However, as cap rates continued to expand for much of the commercial real estate industry in 2010, research firm Boulder Group out of Northbrook, Illinois recently released a report on first quarter numbers. The news was promising.
Boulder Group found that for the first time in a long time, single tenant net lease cap rates, across the retail, office and industrial sectors, compressed in the first quarter of 2011. Of course, this is great news for the commercial real estate industry as a whole. Per this GlobeSt.com article:
Randy Blankstein with the company tells GlobeSt.com that cap rates had been climbing in all asset types for the past year, but now the trend looks more like a plateau. He says interest rates will likely rise, and sellers and developers will put more product on the market, keeping the cap rates at about even the rest of the year.
He says net lease demand has come from investors who are in pursuit of a focused investment strategy heavily concentrated in the bank and drugstore sectors, and ground leases. “Geographically, the top 25 ‘NFL’ metropolitan areas are a huge share of activity, where there’s overwhelming demand for core offerings, and only a little investment going after second- and third-tier markets. The spreads will continue to increase as financing gets better.
However, I take issue with what Mr. Blankstein suggests. Most investors of single tenant net lease properties have a different strategy that the vast majority of other commercial real estate investors. While most others focus on ways to grow rents or limit expenses, single tenant net lease deals avoid those two issues because of long term fixed rent leases and all expenses being passed through to tenants.
Most single tenant net lease property investors’ concerns lay around the credit of the tenant, location, how much term is left on the lease, and whether or not the rent being paid is under or over market, as ways to establish value.
Obvious issues like supply and demand will also play a significant role when it comes to cap rates and ultimately value, which we saw in the last few years as many investors pulled their dollars out of real estate altogether. Yet, the fundamentals of many single tenant net lease assets did not suffer.
The issue, of course, is that very last sentence: “The spreads will continue to increase as financing gets better.” Investors typically seek single tenant net lease deals because they are relatively safe. As long as their is a good yield (i.e the spread between the cap rate and the interest rate at which they can finance the asset), they are more likely to invest.
If interest rates start to creep up, the yield will diminish unless cap rates start to expand again. Blankstein seems to be suggesting that when the availability of capital for single tenant net lease deals comes back (there has been a shortage due simply to the credit risk a single tenant deal provides by putting all of your eggs in one basket), spreads will increase because “financing is better” or “more available”. But if interest rates start to increase, that spread diminishes, and offsets the increased ability to finance deals at favorable terms.
Reprint from llenrock.com by Dave Jacobs