While industrial was hot in 2020, there were questions about the office sector. But long-term, Craig Tomlinson, Senior Director and Partner in Tulsa, Ok., isn’t concerned about the sector. In 4Q, net lease office sales posted their second quarter of $1-plus billion growth after being hammered in the second quarter of 2020. Many of those properties exchange hands with their tenants working from home.
“The reports of the office’s demise are greatly exaggerated,” Tomlinson says.
On the other hand, many parts of retail were hit hard by the pandemic. The sector posted its slowest year since 2012, though cap rate demand did pick up in the second half of the year.
Do the relatively low sales numbers mean there is pent-up demand in the marketplace? BJ Feller, Managing Director and Partner for Stan Johnson in Chicago, Ill., isn’t sure. He thinks things began to open up in late 2020.
“Pent-up demand is likely an unfair way to categorize marketplace conditions,” Feller says. “We see the demand as a continuation of what was witnessed in the second half of 2020. An approaching return to normalcy in late 2021 could be a godsend for the net lease investors allowing capital to flow into some of the tenant segments that had been largely illiquid in 2020, such as fitness and restaurants.”
Ryan Butler, Managing Director and Partner for Stan Johnson in Tulsa, Ok., says investors are beginning to evaluate the sectors hardest hit from the pandemic.
“We’re starting to see investors dip their toes into segments similar to, and including, gyms,” Butler says. “Data from Placer.ai suggests that people are returning to fitness facilities and working out in gyms again. So, with higher returns currently available to investors, and better unit-level economics, we think this will be one area that starts to become more heavily traded, especially as the COVID-19 vaccine rolls out.”
Even with demand beginning to return, prices could be under pressure for a long time.
“For assets above $5 million, the lenders practically drive decisions by limiting proceeds and shortening amortization schedules for borrowers,” says Tomlinson says. “Business models for certain property sectors were exposed during the pandemic – gyms are just one. Pricing for those leases could be stunted for many years, until institutional memory fades.”
If sales of more of these non-essential retail buildings housing gyms increase, it could push cap rates higher for the entire market.
“Prevailing cap rate trends in 2021 will largely be driven by the composition of the sales in the marketplace, more than anything else,” Feller says. “It’s possible we could see cap rates rise if investors start meaningfully increasing acquisitions outside of the essential segment. These higher cap rate assets may push broad rates higher.”
Still, the rising cap rate story will probably only apply to certain parts of retail. “We do not expect the essential assets to see cap rate expansion,” Feller says. “If anything, we expect compression here, as the pronounced supply-demand imbalance persists.”
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