How Rising Interest Rates Are Impacting NNN Retail Properties
For many novice commercial real estate investors, triple-net (NNN) leased retail properties have long served as a point of entry into the asset class. Typically, NNN retail properties are standalone buildings featuring one, or occasionally several, retail tenants and the properties are usually unencumbered by virtually any responsibilities on the part of the landlord.
As Andrew Bogardus, executive director in the net lease group at Cushman & Wakefield described it, "if there's graffiti, or if the roof leaks, the tenant is not calling you. They're taking care of it themselves, and you're still getting your check every month."
The ease of these assets makes them particularly appealing in low interest rate environments, when investors find it difficult to achieve meaningful yields through other stable investment options, such as government bonds.
But how does the market for NNN retail properties evolve when interest rates rise, and suddenly the 5% cap rate on a Dollar General in rural Louisiana is competing with a comparable return on a six-month treasury note? And what should investors look for when they're surveying the vast and diverse array of NNN leased properties available in the market?
Bogardus walked LoopNet through both the basics of NNN retail properties, as well as their current state of play.
What to Look for in a NNN Leased Retail Property
According to Bogardus, smaller investors pursuing NNN retail properties are often seeking a 1031 exchange opportunity. They are perhaps disposing of a more labor-intensive property - "a single-family residence they rent out or a four-unit apartment building that they've been managing themselves" - and they are looking to acquire something where they can just "collect a check" each month.
Or, as Bogardus termed it, "mailbox money."
From banks to automotive chains, there is a NNN retail property for almost every kind of investor. Some of the most common types of retail tenants occupying these properties include bank branches, quick service (or fast food) restaurants, automotive supply stores, drug store chains, supermarkets and discount retailers.
Investors interested in acquiring one of these assets will want to take into account the general location of the property. Ideally, it should be in a high-visibility, high-traffic area surrounded by complimentary retailers. Big name, national retailers will generally garner the most interest from investors and be offered at the lowest cap rates; but even among those tenants there is a hierarchy. Bogardus said that trendier, more popular users - say a Chick-fil-A or In-N-Out Burger - will command more attention and higher prices than their less popular brethren (think Arby's or Sonic Drive-In).
Leases on NNN retail properties are typically long-term - 10-20 years is fairly standard - with regular increases on an annual basis. However, investors will want to be mindful of how much term is left on the lease; the more term that remains, the more desirable the property usually is, Bogardus explained.
And then there's the question of "Who signs the lease?" As Bogardus rhetorically queried. Bogardus said that investors need to understand if their prospective property is leased to a corporate owned store or a franchisee. Because of their high credit stature, corporate-owned locations are considered to be preferable.
Understanding the stability of the current tenant is key for NNN retail investors, because the one responsibility owners do have is leasing the building again should the existing tenant vacate the premises.
The Current Market for NNN Leased Retail Properties
As one might expect, the rise in interest rates - which has elevated the yield on any number of stable investment options - has profoundly affected the market for NNN lease properties.
"We've seen demand since about September [2022] fall off significantly," Bogardus said. "It's been a lot slower."
As Bogardus explained, before the rise in interest rates, investors could expect to secure a loan for a NNN retail property in the range of 3%-3.5%. But in the current environment, the cost of debt has risen dramatically and quickly, and now investors are looking at interest rates between 5.75% and 6.25%.
"So, the cap rate needs to go up to get the same cash-on-cash returns," Bogardus explained.
But cap rates on NNN retail properties have remained surprisingly stubborn. Bogardus indicated that most institutional investors are now seeking cap rates between 6% and 6.5% on these properties, but sellers are still locked into the notion of achieving cap rates around 5%.
"We have a big disconnect," Bogardus remarked.
That disconnect is representative of a scenario that has been playing out in real estate across asset classes and geographies, where sellers have been reluctant to capitulate to the current interest rate environment and accept the impact it has had on cap rates.
The effects of that divide are perhaps even more keenly felt in the NNN world, as most NNN buyers are less interested in long-term appreciation or potential future upside and more concerned with achieving a stable, consistent return. While NNN retail properties undoubtedly present fewer risks for owners than many other real estate assets, the biggest threat to returns - an unexpected vacancy - still exists; so, why take that risk when a similar return can be achieved through other means?
Nonetheless, Bogardus believes it's just a matter of time before cap rates realign with interest rates. "Once the interest rates stabilize, then sellers can figure out where they need to be on the cap rate."
Until then, Bogardus noted that buyers seeking a 1031 exchange are still very active in the NNN investment market. "They want to defer the taxes, and so they're trying to buy a property with a long-term lease [and a] national tenant."
He also added that properties occupied by those aforementioned, more popular and stable retailers are still trading more briskly. Whereas if it's a retailer "that doesn't have as good of a reputation, or maybe it's a franchisee instead of a corporate-owned store, then the cap rates need to go up."
This article was updated on 12/12/2024
