Faced with rising interest rates and lingering fears of a recession – assuming one isn’t already underway, commercial real estate investors experienced a turbulent summer. While many economists had hoped recent rate hikes would temper inflation, consumer prices remained stubbornly high in August even as gas prices fell, all but guaranteeing interest rates will remain on their upward trajectory.
Reduced liquidity yields fewer opportunities to buy and sell, and investors who find attractive deals will have a much harder time financing them as lenders become more discerning.
Fortunately, not all asset classes face the same headwinds, and the historic stability of net lease properties— especially those with credit-worthy tenants in place under long-term leases—makes them a safer bet than multi-tenant properties that could see occupancy plummet during a downturn, as was the case during the pandemic. Net lease properties also alleviate much of the risk that owners normally shoulder. Triple-net-lease (NNN) tenants, for example, are responsible for utility and maintenance costs, thus bearing the brunt of inflationary pressures.
Yet just because an investor wants to trade into net lease doesn’t guarantee their ability to do so. The following factors will determine who is most likely to get deals across the finish line in the current environment.
Location, Location, Location
The old industry adage is especially relevant today as lenders become more selective about the deals they finance.
Once investors determine what type of net lease properties they would like to acquire, they must invest a significant amount of time upfront to evaluate each opportunity and identify those that offer the desired balance between risk and return. My firm specializes in net leased health-care assets, which provide essential services—many of them covered by Medicare, Medicaid or private insurance—to the country’s aging population. Notably, national health spending is expected to average 5.1 percent from 2021-2030, reaching nearly $6.8 trillion by 2030, according to the Centers for Medicare & Medicaid Services.
There are several advantages to investing in health-care properties with a net lease structure. Many house “sticky” tenants that are less likely to move because of their proximity to patients and investment in equipment that would be cost prohibitive to relocate or replace. Often these facilities must be licensed in order to operate, which also reduces the likelihood of a move and creates higher barriers to entry from an investment standpoint. Finally, while some facilities are leased to tenants that provide elective or cosmetic procedures, others deliver services that are needed regardless of economic conditions, making them more recession-resistant than properties like net leased restaurants and apparel stores that rely on discretionary spending.
Net lease assets may be a safer bet, but they aren’t foolproof.
As the borrower, your experience level will have considerable impact on your ability to obtain a loan: The stronger your track record, the easier it will be to secure funding. Newer players may need to rely on more-established equity partners that have either earned the trust of lenders or allow them to circumvent financing altogether through an all-cash deal.
In a slowing market, investors will also need to maintain realistic expectations when structuring each deal.
While many net lease properties continue to trade quickly, rising cap rates could widen bid-ask spreads, requiring patience on the part of the buyer to ensure they don’t overpay for an asset. Those who are well-capitalized can wait until there’s less competition and pricing comes down, allowing them to buy low and, hopefully, sell high.
Once they identify an opportunity, investors – especially those with less experience – should be prepared to bring more equity to the table. While loan-to-value ratios of 60 percent to 70 percent are typical on net lease deals, borrowers may need to finance as much as 40 percent to 50 percent of the deal with equity.
Despite the extra hoops buyers may need to jump through, net lease assets remain attractive to investors and financeable in the eyes of most lenders. It may be slightly more challenging for newcomers to enter the space, but those who do their homework, leverage their relationships and remain determined yet realistic in their pursuit of each deal can capitalize on market conditions that may be more favorable than recent headlines suggest.