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Q&A: The net-lease outlook for franchising


An interview with Jon McClure and Peter Carlson, Principals, Chesapeake Companies in Minneapolis

Q. What is your assessment of the state of the net-lease market across the country?

A. We currently have projects underway on both coasts and in middle America. From our vantage point, it appears that the overall net lease volume is down by about 67 percent nationwide.

Q. What types of developments are still in demand?

A. Developments which are selling seem to fall into one of two buckets: those that have national tenants with high quality credit, very well-located, in a strong demand area, and those that are of lesser quality, with a financially stressed owner who needs to sell and will do so at a discount.

It's really just a two-tiered market - the distressed deals versus those that are of extremely high quality. Those in the middle are not trading at all, unless there is a particularly distressed owner involved.

Financial buyers without a solid real estate operating background will have an especially difficult time over the next few months. The majority of deals will be going to all-cash buyers, with extremely low leverage in the deals.

Q. What is your sense of how the credit markets currently view franchising, and how are those attitudes affecting net lease transactions?

A. Debt capital is tough to arrange, especially leasehold financing for new construction. Equity is equally difficult. I think people in the franchise industry-- including developers - who have a strong track record, access to capital, and national experience - will continue to find deals and emerge stronger than ever.

Q. At this point, how do you view the opportunities for selling and/or buying?

A. We've made a decision not to sell into this weak market. As for buying, we think it's still a little early for that. But we anticipate some pretty good opportunities toward the end of this year, and certainly in 2010.

Q. What are your expectations regarding the outlook for capitalization rates?

A. Cap rates are definitely up, by as much as 100 basis points or more. Again, where they will land on a specific property will depend directly on where that property is on the "distressed vs. high quality" scale.

Q. Retailing has been particularly hard hit. What do you see on the horizon for the retail net lease market?

A. When people began to realize last quarter that this downturn was going to last much longer than they anticipated, they really began to turn cautious. Retailing used to be the darling of the net lease market, but with NOI plunging as consumer demand continues to shrink, we're seeing a lot of store operators looking to renegotiate their leases and seek other concessions from landlords. Going forward, however, we think there will still be investor interest in those retailers who are "best in class" and provide necessity-based services, as well as those with high quality balance sheets.

The unfortunate thing is that we're looking at a receding tide - good companies are being dragged down with the bad. Even if you are buying a star performer like a Walgreen's, don't expect lenders to relax their underwriting. Deals are closing, but even some of the strongest retailers - like Walgreen's, for example - are choosing to abate their growth rate and wait it out.

Q. What special challenges do you face in serving the ground-up development needs of major franchisors?

A. Aside from the ongoing problem of successfully navigating through the local entitlement process, which is an ever increasing challenge, perhaps the most critical obstacle to making a transaction work today is how sensitive lenders have become to the credit of the prospective tenant and the terms of the lease. For free-standing, ground-up, built-to-suit projects, lenders are demanding long-term leases and limited tenant specific improvements. For the developer, it means we have to underwrite every deal much more carefully, and verify every salient fact. The critical question we constantly have to ask ourselves is "will the tenant and lease structure be bankable?"

Q. What's your quick assessment of the outlook for the net lease market for the rest of this year?

A. We don't see much improvement until the middle of 2010. Many major retailers and franchisors are pushing back their planned '09 store openings into '10. And, as for the rest of this year, we expect continued compression on distressed owners, lower prices and increased cap rates.

There is no question that there will be great distressed investment opportunities, but capital will continue to be very hard to come by. Significantly fewer people will have the ability to buy than was the case during the recession of the late '80s and early '90s.

What's happening today is not simply the result of overbuilding - systemic financial events have taken the capital out of the market. We do think the market will come back, but more gradually than in past downturns. We should be watching for steady quarter-to-quarter improvements, rather than knee-jerk bounces in the markets.

Chesapeake Companies is an integrated real estate investment and development company. For more information, visit www.chesapeakecompanies.com.

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