Interest rates are expected to rise throughout the year, starting in March. This increase will impact triple net lease interest rates. Predictions range from three rate hikes totaling 1% all the way to seven rate hikes totaling 4%, and even more in 2023, depending on inflation. Because interest rates have been historically low, the estimated rate increases are not likely to make or break commercial real estate deals, especially in certain markets, like essential retail.
“At the Mortgage Bankers Association (MBA), the general belief is that even with higher interest rates, strong interest from both borrowers and lenders is likely to continue to drive increases in lending and commercial and multifamily mortgage debt in 2022.”
A small interest rate hike within the next few weeks is possible, but not expected to make any ripples in the lending habits of banks and financial institutions. However, triple net (NNN) lease buyers, if you are planning to invest this year, now is a good time to do so.
Here’s what you need to know.
Triple Net Lease Interest Rates Are Rising: Here’s The Effect on Buyers
Rising interest rates and fluctuations can be favorable, slightly affect your mortgage plans, or not matter at all when triple net investing. Since triple net leases are pre-set for 10 to 15 years, inflation, interest rate hikes, and any rising costs are often covered with built-in rent escalations.
These tangible assets are known to retain their value in both up and down markets and if rates increase due to economic growth, NNN investments can benefit. Historically, cap rates rise gradually and minimally with interest rates, lagging about three to six months behind, depending on various factors, mainly the supply and demand curve. Therefore, interest rates have minimal effect on most NNN buyers.
“A recent study found commercial real estate performance has been good during periods of high inflation and returns are much more closely correlated to growth than inflation.” – Greg MacKinnon, Research Director, Pension Real Estate Association
Planning on NNN Financing? Purchase a Triple Net Now to Avoid Increasing Interest Rates
Triple net lease buyers and those using the 1031 exchange who need financing, we recommend purchasing as soon as you can, while NNN interest rates are still low and cap rates are in the 4.50–6.50% range, so you achieve the highest cash-on-cash (CoC) return possible.
Although interest rate changes do not typically affect cap rates right away, some lenders have already begun to inch up interest rates in preparation for the coming Federal Reserve rate hikes.
Here are the main reasons to buy a NNN property now:
- The NNN market remains tight with reliable, higher-cap-rate properties coming under contract sometimes within minutes of being advertised.
- Although triple net lease market strength is not directly and immediately influenced by interest rate movement, a higher interest rate can slow your ability to pay down the loan and impact your IRR.
- As interest rates rise and cap rate increases lag, this can narrow the cap rate to interest rate to spread, potentially affecting your CoC return.
- When obtaining NNN financing, lenders look at the cash flow in relation to debt yield, which can also be affected by higher interest rates.
Let’s look at the cap rate spread and cash flow related to debt yield a little closer, so you gain a better understanding of how rising interest rates may influence your triple net investment’s cash flow.
Cap Rate to Interest Rate Spread
First, it’s important to note that an advertised cap rate on a triple net lease property is calculated on an all-cash basis. It signifies the level of risk and is just one measurement of the equity return on investment. Other calculations and variables also affect a triple net investment’s outcome, including the cap rate spread.
The “cap rate spread,” or cap rate to interest rate spread, measures and compensates commercial real estate investors for the additional risk assumed by taking on debt. If the spread widens, as it has over the last few years, investors are more highly rewarded.
“When interest rates change, cap rates tend to be slow to catch up, and when they finally do, it’s usually only partially. In the 13 years I’ve been a triple net lease advisor, even during the Great Recession, NNN cap rates have stayed reasonable and unchanged for long stretches of time, mostly between 4.50% on the low end and 7.00% on the high end, with some exceptions, of course,” said Chris Schellin, President of Westwood Net Lease Advisors.
When interest rates rise enough to make a difference (around one percent or more), the cap rate spread may narrow temporarily, but this is not predicted anytime soon.
Cash-on-Cash (CoC) Return & Interest Rates for Triple Nets
Your CoC return is the amount of cash you receive (rent minus debt service) divided by the amount of cash initially invested. When you take out a commercial loan to finance your triple net property, the interest rate on the debt can affect your CoC and the long-term value of the investment. With all things being equal, a higher interest rate can lower your CoC return, and a lower rate can increase it.
For example, if rent earned is $110,000 and your debt service is $50,000, your cash flow is $60,000. If your down payment was $1,000,000, your CoC return would be $60k/$1mm = 6% cash-on-cash.
If the interest rate were half a point higher, that $50,000 in the example might become $55,000, which would give you a 5.5% COC return instead of 6%.
Cash Flow Related to Debt Service or Debt Yield
Another figure you need to know when securing a commercial mortgage is the cash flow related to debt service or your “debt yield.” Lenders must ensure the property’s NOI covers its operating expenses and debt payments by about 1.25 times (the debt service coverage ratio – DSCR).
When interest rates increase, so too does the amount needed to cover debt payments.
In Any Economy, Triple Net Commercial Real Estate Offers Least Risk
Historically, no matter what the economy is experiencing, triple net property investments are known to be the least risky of the commercial real estate market. These property types (retail, medical, child care, fast-food, QSR, auto parts, drug stores, convenience stores) have recently come through the worst modern-day economic and health-related crises, and they are stronger for it.
NNN properties are most often leased to investment-grade tenants that guarantee the lease for up to 20 years – for example, Dollar General, Walgreens, Taco Bell, Montessori, and 7-Eleven – and provide essential, recession-proof, pandemic-proof goods and services.
Triple nets offer predictability and surety of income, tax opportunities, and diversification within the market that builds wealth. Their reliability keeps mortgage interest rates lower than gross lease property rates, and cap rates consistent, in the range of 4.50–6.50%. They offer a potential IRR that rivals other types of investments (7–10%) without the daily worry of maintenance and value fluctuations.
To Wrap it Up – Interest Rate Increases on Commercial Triple Net Lease Property Investments
Despite minor interest rate fluctuations and fears of rate surges, commercial triple net lease property cap rates have not changed dramatically in decades. This allows us to confidently satisfy both the most conservative and aggressive triple net lease investors, and instill peace of mind in those who are searching for their first or next NNN investment.
Rising interest rates throughout 2022 should not make a huge difference in the NNN market right away, but they may change your investment strategy. We highly recommend you purchase a NNN as soon as you can to get the most ideal property for your goals, avoid any economic unknowns, and maximize your CoC.
Begin Your NNN Property Search Today, at No Cost to You
To locate the most ideal triple net property for your financial and lifestyle goals and have the best buyer representation, from before the property search through closing, engage an expert triple net lease advisor from Westwood Net Lease Advisors. We’re here to help you with every step of the process, including sourcing reputable lenders with competitive interest rates, at no cost to you. Contact us today, with no obligation, to learn more. 314-997-5227