Interest rates

What Rising Interest Rates Mean for Net Lease Investors

A volatile stock market combined with rising interest rates and inflation has yet to disrupt the inflow of capital into net leasehold properties. The passive income strategy, invariably explained as an obligation wrapped up in real estate, provides investors with long-term credit tenants who are largely responsible for all expenses of a property, including property taxes, insurance and maintenance.

Public and private investors continue to pour capital into net rental assets to earn a return in what has been a low yield environment for the past few years. Coming out of 2021, in which industrial assets accounted for half of the $103 billion in record annual sales, single-tenant net leases in the first quarter of 2022 totaled nearly $21.7 billion, that’s a 30% year-over-year increase, according to Stan Johnson Co., a Tulsa, Okla-based net hire brokerage firm.

READ ALSO: Why retail investors are turning to industrial NTLCs

Unsurprisingly, industrial asset sales generated the lion’s share of first-quarter activity at $11.4 billion. Offices and retail accounted for $6.9 billion and $3.3 billion, respectively.

Nationally, the average capitalization rate for net leasehold industrial properties fell 17 basis points to an average of 6.6% in the first quarter of this year compared to the fourth quarter of last year, while office and retail cap rates saw smaller declines at 6.7% and 5.75%. respectively, according to the Boulder Group, a net rental brokerage firm based in suburban Chicago.

Source: Stan Johnson Co.

For much of 2021, the benchmark 10-year Treasury yield was below 1.5%, and interest rates for long-term debt were between 3% and 4% for many leases. conventional nets. This environment has changed dramatically since the end of 2021. Today, interest rates are higher by about 100 basis points, after the 10-year bond yield surged from around 140 basis points to above 2.9%. So far, demand for net leasehold properties has not slowed, even after the Federal Reserve raised the federal funds rate by 50 basis points in early May.

“Buyers are starting to point out that interest rates are rising, but rates aren’t fully priced into the market yet,” said Jonathan Hipp, group head of US Net Lease at Avison Young in Washington, DC. tenants in prime locations are still trading aggressively.

Cap rates are expected to adjust upwards with such a move in interest rates, albeit with a time lag. But observers suggest that buyers expecting a substantial move in cap rates are likely to be disappointed.

“The correlation between interest rates and cap rates is not 100%, and investment demand and supply are so out of balance that cap rates will not move as far as investors would like. investors,” said Randy Blankstein, chairman of the Boulder Group. “I think there is going to be a minor adjustment to office and retail cap rates. But industrial cap rates could continue to compress, even in a potentially rising rate environment, because industry remains the darling of all sectors.

In February, Avison Young’s Capital Markets Group represented Mesirow Realty Sale-Leaseback in its disposal of a 2.7 million square foot net rental warehouse in Des Moines, Iowa, for more than $325 million. dollars. Capital Square purchased the property leased by Amazon. Image courtesy of Avison Young.

Market in transition

It wasn’t that long ago that lenders had interest rate floors because Treasury yields were so low. But with the concomitant rise in Treasury and interest rates, lenders and borrowers are readjusting to the market. In some cases, this means borrowers must decide whether to accept a lower cash yield or return the funds to limited partners. At the same time, lenders need to deploy debt to meet their 2022 allocation targets.

“I haven’t encountered any lenders pulling out, especially on industrial and medical office contracts,” said Nicole Patel, senior vice president of Four Pillars Capital, a Dallas-based mortgage banker Stan Johnson launched in 2021. “Demand is so high right now that I can’t imagine cap rates moving. So either lenders will have to adjust their underwriting to support current cap rates or borrowers will have to feel comfortable to bring more money to the table.

Lenders who provided debt at 70-80% of an asset’s value a few months ago have generally reduced their leverage to 60-70%, observers say. But the amount of debt a borrower receives, as well as the interest rate, also depends on the location, whether the surrounding market is declining or growing economically, the strength of the sponsor, and whether a lender is above. above or below his allowance for an individual. product, among other variables, said Ben Reinberg, CEO of Alliance Consolidated Group of Cos., a Chicago-based real estate investment firm that owns more than $350 million in medical properties.

“Lenders are hedging right now,” he said. “They want to deal with experienced borrowers who understand the debt coverage requirements and don’t over-leverage their properties. But for the bargain, there is a real demand to finance net rental properties.

The fact that many institutional buyers and high net worth individuals are active in the market is likely helping to keep the downward pressure on cap rates, Hipp suggested. Although they can rise significantly between the signing of a letter of intent and its closing, interest rates have not yet deteriorated the transactions he is working on. For now, he’s not too worried if they become a problem.

“I wouldn’t advise a seller to increase their cap rate by 100 basis points to make a deal with a particular buyer, because with the amount of capital that’s fueling the market, I think there’s a buyer at cash or someone else out there who might close,” he said. “If you need debt to win the competition for an asset, that might put you at a disadvantage.”

In October, Alliance Consolidated Group of Cos. paid $9.25 million for a net-lease healthcare property in Lawrenceville, Georgia. Gwinnett Pediatric Partners, which operates the Atlanta Autism Center in the 12,000 square foot building, has leased the asset for 15 years. . Image courtesy of Alliance Consolidated Group of Cos.

Inflation influence

In addition to rising interest rates, inflation is starting to become a concern for some net rental investors. Notably, rent increases built into leases may not keep up with inflation, which soared 8.5% in March, the biggest annual jump in 40 years. Additionally, the long lease terms associated with net rental assets prevent landlords from quickly adjusting rental rates to market conditions in the same way as apartment and hotel landlords.

Given the chance, net lease buyers are looking for healthier rent increases going forward. Alliance Consolidated, for example, is pushing for a 3% annual increase in sale-leaseback deals, and might pay a bit more for an asset to achieve that, Reinberg said.

While some net leases tie rent increases to the consumer price index, they are typically capped at around 2% per year. But many net leases today have fixed annual rent increases, also around 2%. Thus, continued high inflation could significantly dampen interest in the sector as the transaction economy becomes unworkable.

“Buyers have become hyper-focused on rent increases and escalations in existing leases,” Blankstein said. “People want to make sure they are protecting the purchasing power of their cash flow.”

Read the June 2022 issue of CPE.