Casting a Wider (Double) Net

Experienced developers recognize that the pieces of the commercial real estate landscape don’t just fit together like a puzzle—they are connected in ways that can cause changes to have a profound and potentially transformative downstream impact. If one piece takes on a new shape, it doesn’t just affect the way everything else clicks into place, it can reveal an entirely new picture. In today’s turbulent and fast-evolving market, we can see this phenomenon unfolding almost in real time, as market pressures lead to a cascade of changes that are altering the way developers, tenants, and investors approach leasing.

Changing with the Times

The first domino in this story is changing developer strategy. Today, even developers who have traditionally preferred to hold commercial real estate assets over the long term are generally selling more of their assets. WMG, for example, has already eclipsed our largest annual sales volume for individual sales for an entire year—and it’s still summer. That change isn’t random, of course, it’s a natural response from developers being flexible and responding to an evolving market—specifically, pressure from higher interest rates. Financing these projects with higher rates and carrying them long term simply doesn’t make as much sense in the current environment. And developers recognize that there is little to no room left to make up any of those higher costs with rental increases. Some tenants are already well above what was their absolute ceiling just a few short years ago, and you can only push that so far. Even those developers who may have been inclined to hold onto their assets are looking to sell more and benefit from the bigger margins available to them shortly after the project has been built.

Investors and Insights

One of the benefits that comes from selling more assets quickly is that the developer is able to benefit from receiving immediate market feedback. They can take that feedback and use it in ways that may inform the details on the front end of how they underwrite their next project. With several sets of eyes from potential buyers reviewing leases and operational dynamics, developers are getting real-time insight into what the market “likes.” They can hear firsthand about everything from general preferences and priorities to specific feedback about a lease provision—feedback that might prompt them to leave a problematic or unpopular provision out of the leases in their next development.

Buyers and Priorities

There is extra pressure to pay close attention to investor priorities because the pool of prospective buyers is somewhat limited compared to previous years. When an investor has other options (e.g. a bond account that will reliably pay them 5%), there is less urgency to invest in commercial real estate and investors can be more selective. In previous years, transactions were more fluid, and you could move quickly—supply and demand were in balance. Now, however, with more assets coming to market and not enough buyers, there is more supply than demand. Those same realities mean that institutional investors are not really in play for many developers. The biggest pool of buyers are high-net-worth individuals or 1031 investors, and they are choosing the very best assets. They want the highest quality tenants, the best real estate, and the most favorable lease structure. And it’s that last point that is having such a fascinating impact on today’s leasing landscape.

Lease Structure Implications

Aside from quality, what individual investors are looking for in their commercial real estate investments is zero landlord responsibility. They are, understandably, primarily interested in collecting a check, not managing a commercial center. That is why the cascade of cause-and-effect, from interest rates and sales volumes to investors and purchasing preferences, has led to a tectonic shift in the leasing landscape. Because that preference for less responsibility is heating the market up for absolute net leases. In an absolute net lease, tenants essentially self-manage the property. Tenants handle all responsibilities after construction and buildout, including things like cleaning, repairs, parking lot maintenance, and other on-site operational maintenance like lawn care and snow removal. That is in stark contrast to a double net lease, where tenants may reimburse the landlord for certain expenses like property taxes, property insurance and property maintenance, but the landlord is responsible for all work and the initial expense of maintaining the site and structure. With the decline in popularity of the double net lease, developments with a double net lease structure have become a second-tier asset right now— leaving them sitting on the market with no interest from buyers or selling at lower prices to provide a higher yield to investors. There simply are not enough buyers with interest, and many developers are slowing or stopping their pipeline of double net lease projects.

Collaborative and Consequential

The mid-to-long-term implications of this shift in the leasing landscape are still unfolding, but it has prompted a higher degree of coordination, communication, and collaboration between many developers and their tenants. Savvy developers are providing tenants with market feedback and discussing the potential for switching to an absolute net lease structure. That change isn’t always easy or feasible with a signed lease in place and landlord obligations to fulfill, but market pressures being what they are, those discussions are absolutely taking place. Some retailers very much prefer the absolute net lease structure, especially as they scale and mature and are better able to manage those responsibilities more efficiently—and sometimes more cost-effectively. Landlords don’t have an obligation to shop for the lowest price, and tenants who can do so are more likely to prefer to take care of those management responsibilities when the costs would have just been passed along to them, regardless. Obviously, the timing and feasibility of transitioning to an absolute net lease is highly dependent on tenant- and site-specific factors like preferences, portfolio, location, building type, internal operational dynamics, etc. That said, given the market forces at play, we will almost certainly continue to see absolute net lease tenants and projects in higher demand in the months and years ahead.