When Spirit Finance Corp., a Scottsdale, Arizona, real estate investment trust, went public in late December, it raised $330 million, about what CEO Morton Fleischer had expected. The roster of buyers, though, surprised him: It was dominated by institutional investors, such as Farallon Capital Management, Fidelity Investments, IBM Personal Pension Plan Trust Fund and the Public Employee Retirement System of Idaho (Persi).
Compared with Franchise Finance Corp. of America, a somewhat similar company that Fleischer headed until it was sold for $2.1 billion in 2001, the difference in ownership was striking. “FFCA was mostly retail investors,” notes Fleischer. “Spirit is 90 percent financed by institutions.”
What’s going on here? Spirit specializes in so-called net lease properties: The landlord collects a base rent from a single tenant, typically for 15 to 20 years, and the tenant assumes all operating costs, including maintenance, insurance and real estate taxes. Spared from those usually escalating expenses, net leases can be a good source of steady income, particularly for public and corporate pension funds looking to manage their liabilities.
“Spirit’s CIO has been, over the years, pretty thoughtful about finding real estate cash flows,” says Michael Torres, CEO of Berkeley, California’s Adelante Capital Management, which handles REIT investments for Persi. “One thing that can be attractive about net lease investments is the shifting of the responsibility for maintaining the physical plant to the tenant.”
Randy Blankstein, president of Boulder Group, a Chicago-based brokerage that specializes in net lease properties, says, “There’s a growing level of institutional interest and institutional money in the net lease sector.” Along with Spirit, two other REITs with a partial or sole focus on the net lease sector went public last year: Capital Lease Funding and NorthStar Realty Finance Corp., both based in New York. Together they raised about $440 million. Fifteen property companies with net lease strategies are traded in the U.S. Among them: the New Yorkbased companies IStar Financial and Lexington Corporate Properties Trust. Moreover, many unlisted REITs also focus on these single-tenant assets, as do some private equity funds.
Bruce MacDonald, president of Net Lease Capital Advisors, a real estate investment and advisory firm based in Nashua, New Hampshire, estimates the volume of net-lease-property sales last year at $27 billion, up from $21 billion in 2003 and $13 billion in 2001.
The seven largest listed net lease companies (excluding those that have not yet been in existence for five years) returned, on average, 28.2 percent a year for the five years ended December. During that period, the National Association of Real Estate Trusts composite index returned an average annual 23.1 percent.
For landlords, relying on a single tenant is, of course, a gamble: It works well as long as the lessee stays solvent. For tenants, on the other hand, net leasing is appealing because it allows for ownerlike control over a facility without requiring the capital investment of ownership.
Demand for net lease deals has been stoked by investors’ increased recourse to section 1031 of the tax code, which lets them defer capital gains taxes by reinvesting the proceeds from the sale of one investment property in another. “It’s difficult to get into a net lease deal today without paying premium prices,” says Boulder Group’s Blankstein.
Of course, there are few bargains to be found in any corner of the real estate market. Ask Spirit’s Fleischer. He recently sold a property and reinvested some of the proceeds through a 1031 exchange. A financial adviser suggested he find another property to buy to avoid the rest of the tax on the capital gains.
Fleischer passed. “I didn’t have to think very long about that,” he says. “I think I’ll just put it in Treasury bills, because whatever I could buy now would be too expensive.”
