Coming out of the great recession, the majority of the commercial real estate transaction volume consisted of three general types of assets:
- NNN leased properties (primarily single tenant)
- Trophy and high quality commercial properties in major “Gateway” cities
- Distressed REO assets
Small private investors weren’t able to compete effectively with large institutions in buying the majority of trophy properties and the large volume of one-off distressed assets never materialized. Instead, the private investor focused primarily on buying NNN leased credit properties. The demand was fueled primarily by access to debt financing with historic low interest rates combined with the desire for higher yielding investments compared to alternative asset classes (stocks, bonds, bank savings accounts, etc.) This demand drove cap rates on these assets to historic lows. With the recent rapid rise in treasury rates, the question now becomes where do private real estate investors go from here.
Risk of Investing in NNN Leased Single Tenant Properties – At Current Valuations
In this article I want to focus on the NNN leased single tenant sector and provide some perspective to our current and future clients. NNN single tenant leased assets, specifically ones with long term leases with fixed rental structures, function similarly to that of a corporate or Treasury bond. Investors receive a fixed income stream (provided there is no default from the tenant) with minimal or no opportunity for an increase in that income stream over the term of the lease. The fixed income stream creates and implied volatility that is extremely sensitive to a change interest rates. When interest rates fall, cap rates tend to decrease; and as interest rates rise, cap rates tend to increase. Exacerbating the situation is that cap rates on these “bond-like” assets can increase more quickly than interest rates given the lack of opportunity for income growth.
Below is a simple example to help illustrate this point:
Client A purchases a NNN single tenant asset with the following characteristics:
- Price: $2,500,000 (un-leveraged)
- Lease Term: 20 Years – with no rental rate increases
- Net Operating Income: $150,000
- Implied Cap Rate: 6.0%
With the current 10-year treasury rate hovering between 2.60%-2.80%, the spread between the “risk free” rate and the cap rate for this asset is between 320-340 bps. Historically, the spread between cap rates and long-term treasury rates has averaged around 280 bps.
With all else being equal, this would imply that there is still 40-60 bps of room for interest rates to rise before cap rates would theoretically start to move higher according to the historical average. The challenge to this thesis is that a 40-60 bps increase in the treasury rate could happen quickly. Case in point, on May 1st, 2013, the 10-year treasury rate was 1.66%. Since then, we have experienced an increase of more than 100 bps in just three months. Combine that with the notion that interest rates are still significantly below their recent historical averages and we have a potential for a large increase in cap rates for these “bond-like” NNN leased assets.
This is illustrated by the stock performance of two publicly traded REITs that focus primarily on Net Leased properties. Since May 1st, National Retail Properties (NNN) and Realty Income Corp (O) are down approximately 15% and 17%, respectively. While the S&P 500 index has increased 6.5% over the same time period. (as of 8/15/13)
If the 10-year treasury rate increases another 140 bps to 4.20% over the next 12-24 months then using the historical spread, an implied cap rate on the same asset would be 7.0%. Therefore, this same property would be valued at:
- NOI = $150,000
- Cap Rate = 7.00%
- Indicated Value = $2,140,000
So even though nothing changed at the property level (the rent is still paid on time, etc.…) the value of the asset has decreased by $360,000 or 14.4%.
This is a very simple example, however it is indicative of how quickly values can change even though nothing negative occurs with the property or the tenant. On a daily basis we try to educate our clients about this risk and present strategies on how to protect against it. \
Still Bullish on Commercial Real Estate
I need to state that there are times and circumstances when we think buying Net Lease single tenant properties are advised (i.e. timing within the current economic cycle and/or a client specific asset allocation). However, given the current market dynamics, we have been advising our clients since the beginning of the year to sell these “bond-like” real estate investments. We are advising our clients to re-invest their proceeds in to multi-tenant properties where they can generate strong cash on cash yields capitalizing on what are still historically low interest rates while offering a hedge against potential inflation.
Commercial real estate has historically provided a strong hedge against inflation. This hedge is driven primarily by the property owner’s ability to potentially pass through the rising costs associated with inflation to their tenants in two ways. First, the majority of commercial leases have annual rent escalation clauses in their leases. These escalations are typically based on a set annual rate or a metric that estimates inflation, (i.e., CPI). Secondly, as lease terms expire landlords can potentially increase rents and/or pass through increases in property operating expenses. (Assumes that the economy improves as inflation increases).
An additional hedge against inflation with commercial real estate is that property owners can lock in long-term fixed rate debt financing at historically low rates. If borrowing costs rise, the property owner is protected during the term of that loan. As the following table illustrates, direct ownership in real estate has demonstrated the strongest correlation to inflation in recent history.
Sources: Bonds & Credit Barclays Capital, CPI + S&P data Bloomberg, National Council of Real Estate Investment Fiduciaries (NCREIF) data from source, REIT data National Association of Real Estate Investment Trusts (NAREIT) from Bloomberg, as of Q2 2012.
In summary, we are bullish on commercial real estate ownership and are seeing some exciting opportunities. We think the best approach for private investors to benefit from these opportunities is to invest in actively managed properties that provide for strong cash on cash returns and value-add potential while maintaining a hedge against inflation.
If you have questions about your real estate portfolio or are looking for new opportunities, please contact me and I would be happy to help.
Keith Goldfaden, Senior Vice President/Investment Sales
904 363 9002 • firstname.lastname@example.org