Cain International on building a net lease portfolio in Europe

This article is sponsored by Cain International

Because of its complexity and relatively small size compared with the US, the European net lease market can be challenging for investors looking to deploy at scale. For investors seeking to build a resilient, attractive, risk-adjusted net lease portfolio in the region, Arvi Luoma, head of European equity at Cain International, says that focusing on the underlying real estate fundamentals and why it is crucial to the tenants’ businesses is just as vital as credit quality, yield and lease term.

How does the European net lease market differ from its US counterpart?

In Europe, something like two-thirds of corporate real estate is owner-occupied, whereas in the US it is broadly the opposite, with around two-thirds institutionally owned. That presents a huge opportunity for sale-leasebacks in Europe.

Arvi Luoma

On the other hand, the region is composed of 27-plus countries, all with their own legal systems, tax systems and local real estate market dynamics. That creates a huge barrier to entry, not only in terms of setting up a vehicle to invest across the continent, but in understanding all those factors well enough to price risk and ultimately transact. It also means there is far more leakage in terms of costs and taxes than in the US, where investment is generally more tax and cost efficient.

In Europe, investing at scale is not straightforward. There are maybe a handful of players investing in net lease on a pan-European basis. On the other hand, the ability to invest in a market where there are more hurdles is inherently valuable. Moreover, if you do build a portfolio, because of the stricter regulatory environment in relation to ESG, permitting, zoning and staff relocation, tenants in Europe tend to be “stickier,” or more reluctant to move than they are in the US, while the underlying real estate tends to be of higher physical quality.

In the US, it is extremely efficient to close transactions. It is also tax efficient, with transparent cashflow forecasting. There is a $150 billion to $200 billion public net lease market, and it is a huge country with a broad set of opportunities. The flip side is it’s highly competitive. There is a lot of liquidity, a lot of activity and a lot of opportunities to aggregate and to make returns, so as an investor, one needs to differentiate.

Another factor is that there is an extremely effective financing market in the US. You can secure debt on almost any real estate in the US at some level, whereas in Europe, lenders are far more conservative, requiring lower LTVs and higher quality real estate. And because of the multi-jurisdictional nature, it is harder to access pan-European financing.

As a result, we believe the most effective way to build a net lease portfolio of scale in Europe is to be geographically diversified and to place a greater focus on the quality of the real estate. While this inherently commands tighter yields, one can still generate attractive returns, albeit perhaps lower than in US net lease. But on a relative risk-adjusted basis, it’s still highly compelling with both greater downside protection and scope for real estate upside – what we describe as premium net lease investments.

What characteristics should a good net lease asset display?

A net lease investment really balances four key factors: the credit of the tenant, the quality of the real estate, the structure of the lease and the mission-criticality of the asset. All must be weighed when pricing risk-adjusted returns. The tougher the real estate is to re-let, the longer the lease you need to be comfortable that you have secured cashflow. A deep operational understanding of the real estate’s role in a tenant’s business is critical; without that, it’s easy to misprice risk.

Where net lease investors have often fallen foul in the past is in concentrating too much on the yield play and forgetting about the real estate and the tenant. They can find themselves with an asset that is decreasing in value and a tenant which is highly susceptible to economic shocks, so that their cashflow can suddenly be reduced to zero with limited scope for recovery.

That is where a number of investors focused solely on buying income have gotten into trouble. Your risk and return calculation will not make sense if you are not being honest with yourself and paying attention to potential downsides and relative risk.

In an ideal world, all four of those factors would be perfect, but in the real world, you inevitably need to compromise on one or two of them. Maybe it’s slightly weaker credit, or more regional real estate, or a less than ideal lease structure, but you like all the other aspects in that deal.

How important is mission-criticality?

The successful underwriting of net lease investments is very closely tied to the concept of mission-criticality because what you are seeking is security and continuity of income through constant occupancy. If something were to happen to the existing tenant, you want to ensure that it is the last real estate they will leave, and if they do, someone else will take it, either because it is quality real estate or because it is integral to a manufacturing supply chain or process.

That could be any real estate essential to the life cycle of a product, from R&D through to production, distribution, last-mile logistics, bricks-and-mortar retail and recycling, as well as the data centers providing the digital infrastructure that control the whole process. That is where we focus at Cain, what we call future-proof supply chain infrastructure.

It is not only about investing in the buildings necessary to make and distribute products, but also about ensuring the products themselves are needed. It is also not just about what is critical to a company, but also what is important to a country, which gives an asset those infrastructure-like characteristics. So, that also forms part of our underwriting.

Conversely, we probably would not invest in offices for our net lease strategies because anyone can move their office tomorrow; there is low frictional cost to do so.

What are some key considerations when structuring a sale-leaseback?

The value-add element of a sale-leaseback lies in how you structure the transaction. What investors need is the operational expertise to understand not just the real estate but the occupier’s long-term strategy and needs. This understanding is critical to structuring investments that drive durable returns.

It is a bilateral discussion. On the one hand the investor seeks long-term security of inflation-protected income, on the other hand the tenant needs operational flexibility and access to capital. It is a long-term partnership. It is important to give the tenant, within reason, as much control as you can over their real estate. If an occupier needs to grow, and there is expansion land within your ownership, they should feel able to talk to you about developing it. Within a large portfolio, there should be sufficient flexibility for the tenant to be able to close a low-performing asset and introduce a better one to replace it.

Which real estate sectors offer the most potential for net lease investors?

It depends on the region, market dynamics and underlying demand drivers. But the diversity of opportunities across sectors is one of the market’s strengths.

R&D or life science space is a great net lease product. Companies want to locate their research divisions in and around the campuses of the major European universities. Their real estate is highly specialized and needs to be of exceptional quality to attract the most talented scientists and engineers to work there. That is crucial to the success of those businesses, so they are likely to stay for the long term.

In the retail sector, convenience makes assets defensive in the face of rising e-commerce, so grocery retail and certain DIY are good sectors for net lease investing. Recycling is another interesting opportunity, because everyone needs to recycle and building new facilities is difficult from a zoning and permitting perspective. Social infrastructure like schools, fire stations and medical facilities on long leases to governments provide truly bond-like characteristics. However, attractively priced opportunities are few and far between.

What are the prospects for the European net lease market going forward?

European countries are beginning to invest more heavily in supply chain resilience and defense, creating long-term demand. At the same time, Europe’s relative stability will continue to attract highly skilled talent, supporting economic growth over the next 10-15 years.

There is, therefore, huge upside potential in the European net lease sector. It is a much smaller market than the US today, but the opportunity for growth is clear. What needs to be highlighted in terms of risk-return comparison is the quality of real estate in the European net lease market tends to be higher. Targeting premium net lease assets that combine both long-term security with quality fungible real estate is the best risk-adjusted play in Europe. A diversified portfolio of scale can generate stable, long-term returns and attractive cashflow beyond inflation with relatively low volatility.

How can net lease investors generate alpha?

Net lease generally sits in a 9-12 percent IRR range. It is very much a long-term, core-plus return profile. More than 80 percent of the return is typically generated through cashflow, which is typically in the 5-10 percent range. Some managers will claim to be able to achieve 15-20 percent returns, but my view is that is usually beta generated by being fortunate enough to buy at the right point in the cycle.

True alpha generation comes from origination and structuring. It requires a deep network to identify owner-occupiers and the expertise to show businesses how sale-leasebacks can unlock capital for growth. It requires disciplined underwriting to manage risk and protect the downside, while structuring opportunities to capture upside.

By unearthing those opportunities, you can secure deals with a more favorable risk-return profile. You can also partner with private equity sponsors in strategic acquisitions. By doing that, you can improve the quality of your investments through credit enhancement, real estate improvements or ESG optimization. Strong net lease investing is not passive. Proactive asset management, like helping tenants maintain, improve and expand their properties to ensure continuity of income and to capture credit enhancement, serves to improve the inherent risk-return profile of your deal, which unlocks true alpha.