inflation appears to be providing another tailwind for investors looking to increase allocations to commercial real estate. But is the promise of commercial real estate as an inflation hedge all it’s cracked up to be?

According to Bureau of Labor Statistics estimates, the consumer price index rose 5.4 percent in September, the fifth straight month in which the inflation rate was five percent or greater. Views remain mixed on whether higher inflation could be transitory—caused by a combination of reopening economy and a choked supply chain—or whether more long-term inflationary pressures are at play.

“I think it is transitory, but inflation could be stickier than people think and continue into 2022,” says Richard Barkham, PhD, global chief economist, head of global research and head of Americas Research at CBRE. Barkham expects inflation to drop back once some of the supply side issues contributing to price increases improve as more people return to the workforce.

One of the common selling points for commercial real estate investment is that the asset class provides a good hedge against inflation because it generates cash flow. Owners also have the ability to raise rents along with rising inflation—in fact some leases have automatic CPI adjustments built in. Higher revenues also correlate to higher property values. However, experts caution that the concept of commercial real estate as an inflation hedge in investment portfolios is sometimes misunderstood, and certain properties are better positioned to in environments with rising prices than others.

Related: Who’s Afraid of the Inflation Wolf?

“Commercial real estate doesn’t give you instantaneous protection against all unexpected blips in inflation,” says Barkham. “However, if you look at a longer period of five, seven or 10 years, generally speaking, the values of real estate will go up with inflation.” Real estate does keep pace with rising inflation reasonably well with higher prices that flow through to rents, although that is not true of all sectors, he adds.

Industry research supports the argument that real estate assets provide protection against inflation. According to Nareit, dividend increases for REITs have outpaced inflation as measured by the Consumer Price Index in all but two of the last 20 years. In 2002, dividend growth failed to edge out inflation by just half a percentage point. The only other time in recent history dividend growth fell below inflation was just after the financial crisis in 2009. Over the 20-year period, average annual growth for dividends per share were 9.6 percent (or 8.9 percent compounded) compared to 2.1 percent (2.2 percent compounded) for consumer prices.

Comparing private CRE vs public REITs

Berkadia recently introduced a new white paper that assesses inflation and risk in real estate. In particular, the research compared performance of private commercial real estate, equity REITs and the stock market. One of the key findings of the research for the post-Great Financial Crisis (GFC) period studied is that higher inflation tends to help private commercial real estate returns, while hurting REIT and stock returns. In addition, when comparing individual property types, privately held apartments and industrial delivered the strongest risk-adjusted performance.

The Berkadia research introduces the inflation ß (beta) concept that takes into account the sensitivity of returns to changes in the inflation rate. The inflation ß quantifies the implied marginal rise or decline in excess returns given a rise in the inflation rate. For example, an asset with inflation ß of 2 implies that for a 1 percent rise in inflation, excess returns will rise by 2 percent. Essentially, as measured by inflation ß, some property types have a more favorable (or unfavorable) inflation sensitivity than others.

The Berkadia research found a post-GFC inflation ß for private commercial real estate that was 1.20, whereas equity stocks had an inflation ß of -2.49 and equity REITs had an inflation ß of -5.27. In simple terms, rising inflation tends to imply rising returns for private commercial real estate, notes Noah Stone, an economic analyst at Berkadia. One of the suspected reasons for that outperformance is the difference in liquidity. The illiquidity of privately held real estate is likely to protect values more during times of inflation, he says.

The Berkadia research also showed that apartments have the strongest risk-adjusted performance during both times of moderate (2-5 percent) and high inflation (5+ percent), whereas industrial has the strongest risk-adjusted performance during time of low inflation (0-2 percent). “In our view, there is no one property type that is a loser. All of them are winners when you look at risk-adjusted returns, but definitely apartments and industrial outperformed on a risk-adjusted basis,” says Stone.

It is important to note a number of variables that can impact an owner’s ability to capture inflation increases, such as supply and demand and the lease structure. “In terms of the apartments, the short-term leases are more flexible and allow for quick and rapid responses that allow landlords to capture rent increases when faced with exogenous factors like inflation,” says Dori Nolan, senior vice president, National Client Services at Berkadia.

Some owners will structure leases with periodic rent increases, or even link rent increases to increases in the CPI. Industrial will provide very good short-term and long-term inflation hedging, particularly as demand is so strong right now. In the past, retail has been quite good at delivering short-term inflation protection, because retailers are usually quick to incorporate price changes into their business models. “I don’t know that retail would be able to do that now, because physical retail has been highly impeded by internet retail,” says Barkham. Office will offer some longer term inflation hedging protection, but in the short term the sector has been weakened by demand factors, he adds.

Another factor to consider is that property types are impacted differently by inflationary pressures on the operating expense side. Although shopping centers and office buildings can pass expenses through to tenants as common area maintenance costs, owners will bear some of the cost on assets that are not fully occupied. In addition, those property types that also have operating businesses, such as seniors housing and hospitality, are more directly impacted by rising costs. Labor costs in particular have been a bigger concern for operators of hotels and assisted living/memory care facilities.

Inflation influences CRE strategies

Cadre is one investment management firm that is factoring inflation into decisions on portfolio construction. “From a blanket perspective, we’re in the camp that there is inflation that is here to stay, at least in the immediate and short-term of the next 12 to 24 months,” says Dan Rosenbloom, managing director and head of investments at Cadre, a tech-centric real estate investment management company. Cade also believes that there will be a run-up in asset values with some properties that will be better positioned to capture it.

Multifamily is one asset type that Cadre is leaning into more so than others. “When we’re buying multifamily, we have to look at the basis and the cost per unit. During an inflationary time, like we’re seeing now, costs will go up. So, your basis looks more compelling related to what replacement cost would be,” says Rosenbloom. The question is if inflation starts to happen, can investors actually capture that income? “This is where market selection and asset selection become really important. You need someone who understands not only the macro, but the micro markets that you are investing in,” he says.

For example, Cadre recently purchased an apartment property in the Southwest where rents in that particular submarket are being marked up by about 20 percent for leases that are rolling. “What we are seeing in that market is that wages are going up or people that are coming in have jobs where they can afford those increases,” he says.

Investors also need to watch out for medium-term hiccups in the economy due to inflation, cautions Barkham. If the Fed thinks inflation is transitory, it won’t be very aggressive in trying to control it. However, if the Fed thinks inflation is going to be something more than transitory, then there could be a sharp rise in interest rates, which will be quite damaging to real estate in the short term. These are all factors playing out that impact scenarios for short-term inflation protection, he says.

Source: “Inflation Fears are Driving More Investors Towards Commercial Real Estate“