By W. Kyle Gore, managing director, structured finance group at Legg Mason Wood Walker Inc.

There is arguably more debt and equity capital pursuing net leased property investment opportunities and investment grade CTLs now than there has been at any time in the past. This is occurring in the face of "flat" or slightly lower supply of transactions from sale-leaseback and build-to-suit transactions compared to prior years.

Market participants generally believe that net leased property activity is beginning to increase overall with 2004 CTL activity expected to exceed 2003 levels. Among other things, a seemingly robust economic recovery, the likelihood that short rates will eventually rise (i.e. possibility of a flatter yield curve), and a continued equity market recovery (theoretically slowing down the flow of equity capital to real estate markets and private REITs generally) may all combine to boost CTL activity in 2004.

The NAIC's decision to stop reviewing (i.e. to automatically convert to NAIC designations) structured transactions featuring ratings of BBB-' or higher may lead CTL arrangers to consider increasing their use of ratings to further promote liquidity to private placement investors and possibly push structures not contemplated by the NAIC CTL guidelines.

The high leverage CTL market has continued to be dominated by investment grade transactions. Transactions featuring tenants with below investment grade ratings have generally required significant amounts of equity and, therefore, been precluded from the private placement CTL market. Conversely, investment grade CTL transactions have attracted a "frenzy" of debt and equity interest. CTL investor subscriptions totaling two-to-three-times over, for investment grade (particularly non-retail) credit transactions, was not uncommon this year.

Why the influx of equity investor interest? Equity investment demand from 1031 "tax deferred exchange" investors continues to grow dramatically. This has caused several major market participants to shift their focus away from CTLs, or other net leased debt activities, and instead onto equity and related efforts. For example, Wachovia Bank, which has a group focused primarily on purchasing net leased properties for resale to third-party 1031 and other "high leverage" net lease investors, is now using CTL financing arranged by Wachovia Securities. In the past, Wachovia had been strictly a CTL debt arranger/provider for third-party borrowers. This increase in equity availability has been a limiting factor in the amount of CTL activity, as market participants generally believe that the incidence of net lease property acquisitions on an "all cash" and "traditional real estate debt" basis is greater than in the past (implying generally lesser need for "high leverage" capital structures).

In addition several groups - including non-publicly-traded REIT's - have raised significant amounts of equity capital over the past 24 to 36 months for investment in net leased property; it is believed that the Wells Real Estate Funds, and various funds sponsored by W.P. Carey and CNL, have collectively raised over $2.5 billion over the past 24 months for investment in net leased real estate alone. Market participants believe that at least 50% of that capital has resulted in a commensurate decline in CTL volume as the private REIT's have typically purchased properties on an "all cash" or low leverage basis.

According to some market participants, the supply of net leased property investment opportunities prior to this Fall seemed "flat" or even slightly down.

Also "flat" this year, and possibly down, has been sale-leaseback activity - driven primarily by corporate finance requirements. This has been attributed to the unusually steep yield curve and the relatively strong investment grade corporate bond market over the past year.

As sale-leaseback-driven CTL's are typically long term in average life and maturity (generally 12 to 20 year average lives), the steep yield curve is effectively a disincentive to long-term corporate finance activity overall. The combination of strong investment grade corporate bond markets - and the near record difference between the three-month LIBOR and 10-year Treasury yields - implies that there is generally less need for "non-traditional" corporate finance activity, such as sale-leasebacks, let alone a desire to commit to long term rent in an environment where short-term "on balance sheet" LIBOR-based borrowings are so attractive. The significant rise on Treasury yields over the summer has seemingly only exacerbated this difference: one-month LIBOR increased only 10 basis points during the same period in which 10-year Treasury yields rose over 100 basis points.

Overall, CTL spread premiums vs. public corporates have remained consistent at 35 basis points to 60 basis points, with 45 to 50 basis points being the general guide. Consequently, CTL spreads have tracked corporate spreads generally, implying an overall tightening in CTL spreads over the past year for market sectors which have featured tighter corporate bond spreads.

Significant interest by high yield funds and other "opportunistic investors" in fallen angel CTLs has lent credence to the argument that the buyside value - liquidity premium and partial collateral protection - inherent in CTLs may be understated.

For example, as recent secondary market activity in Kmart, Rite Aid and Ahold-related CTLs has demonstrated, in many instances the CTLs - by virtue of being secured by underlying real estate which may be worth anywhere from 50% to 100% of the CTL face amount even on a "dark" (i.e. no tenant in place) basis - have traded more frequently and at higher prices than comparable maturity or average life public corporate securities for the same credit. Many investors believe that direct access to collateral in a CTL structure is far superior to covenant protection in a "traditional" private.

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