At first mention, the commercial real estate investment scene - conjuring images of Donald Trump flanked by a pack of murmuring lawyers - doesn't necessarily mesh well with the comparatively conservative, buy-and-hold world of private placements. Take the eagle-eyed due diligence and thirst for solid, long-term investments of the latter and add in the concrete, long-lived assets of the former, however, and you have a recipe for private buyside appetite.

The net-lease market has quietly been a staple for private placement buyers looking for added yield on quality, long-term paper since the two met, but the relationship became tenuous over the past two years as the Financial Accounting Standards Board (FASB) put special purpose, off-balance sheet vehicles under the regulatory microscope. Now that the seemingly incessant FASB fog has diminished into a mild haze - for this market, at least - the net-lease market should be looking at a fairly bright horizon. Factor in a groggy economy and its trickle-down ramifications for the capital markets climate, however, and the equation isn't quite so simple.

According to the June 11 Federal Open Markets Committee (FMOC) Beige Book summary of regional economic conditions, overall commercial real estate continues to be weak, with only scattered indications of conditions stabilizing at a low level. The Boston district has seen already-high office vacancy rates rising and rents falling. Office vacancy rates have also edged up in suburban Philadelphia. Nonetheless, both districts reported an increase in purchases of office buildings by institutional investors and real estate investment firms.

New York's office market has shown signs of improving recently, after having weakened in the first quarter. Brisk leasing activity in Lower Manhattan - largely from the health sector - pushed that area's vacancy rate down sharply to its lowest level in a year. Commercial leasing and construction activity in the Richmond district was generally flat, but the retail sector was one of the bright spots in recent weeks.

"Market volumes appear to be up slightly over last year," said one net lease industry pro, "2002 was a significantly down year for many, but a record year for us by luck of the draw." Rates remain at or near historic lows (notwithstanding the recent 100-plus basis point rise in the 10-year Treasury) and the cloud of uncertainty created by FASB's FIN 46 lifting somewhat, but both factors have been mitigated somewhat by several, slightly less visible factors.

Short-term borrowing costs for corporations remain at historic lows, as evidenced by the 1.11% 3-month Libor yield. A slow economic recovery has stunted capital needs for creditworthy corporations, and the availability of short-term debt for such companies remains high while lower-rated credits face tightening. The result? Corporations aren't overly motivated to lock in long-term, higher-cost capital via a sale/leaseback or net-lease transactions, and build-to-suit activity - another key driver of net-lease financing activity - is still down somewhat as economic recovery slowly awakens.

In fact, the outlook for commercial property construction on the whole is flat at best. In a column appearing on the Web site of the Associated General Contractors of America (AGCA), Ken Simonson, chief economist for the AGCA, outlines the nonresidential construction forecast.

"Private nonresidential construction is nearly flat," Simonson wrote. "A major improvement over the steep declines through much of 2002. The total for nonresidential building construction in March is just 0.1% below February's figure, and very close to the previous six monthly numbers on a seasonally adjusted basis. Health-care construction is leading the pack, but other nonresidential segments have begun to turn positive or are declining less than before."

"Electric power plants are the exception," Simonson continued, "plunging 22% year-to-date. Public construction is a sadder story. The March total is 3.5 percent lower than in February, following a 2.1 percent drop that month. Public construction, other than elementary- and secondary-school building, is likely to do even worse in comparison to 2002. Governors, legislatures and local governments are still wrestling with budget gaps, making further cuts inevitable."

With fairly stagnant new construction activity and the economic factors outlined above hobbling "traditional" net-lease activity, the net-lease market so far in 2003 appears to have been dominated by synthetic lease restructurings, said the market source. This has allowed corporations to realize the benefits of extremely low, short-term floating-rate yields without having to change accounting treatment.

"Definitely not an outcome we would have predicted a year ago in the face of what had seemed, at the time, to be an effort by the FASB to force the consolidation of synthetic leases and similar transactions by corporate tenants," the source noted.

"We continue to believe that synthetic lease transactions are not `true' credit tenant leases (CTLs), given the tenant's significant residual exposure," the source continued. "That certain large banking institutions have devised `non-SPE lessor' structures to successfully avoid consideration under FIN 46 does not obviate the fact that a synthetic lease transaction is more analogous to a direct corporate borrowing than to a true lease transaction." That said, the source noted, "such structures are clearly advantageous to companies willing to undertake the `back-end' real estate risk - whether real or slight - in order to achieve a significantly lower borrowing cost on a floating-rate basis."

As to the near future of the "true" CTL market, the source noted that CTL activity might actually increase once short-term rates rise and the allure of using short-term money - "unhedged" against rate fluctuations - to finance long-lived assets such as corporate real estate begins to abate. Conversely, the source continued, it is unclear what continued increases in Treasury yields without a commensurate rise in shorter-term yields, specifically Libor, will do to CTL activity.

"One might argue that companies will seek to lock in historically low rates while they can by engaging in long-term sale/leaseback transactions, while others might argue that the greater the negative spread between 3-month Libor and the 10-year U.S. Treasury, the less likely corporate treasurers will be to secure long-term financing," the source said.

For now, the net-lease market continues to feature significantly more debt and equity appetite than good deals, sources noted. According to one market pro, the WorldCom bankruptcy auction of a building net-leased to the Bank of New York last month underscores this point.

Twenty-one separate equity bidders, backed by a host of placement agents and institutional debt investors, hotly completed for what is essentially a very high-priced, special-purpose property in a somewhat depressed Somerset, New Jersey real estate market - simply because both the credit and the lease form are very strong. According to sources, Wachovia won the deal as an equity investor/purchaser.

Going forward, net-lease market pros agree that the economic recovery, expected to take a firm hold in the second half of 2003, should serve to increase corporate capital needs, theoretically leading to more sale/leaseback and build-to-suit activity in general, although not as much as one might normally expect in light of the continued allure of short-term, direct corporate borrowings versus longer-term sale/leaseback transactions.

"As to our firm," one source said, "Our last three years were each record years in terms of the number of structured net-lease debt transactions and overall volume. While we expected this year to be a down year for many reasons, our backlog of potential transactions is growing - such that we believe the next two calendar quarters will evidence a decent, albeit nonexceptional, rise in net-lease activity in the market overall."

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