Lower Interest in Banks as a NNN Play

August 4, 2021

The increasing popularity of online banking, coupled with bank consolidation and branch overbuilding in recent years, has created some uncertainty among net lease investors who used to be big fans of bank-occupied assets.

Historically, bank branches were the gold standard for net lease investors. These properties, with their long-term leases, investment grade tenants and passive management, were exceptionally appealing to those who sought low risk, no worry investments. But the demand for them is gradually waning.

“Demand for bank branches has decreased over the last five to 10 years within the private capital market,” says Alex Sharrin, managing director of capital markets, Americas, with real estate services firm JLL. “These buyers (high-net-worth individuals, 1031 exchange purchasers) tend to place themselves in the shoes of the consumer when determining the viability of a potential retail investment. As they see retail demand contract, their investment thesis typically follows suit.”

Yet, net lease experts aren’t willing to write off bank branches completely. Melinda Marston, president, single-tenant net lease, for JRW Realty, says bank branches net-leased to quality tenants remain “highly attractive.”  Just last month, the firm, working in conjunction with The Boulder Group, facilitated the sale of nine net-leased branches located in Illinois and leased to First Midwest Bank.

“Frankly, it is fairly rare nowadays to see bank branches on the market for very long before they are acquired,” Marston says.

So far this year, banks are benefitting from an overall strong net lease investment climate. The Boulder Group’s most recent bank report (for the first quarter of 2021) shows some compression in cap rates on bank-occupied assets, at 5.35 percent during this year’s first quarter versus 5.47 percent in the first quarter of 2020. This was the first period of compression following multiple years of upward movement for bank cap rates.

“Branch operations remain vital to the banking industry, serving a dual purpose of providing space for ongoing customer servicing and as a centralized office location for key personal to facilitate important banking relationships,” says Marston. “Given these drivers, we are seeing significant demand for net-leased bank branch properties that are located in strong retail locations, that have favorable demographics and that feature high deposits at their branch location.”

The few new construction branches that come to market achieve cap rates between 4.00 to 4.25 percent, on par with cap rates in 2015 and 2016, according to Jason Maier, senior director in the New York City office of brokerage firm Stan Johnson Co. Properties with less than 10 years left on their lease are pricing wider, at between 5.5 percent and 6.5 percent.

Last year, roughly $1.07 billion in net lease bank branches sold nationally, according to The Boulder Group. That’s a slight decrease from 2019, when $1.26 billion in bank properties changed hands. But it’s significantly higher than the $850 million that traded in 2018.

“Bank volume benefited in 2020 as they were deemed an essential tenant and investors flocked to higher quality investment grade tenants,” says Randy Blankstein, president of The Boulder Group.

It’s worth noting that the transactional data for net lease bank branches is a bit confusing, if not misleading. Blankstein explains that even though overall demand for bank branches is down, transaction volume is up because the activity is concentrated on assets housing the 10 largest banks in the nation.

“Demand for non-top 10 banks has declined as has demand for older large footprint top 10 bank properties,” Blankstein says. He adds that Chase, for example, also accounts for a large share of acquisitions of its own properties, which shows up in volume even though demand is not coming from outside investors.

For non-portfolio sales, 76 percent of buyers today are private individuals (mostly in 1031 exchanges), according to Blankstein. That’s an increase from five years ago when 61 percent of buyers were private. Since many of the top five banks are trading at sub-5 percent cap rates in today’s market, most institutions—REITs, in particular—are not competitive as buyers.

Ongoing branch closings

WMRE’s annual Net Lease Investment Survey, published in May, revealed that net lease investors aren’t as interested in banks as they were five years ago. Experts blame technology for disrupting the long-term outlook for these properties.

Last year marked yet another year of bank branch closings, continuing a decade-long trend. After reaching a peak of more than 98,000 branches a decade ago, total bank branches now stand at 85,050, according to JLL. This represents a 1.5 percent decline from 2019.

However, the pace of branch closings slowed in 2020 compared to previous years, JLL reports.

As the number of bank branches continues to decline, banks are using their physical locations in different ways. Online banking has reduced foot traffic in physical branches, particularly in urban cores and among certain demographic groups, including millennials and Generation Z, according to JLL’s Sharrin. By digitizing a variety of retail banking tasks, such as depositing checks and applying for a mortgage, banks can operate out of smaller spaces and with fewer employees.

Since 2017, mobile banking has been on a steady growth trajectory. At year-end 2017, global finance application downloads totaled 725 million on the Apple and Google Play stores, according to Sensor Tower. This number expanded to 1.2 billion in mid-year of 2020, an increase of 65.5 percent.

“The concern lies with the projection of the industry,” says Andrew Ragsdale, senior managing director with Newmark’s net lease capital markets group. “Investors are asking themselves: ‘Where will the banking industry be in 10 to 15 years?’ Clearly there is momentum to the online banking industry, which gives pause to investing in physical brank locations to some investors today.”

Given the growth in online banking, investors are digging deeper into the real estate fundamentals of bank branches, Ragsdale notes. For example, they’re focusing on rent per square foot rents as compared to market rents in the area, building functionality and the ability to re-lease.

And it’s not just online banking that’s compelling net lease investors to approach bank branches with more caution. The consolidation that continues in the banking industry creates investor uncertainty. For example, following the SunTrust and BB&T merger, the newly-combined financial institution announced the closing of roughly 175 branches.

Investors more selective

Though JLL’s Sharrin hasn’t seen many investors explicitly divest bank branches because of concerns about online banking, he’s seen less new capital enter the space for that reason. “Over the last 12 to 18 months, the bulk of capital flows in the net lease market have flowed towards convenience and gas, quick service restaurants, and medical-oriented retail (urgent care, pediatric care, behavioral health, etc.),” Sharrin says.

Banks with a national reach, recognizable brand and strong credit are still attractive to net lease investors, as evidenced by compressed cap rates and strong pricing. However, they’re more selective than they were previously, Blankstein says.

Because banks are struggling to determine their necessary footprint in this age of online banking, investors want to make sure they’re buying bank branches with current prototypes unless a residual real estate play in involved.

The good news for net lease investors that own bank branches is that they’re usually well-located and almost always feature drive-thrus. This makes them especially attractive if they’re located in areas where it’s difficult to obtain approvals and entitlements for drive-thrus, Maier points out.

Additionally, the buildouts, for the most part, make it relatively simple to re-lease the property to another tenant, or change the use, while still using the same footprint.

Net lease investors are particularly concerned about replacing the income stream if the bank were to vacate since these assets often carry rents that greatly exceed market. Alex Geanakos, director of JLL capital markets, Americas, frequently hears investors say: “This is a tremendous credit and income opportunity, but a poor real estate opportunity.”

Maier offers a final piece of advice to investors who own bank branches: “Keep a tight eye on the branch deposit levels. A branch with a strong deposit base, strong history and upward trending deposits should continue to operate well into the future.”

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