Thinking of purchasing a triple-net (NNN) lease property but not sure if you should take on debt to do so and if the cap rate to interest rate spread matters? In commercial real estate, when interest rates fall faster than cap rates, which is currently happening, higher growth in net operating income (NOI) can lead to larger spreads over the fixed interest rate, increasing overall cash-on-cash (CoC) return.
Here’s what you need to know about falling interest rates, cap rates, and cash-on-cash returns in relation to NNN investing.
A Review of Cap Rate to Interest Rate Spread & What it Means When Buying a NNN Property
The cap rate to interest rate spread (or the “cap rate spread”) and the cash flow related to debt service both influence your investment’s return on investment (ROI) and internal rate of return (IRR).
Put simply, the “cap rate spread” is the difference between the combined nationwide cap rate and the current interest rate. It is a measure of the risk-and-reward premium for commercial real estate (CRE) investing.
Knowing the current interest rate available and the advertised cap rate on a triple net lease investment, you can estimate the incremental difference – or the “spread”– in returns expected over risk-free bond returns. If the spread widens, investors are more highly rewarded, indicating greater demand for investment properties.
When you take out a loan to purchase a triple net lease property, the interest rate on the debt has more to do with your CoC return and the long-term value of the investment than the specific cap rate. Your CoC return is the amount of cash you receive (rent minus debt service) divided by the amount of cash initially invested.
Even though traditionally, the cap rate spread has little effect on the value of NNN investments, a lower interest rate can be beneficial to your internal rate of return and asset value. At Westwood Net Lease Advisors, 2021 has seen a record number of NNN transactions close with positive leverage driving actual cash-on-cash returns significantly higher than the advertised cap rates.
Cap rate is calculated on an all-cash basis and is just one measure of the equity return on investment, as many other calculations and variables also affect the outcome – one of which is the cap rate spread.
Dispelling the Myth: NNN Investments Don’t Offer Positive Leverage
One NNN opportunity is the potential for positive leverage. Many CRE investors falsely believe these properties don’t provide the option for positive leverage due to the long-term leases with fixed rent. However, when financing becomes less expensive with low interest rates and your tenant continues to pay the same amount of rent or more during an escalation period, future cash flows could increase as debt-service costs decline.
By making annual payments as a percentage equal to the return on the property, your debt essentially pays for itself, and the equity portion could provide the same return as it would in an all-cash purchase.
If you plan to purchase a NNN property with all cash or the capital gains in a 1031 exchange, with interest rates falling to record lows, you may want to reconsider. Contemplate using your cash for down payments on more than one property and financing the rest.
Given the current low interest rates, the potential to purchase additional assets that produce tens of thousands of dollars in surplus income could expedite paying down the debt, resulting in positive leverage and enhancing your investment portfolio. This creates wealth without the uncertainty inherent in other types of CRE and stocks and bonds.
To Wrap it Up – Declining Interest Rates + Steady Cap Rates = Higher CoC Returns
Declining interest rates. Cap rates holding steady. Lower-risk triple net properties garnering better interest rates than other commercial real estate. When combined, the opportunity to take advantage of an interest-to-yield rate spread could pay down a commercial mortgage faster, possibly creating a better cash-on-cash return with positive leverage and a 7–10% internal rate of return (IRR) for up to 15+ years.
But don’t wait too long to decide to invest – NNN supply is low, demand is high, and inevitably, the low interest rates we’re enjoying now will come to an end. As nationwide advisors who primarily focus on no-cost buyer representation, Westwood has a unique position in the marketplace, offering our clients a buying advantage. Pre-market and off-market triple net availabilities are readily shared with our team, providing you with the first opportunity to view these highly sought-after properties and arranging for the best financing terms possible.