Capitalization rates in single-tenant net lease deals are climbing

Warning signs are appearing, but the net lease sector remains stable.

The net lease property sector, awash with investor capital and coming off a record year of sales in 2021, saw a slowdown in new deals signed last year. Transaction volumes are off to a tepid start in the first half of this year as investors continue to assess the impact of rising consumer costs and interest rates.

Under a triple-net lease, a commercial tenant agrees to pay their share of property expenses, including real estate taxes, building insurance and maintenance costs, thereby reducing the risk of property ownership for investors while potentially providing attractive returns.

One important subsector of net leases, especially in the more robust US net lease market, is the single-tenant property occupied by a sole corporate user. These can sometimes result from a sale-leaseback deal and can involve real estate that occupiers feel is mission critical, or otherwise important to the continued operation of the business.

As expected, the single-tenant net lease market witnessed a fifth consecutive quarter of slowing activity, according to a recent report by capital markets firm Northmarq, which shows that across all three major property types, sales volume dropped more than 42 percent quarter-on-quarter and fell almost 63 percent year-on-year in the first quarter of 2023.

Likewise, Northmarq finds that capitalization rates in single-tenant deals have risen slightly across all three property sectors, with the largest quarterly movement occurring in industrial. Industrial properties in the current market remain very liquid and are an attractive commercial real estate asset class.

A similar survey by global brokerage Avison Young shows that while deal volume is down, capitalization rates in the single-tenant net lease medical property subsector climbed more than 116 basis points over last quarter, even as average remaining lease terms there dropped slightly over the same period. That report shows capitalization rates in single-tenant net leased convenience store transactions dropped by nearly 94 basis points over last quarter. On average though, capitalization rates remained comparatively stable.

Fixed income proxy

As higher debt costs translate to reduced buying power for some, and as overall appetite for risk abates, net lease assets continue to attract investors looking for stable returns. Leased real estate can be a good proxy for fixed income, especially in net lease deals where the tenants pay many of the costs that are typically associated with property ownership. This will prove especially true for investors who understand the effect that falling inflation could have on the market in the coming quarters, and for those that are properly diversified across regions and asset classes.

Sale and leaseback deals involving mission-critical real estate have driven much of the net lease real estate sales market of late, as companies look to leverage their own real estate portfolios for an injection of capital while working with owners to maintain some operational control of their building. Many corporations can unlock the full value of their property – as opposed to just a portion of it from new financing – with cap rates and rental payments often beating the cost of new debt.

This can prove a win-win for both the seller and the buyer, the latter of which can potentially enjoy stable, index-based cashflows in the near-term and asset-backed investment returns in the future.

Build-to-suit properties are another way for investors to mitigate risks as newer, purpose-built real estate is less likely to lose value or fall into obsolescence over the term of a triple-net lease, which can often stretch 10-15 years or more. However, construction costs do continue to rise and some lenders are shying away from the risk commonly associated with development loans.

Meanwhile, acquiring existing net-leased buildings could prove less favorable as older leases could have been structured with softer rent escalations or other terms that have fallen out of favor in the current inflationary period. Still, there are deals to be had if buyers and sellers can come to an agreement on pricing.

Health checks

One important way investors can protect their returns and mitigate risk is by doing their due diligence and checking the financial health of the tenant. The same headwinds that are impacting the commercial real estate market overall are affecting commercial tenants as well. Rising interest rates, supply shortages and changes in consumer behavior are hitting bottom lines and affecting many businesses large and small.

By all accounts, the creditworthiness of a tenant is as important as the real estate itself in a net lease deal. Real estate investors may specialize in assessing the condition of buildings in the market, but may be less adept at judging a tenant’s ability to pay its rent. In these instances, bringing in a third-party firm could prove beneficial.

In the net lease sector, owners are sharing the operational risk with the occupier. If the tenant cannot meet its financial obligations, then deals can fall apart quickly. The same care should be taken when looking at a tenant’s creditworthiness as if underwriting debt for the company or acquiring it outright. A financially healthy tenant can be the difference between years of stable returns and the headache of vacant or distressed property.