In a time of geopolitical tension, elevated interest rates and persistent volatility, investors look for dependable returns.

This is leading investors to consider new strategies, said Jon Strang, head of industrial and net lease at investment management firm Cain.

“Net lease strategies, once viewed as a niche part of the real estate market, are drawing growing interest as real estate reprices, financing conditions improve and occupiers look for new ways to release capital,” he said. “The asset class is entering a new phase of growth.”

Bisnow spoke to Strang about the drivers behind the increased uptake of net leases.

Bisnow: For those less familiar with the strategy, what is a net lease?

Jon Strang: People often think net lease is simply about long leases, but it's really about high-quality income.

The objective is stable, predictable cash flow over the long term, backed by strong-credit tenants, long contractual lease terms, little to no landlord obligations and, in the case of our strategy, high-quality supply chain infrastructure.

Leases are typically triple-net, so the tenant carries every cost of occupying and operating the facility, including capital expenditure, insurance and taxes. Almost nothing varies in the landlord’s net income, so returns can be forecast with real predictability.

That is valuable now, when underwriting most real estate carries a high level of uncertainty.

Bisnow: What are the main benefits of net leases?

Strang: Around 90% of the returns in a typical net lease deal come from cash flow, with only a small amount from residuals. Leases are long, and most of the real estate risk sits with the tenant, so total return can be forecast with a high degree of certainty over 10 or even 15 years. That is powerful.

It's also an attractive financing tool for occupiers. Sale-leasebacks release capital tied up in real estate for reinvestment into operations, while the business retains long-term control of assets critical to it. Build-to-suit developments let businesses expand using the balance sheets of investors.

Bisnow: Are there any downsides?

Strang: A long lease is good for security, but when the asset and its market are performing well, as in the recent logistics boom, locked-in rent, albeit inflation-linked, can underperform market rental growth. It tends to outperform when the market is doing badly.

We also see this as core-plus rather than value-add. The variables are few, so outcomes should sit in a tight band around underwriting.

A good investor will maximise returns through intelligent asset management, but those opportunities are ad hoc and cannot be underwritten at acquisition. Outperformance against the initial underwrite is therefore likely to come from beta rather than execution.

Bisnow: Why are net leases becoming more popular in Europe?

Strang: Europe has a much larger proportion of owner-occupied real estate than the U.S., giving potential for high volumes of sale-leaseback activity.

U.S. companies are more likely to be private equity-owned. These are sophisticated owners who scrutinise their balance sheets and allocate capital as efficiently as possible, something a sale-leaseback helps with.

That mindset is emerging among European owner-occupiers, who increasingly understand the tools available to free up capital to reinvest in their core business operations, so sale-leaseback activity should keep growing.

Europe is smaller in transaction volumes but could be a similar size one day: The U.S. has had decades to mature its net lease sector, whereas it's still a relatively new concept in Europe, with an education process attached.

Bisnow: What makes a good net lease asset?

Strang: First and foremost, the property must be mission-critical — that is, vital to the tenant’s operations. The tenant is committed long-term and will likely remain in occupation beyond lease expiry.

Offices, aside from headquarters, are rarely single-tenancy and are never mission-critical. Retail is typically multitenant, although you get single-tenant, big-box concepts or supermarkets, where mission criticality is harder to define and usually argued on store profitability.

Industrial is often single-tenant and very often mission-critical, so it lends itself well. As the sector has grown in prominence, it has helped drive additional net lease volumes.

Cain also looks past a single strong-credit tenant on a long lease to the fundamentals of the asset. We favour buildings a wide range of occupiers could operate efficiently, in markets with sustainable demand, with specifications that are future-proof or easily upgraded.

ESG factors are also very important. Higher-quality real estate provides better risk-adjusted returns through greater third-party usability, financeability and, ultimately, saleability.

Bisnow: Would data centres be good assets for a net lease strategy?

Strang: Data centres are an interesting emerging asset class, but we’re yet to see significant transaction volumes in Europe. Power availability and stricter planning laws are bottlenecks, but latent demand is seemingly so large that solutions will be found.

There is more activity in the U.S., and we assume similar deals here are a matter of time.

They are hugely expensive, and while the likes of Google have funded their own facilities to date, expansion is so rapid they will not be able to self-fund all of it. That is where a net lease investor could come in, funding hyperscaler expansion in return for long-term, triple-net leases.

In theory, they are interesting net lease assets, long leased to investment-grade covenants and seemingly very mission-critical. The additional risks matter, though, notably concentration.

Deals we have seen range from the low hundreds of millions to over a billion. Net lease means buying individual assets that are binary by nature, being single-tenant, so the strategy relies on diversification across many properties.

A lot that size only makes sense for the largest investors. There is also obsolescence risk as the technology evolves, which I don't think the typical real estate investor fully understands.

We’ll be watching closely and are looking at deals, but it needs a higher level of scrutiny given the concentration risk within any client's portfolio.

Bisnow: Which other asset classes are on your watchlist?

Strang: We think there is an interesting opportunity emerging in defence-linked real estate as European governments increase spending in this space. We’ve seen a handful of deals come up in the last year and see the trend accelerating.

Many assets won’t touch the market because they’re so sensitive they will remain government-owned, but there will be offshoots such as facilities producing nonlethal equipment or upstream supply chain. They make great net lease assets.

Covenants are top-quality, either governments or large defence companies that are highly rated and very profitable. They sign long leases because their plans are long-term, and the assets are highly critical, especially in how they serve national security.

Ownership restrictions apply depending on the investor's jurisdiction, but it’s an area we’ll watch closely as the market develops.

This article was produced in collaboration between Cain and Studio B. Bisnow news staff was not involved in the production of this content.

Studio B is Bisnow’s in-house content and design studio. To learn more about how Studio B can help your team, reach out to studio@bisnow.com.