Predictability in an unpredictable environment
The stark reversal in commercial real estate we experienced in 2022 continued to take hold the first half of 2023. Traditional commercial real estate faces sustained macro headwinds stemming from an elevated inflationary environment and corresponding rising operating costs (maintenance, insurance, etc.), the highest interest rates observed in recent memory, and limited access to credit. Furthermore, revenues are leveling off as supply-demand is starting to balance in certain sectors. Despite the more difficult market backdrop, Blue Owl maintained a forward posture on the buying opportunity that would emerge this year, especially in the net lease market where many of the challenges facing the traditional commercial real estate market do not exist.
The combination of economic uncertainty and the absence of available credit has left companies considering sale-leasebacks as they have fewer available sources of capital and fewer strategic options to optimize their balance sheet. While most real estate investors are on the sideline, as evidenced by the meaningful drop in transaction volume, Blue Owl remains steadfast in our pursuit and execution of some of the most attractive transactions we have seen in over two decades.
Our Super Bowl has arrived
The current volatile and unpredictable interest rate environment appears to continue to impact companies of all sizes and capital structures – including investment grade firms, who typically rely heavily upon their robust cash flows to secure liquidity and access working capital for operations. In response, many companies are turning to sale-leasebacks as an additional source of capital to finance their business initiatives and fuel growth. The combination of limited credit, high rates, elevated inflation, endemic global geopolitical issues, and a material disruption of the real estate capital markets have created a “perfect storm” for our business model of being a premier provider of capital by offering greater scale, increased speed and more flexibility to transaction partners, in our view. These conditions have allowed Blue Owl to put significant dollars to work in pursuit of incredibly favorable yields and total returns for our investors.
To put the above dynamics in perspective, a sale-leaseback of a mission critical research & development facility tenanted by an A-rated company would have traded between a high 4% cap rate to a low 5% cap rate 18 months ago. Given the current landscape and economic backdrop, we were able to put a tenant with this rating under contract at a cap rate of 7.65% for a 13-year lease term. When reviewing the transactions we have executed in the past 6-12 months, one point is clear: we are in the midst of the best buying opportunity in the firm’s history. The terms we have been able to negotiate in today’s market are far better than those observed in the last few years. When comparing 2022 deal terms to those struck in 2023, our weighted average entry cap rates have increased 130 basis points, rent escalations are up 48 basis points, and lease terms are staying at approximately 20 years with the same strong credit quality.
At the same time, the size of our current investment pipeline has reached a new peak where it is approaching nearly $50 billion. In 2023 alone, we have acquired or currently have under contract to acquire over $7 billion of real estate. For the assets we have sold this year, we have generated over 100 basis points of cap rate compression in a challenging market environment, demonstrating the attractiveness of net lease assets.
Reshoring movement: "Made in America"
A primary contributor to our current net lease pipeline is a trend of companies seeking to “reshore” their manufacturing facilities and operations back to the U.S. – one of the market effects of the passing of the CHIPS and Science Act in August 2022. The CHIPS and Science Act authorized a $250 billion investment to bolster domestic research, innovation, and semiconductor manufacturing in the U.S. The objective of the law is twofold: restoring the United States to its former role as the global leader in technological innovation and manufacturing, while at the same time addressing the now well-known global supply chain issues. As a result, companies such as Intel, Micron, and Samsung have introduced multi-billion-dollar developments here in the U.S., and Blue Owl is well positioned to act on those opportunities.1
We currently have $20 billion worth of semiconductor/advanced manufacturing deals in our pipeline (approximately 40% of the total pipeline), with over $1 billion closed/under contract. Further, we recently signed transactions with two investment grade companies that are leaders in the semiconductor and memory chip industries to acquire their mission critical R&D and fabrication facilities at very attractive cap rates.
Considering the scale of these projects, which can be several billion dollars in cost, we believe there are very few groups that can provide the capital and depth of partnership for these types of transactions the way Blue Owl’s Real Estate platform has proven to do. Our 14-year track record of success coupled with multiple billions in dry power position us well to take advantage of these opportunities in the near term.
The rush to net lease
As investors’ risk tolerance appears to continue to recede in today’s markets, we are seeing increased attention and interest towards income-generative strategies – those focused on steady current income and downside protection. The triple net lease structure has become especially attractive given its insulation from operating expenses (e.g. real estate taxes, insurance, maintenance), which we have seen increase dramatically over the last 12 months. One of the more notable areas of expense increase is associated with commercial property insurance costs, particularly in the coastal markets like Florida and California, largely due to climate change, inflation and a volatile rate environment. More specifically, commercial property insurance premiums increased 18.3% on average in the second quarter of 2023, compared with 8.3% at that time a year prior.3 Leading insurance companies such as State Farm, Allstate, AIG, and Farmers are either reducing their exposure in these locales or exiting the states altogether.
The structure of our triple net leases insulates us from rising expense growth because the tenants are legally responsible for the expenses associated with operating and maintaining the asset. Additionally, the majority of our total return profile is driven from contractual rental income, greatly reducing capital appreciation risk on our exit. The singular focus and goal of our strategy is to provide attractive risk-adjusted returns through long-term, predictable cash flow by acquiring mission-critical real estate backed by investment grade and creditworthy entities. Our investors are receiving a bond-like, steady income stream with the real estate collateral serving as additional downside mitigation in the event of a default and conversely upside upon monetization.
Lending landscape remains challenging
Debt markets and increasing cost of capital continue to be another element of strain for real estate managers and investors. The high-profile bank failures earlier this year brought a new level of scrutiny and concern to the bank community. Adding to those concerns is the fact that nearly a third of the outstanding U.S. commercial real estate debt is coming due before the end of 2025.4 As a result, lenders have continued to pull back and are exercising caution over which deals they choose to finance. To the extent financing is available, it is incredibly expensive with shorter duration and less flexible terms.
While our financing costs have increased, we have been able to maintain an attractive spread between our all-in cost of financing and our entry cap rates resulting in positive leverage for our transactions. As discussed earlier, our entry cap rates have ticked up meaningfully as a result of corporations needing alternative financing solutions, which has allowed us to maintain our cash yield.
In the first half of 2023 alone, we have raised $2.2 billion in debt proceeds. Our capital markets team has utilized a wide range of financing sources to help us adjust to various market headwinds which include traditional mortgage debt, credit facilities, commercial mortgage-backed security (CMBS) and asset backed security (ABS) issuances, and private placement notes. The long-term, fixed-rate nature of our debt allows our strategy to withstand market cycles while seeking to deliver predictable cash flow to our investors.
Despite the ongoing uncertainty in the markets, this environment continues to be the largest and most attractive buying opportunity that we have seen in over two decades for net lease real estate strategies. Our differentiated sourcing and ability to transact off-market allows us to take advantage of these rare opportunities. Our strategy was designed to perform in varying economic conditions and seeks to deliver predictable income and downside mitigation to our investors.
We strongly believe Blue Owl’s Real Estate platform is well positioned to continue delivering consistent current income and attractive risk adjusted returns to our investors in the current market environment.
Co-President & Head of Real Estate, Blue Owl Capital
Past performance is not a guarantee of future results. The views and opinions expressed herein are those of Blue Owl and are subject to change as markets and other conditions fluctuate. Blue Owl is under no obligation to update or keep current the information presented.