How Interest Rates & Uncertainty Affect Single Tenant Net Lease Properties

Date: 10/14/2013

Single tenant net lease investment properties are a good option for investors who are interested in owning real estate, but don’t want the possible management hassle and operating costs of other real estate investments. The net lease and sale/leaseback markets have been hot with transaction volume up and cap rates down. However, shutdowns, debt-ceiling issues, Obamacare and rising interest rates create uncertainty.

On the most recent episode of the “Commercial Real Estate Show” program, my guests and I discussed sales velocity, cap rates, financing options, hot tenants, investor concerns related to shorter lease terms and the uncertainty factors that could affect the market.

Increased sales velocity

Investors look for safe yield in an uncertain environment. The safety of national credit tenants on long-term leases has lead to strong sales volume in the sector. Dollar stores, drug stores and quick-service restaurants are among the most popular tenants, and all three experienced an increase in sales velocity during the past 12 months, said Sheree Strome, vice president of the National Net Lease Investment Group at Bull Realty.

For dollar stores, velocity jumped 23 percent, she said. Drug stores climbed 10 percent and quick-service restaurants increased by 40 percent. “Buyers like credit tenants, good locations, triple net leases and rent increases for quick-service restaurants,” Strome added.

“Over the next 18 months, we anticipate $15 billion in new product hitting the market,” said Geoffrey Linden, vice president of acquisitions for Agree Realty Corp. Although supply isn’t as robust as it was in 2006, new, high-quality product coming online means single tenant net lease properties should continue to be a popular investment, he added.

Higher cap rates with shorter lease terms

“Investors are so different today, with even REITs changing their strategies and chasing lower cap rates on lower lease terms,” said Karen Hutton, CEO of The Hutton Company. “If I have a 10-year lease for a credit-rated tenant and a 15-year lease for the same tenant, the difference in the cap rate could be as much as a percentage point depending on the tenant and the location,” she added.

Local buyers and experienced investors that understand the market well are picking up more of the short-term lease properties, Strome said. “If you are considering purchasing a property with a short-term lease, get to know the property and the tenant,” she said. You want to gauge the renewal risks; the risks of the tenant moving. Be sure you understand the location dynamics, rental value, competing sites, rent-to-revenue ranges and other factors specific tenants use for site selection and renewal decisions.

Financing is readily available

“Access to capital is robust,” Linden said. “For public real estate investment trusts (REITs), there’s the equity markets. You also have the unsecured debt market for the larger players, as well as the secured debt market and mortgage financing, which is readily available.”

Non-recourse financing is also available through life insurance companies and other lenders, said Hutton. “In the past, there would be some separation between banks and non-resource lenders in terms of interest rates, but I’m seeing those neck and neck.”

The current low interest rates certainly help make single tenant properties an attractive investment. Depending on the tenant, guarantee, lease term and location, financing is available as of today at rates as low as 4% for up to 70 percent of the purchase price. If you acquire a dollar store at a 7% cap rate, the effect from the positive leverage of 300 basis points on the debt portion will increase returns dramatically.

Interest rate effect on cap rates

Cap rates have continued to fall, especially for triple net, 15-year leases, Strome said. Cap rates depend on a variety of factors, including the kind of tenant, lease terms, location and demographics. Auto parts stores tend to have cap rates between 6 and 7 percent, while drug stores are lower at 5 to 6 percent, she added. Dollar stores fall in the middle at around 6.5 to 7 percent.

With interest rates expected to rise, the effect on cap rates remains unknown. “We’ve all enjoyed historically low cap rates and while interest rates will creep up over the next year, I don’t really see cap rates following rapidly behind them,” Hutton said.

However, Linden feels cap rates will rise more quickly. “In net lease, we have long-term leases with fixed rental rates so we aren’t able to monetize on the improving economy,” Linden said. “The only way to keep up with other investment classes will be for cap rates to rise as well.”

Strome believes cap rates will increase. “Cap rates will increase some as interest rates rise,” Strome said. “But not as fast as rates rise, mainly because of the strong demand for mailbox money. There is always something out there creating uncertainty. Single tenant properties offer the safety many investors find attractive.”