We are new to the BP community and very impressed by it. We would be grateful to get the opinion of the community on the impact of interest rates on RE, especially given the current economic climate.
We are currently screening potential NNN commercial properties for purchase and would like to understand the impact of an interest rate hike. With mortgage interest rates at 3%, a 5% CAP rate is decent. If interest rates rise to 5%, a buyer would probably ask for a 7% CAP for the same property. Disregarding appreciation due to time passage, the CAP rate moving from 5% to 7% is going to bring the property valuation down by ~29%, unless of course one manages to increase the NOI. However, most leases last 10-15 years and have fixed increases (typically 10% every 5 years) that do not adjust based on interest rates or inflation. If in 5-10 years we want to sell we might have to do so at a low price to be competitive. If we refinance (typical commercial loans do not last more than 10 years) we may find that we are struggling to make mortgage payments for the new loan with the increased interest rate. So it seems that the buyer bears all the risk of rising interest rates. It also seems that in this scenario, the only way one could still profit is by having bought a property that is appreciating very fast. Do you agree with the above analysis, or is there something we are missing here? Any words of wisdom or thoughts on the above would be highly appreciated.
@Peter Goran Pete, I wouldn’t use the cap rate the way you are. I use the cap rate simply to decide whether to even pursue a property further.
It’s one of my cut lines for qualifying properties. For instance, my last NN STNL purchase started with me investigating properties of a certain asset class with a 6% cap. Once there, I could subtract the debt service and capital improvement set-aside (note this was a NN) to determine my net cash flow.
I’m not a big player in this game but earned, part-time, an early retirement with the ability to do pretty much anything I want. Pay attention to net cash flow.
This generally has me very concerned with Commercial. Most leases as stated are long term with fixed (non-CPI based) escalators. These leases have been built around the theory that inflation was going to hover at a 2% indefinitely. Well..... throw that theory out the window now.
Couple that with the COVID issues with Office and Retail and Commercial (ex industrial) goes from bad to worse. We are just seeing the tip of the iceberg of leases rolling off and space going vacant.
Now add in refinancing risk with higher rates. The picture goes from worse to terrible.
Caps haven't budged to reflect the new reality..... Not sure when it happens, but it has to a some point.....I think..
Thanks for your replies. It appears that given the current economic climate, properties where the owner can pass the effect of interest rates and inflation to the lessee may present less of a risk.
I have been doing the business of commercial about 18 years now. I am an expert in the NNN space single and multi-tenant and review about 1,000 properties a week nationally. I have clients all over the country and I am also an investor myself and owner of my firm.
Typically before going into these types of questions potential clients go to my site and fill out my form. I have to know information about them to see where they are at in life for age, working for someone or owning a business, and what type of cycle (wealth creation, wealth stabilization, wealth preservation).
So you can take what I say here in a general view and not a specific view.
People not experts on the space can have a skewed view of what they believe.
Retail not going from bad to worse. I am having my best years EVER in the business as a broker. Lots of people made millions owning houses and apartments and come to me saying they are glad it paid off for them but they never want to do it again. They want to go passive now and have less headache they do not care what the yield is.
Now the risk profile of a NNN STNL tenant is key to your investment. A Popeyes franchisee tenant of 20 locations going for a 5.0 cap rate in a good area is not the same value as a Davita NNN that is BBB- or better rated by Standard and Poors and a billion dollar company with strong guarantee on the lease. Also a Davita in a rural location is way different than one in a strong suburban to urban core are for current and future dirt value.
For NNN about the best we do is 10 year fixed with 30 year amortization in the 3's for interest rate but NOT 3.0 rate. My goal with most clients is to try and hit 175 basis points to 200 spread between debt and interest rate with national investment grade credit tenant in a good location.
My last 5 closings we all went up against 3 to 5 other offers and won them all because I have a reputation in the business. Owners and listing brokers want SURETY of CLOSE. They do not want buyers that are wafflers or flakes looking at their properties. Often buyers look at NNN with unrealistic expectations. Sure so many years ago cap rates were higher but debt was 100 to 200 basis points higher as well so yield was about the same. With Coronavirus happening many people across the world have re-evaluated money versus time. They would rather take a passive all in return with mortgage paydown of around 10% annually then a headache at 15% to 20%. This tends to be even more true as people either get older in age or net worth increases into 10 million or over. For some of my clients they feel this way at 5 million net worth.
Neighborhood small balance commercial is expanding in warm belt states like crazy right now. I am very bullish on retail and buying it up as fast as I can. I buy value add for repositioning ( lease coming due, dark buildings, outparcels of land to develop). Tenants see now as a opportunity to get great lease terms expanding.
For instance if a ground up property costs me 200 a foot to build plus land, legal, and real estate commission fees to sell then I need to get a certain lease rate per ft to make it work. Conversely if I have a well located building I am buying existing for 60 a foot and put 30 to 40 into it for 100 a foot with free land cost basically then I can start rent lower to tenant and still make a ton of profit.
In smaller markets that could hurt other properties with higher in place rents but in stronger markets me getting it cheaper and leasing up cheaper should not affect the market much because tenants will pay up for the best sites.
I have talked to thousands of investors over the years and instantly know if NNN is right for them or if they are wasting their time.
I could post a whole book on this subject but do not have the time to go into more detail.
With interest rates potentially rising, now is a good time to lock in a long term fixed rate on financing. Typically if the remaining lease term is at least 10 years, then we can lock a loan interest rate for 10 years. For properties with investment grade tenants and 15+ years remaining lease term, then 12-15 year fixed rates are possible on the financing. If the lease has rent increases, the owner's cash flow rises with the rent bumps while loan payment remains constant for term of the loan.
I have always added in a general rate of inflation when building a proforma for potential opportunities. The CPI isn't always a great measure of inflation... as we know. But including it in your underwriting will give a more accurate stabilized NOI
@Peter Goran Pete, I wouldn’t use the cap rate the way you are. I use the cap rate simply to decide whether to even pursue a property further.
It’s one of my cut lines for qualifying properties. For instance, my last NN STNL purchase started with me investigating properties of a certain asset class with a 6% cap. Once there, I could subtract the debt service and capital improvement set-aside (note this was a NN) to determine my net cash flow.
I’m not a big player in this game but earned, part-time, an early retirement with the ability to do pretty much anything I want. Pay attention to net cash flow.
I think there is a lot to unpack in your first post. There are some statements I tend to disagree with, but ultimately rising interest is a risk, but buyers can also hedge by fixing their debt terms. If we experience severe inflation, you will be able to pass variable costs to the NNN tenant (reducing cash flow risk) and you will own an asset that costs more to re-build.
When leases expire, you raise rent, its the easiest way to increase NOI and thus value. Bottom line, there are a lot of factors in the valuation of NNN, and its not nearly so simple as cap and interest rate.
Do you want to hold a tangible income producing asset during inflation? Or do you want to hold cash?
You need to separate cap rate from any discussion regarding interest rate. Debt service is not part if NOI and it cannot be added haphazardly to the equation.
Would you raise or lower your price based on what a borrower gets for a rate? Obviously not. Some borrowers get 3%, others get 5%. it has nothing to do with what you charge for a property.
What WILL happen is a reduction in the pool of buyers, but that’s ok. You’ll be called by more professional buyers who understand the commercial market.
