Stable Interest Rates & Strong Market
Retail sales continued their growth, with an increase of 1.6% in 12 of 13 categories in March 2019, and another slight rise in April. Commercial real estate (CRE) interest rates remain steady at 4.5-6.5%. A strong economy, stable real estate prices, low interest rates, and steady cap rates all come together to make this one of the most favorable times to invest in a triple-net (NNN) lease property. Still, many investors question the importance of cap rate when making a buying decision and what its relationship is to interest rates.
Cap Rates in Relation to Interest Rates
The capitalization rate, or cap rate, is the level of risk and equity return on your NNN investment. Cap rate is a very important factor in evaluating a triple-net lease investment opportunity, though it should not be the sole focus in your investment strategy. The cap rate is calculated by dividing net operating income (NOI) by the purchase price to give you a natural rate of return for a single year (excluding potential debt on the asset).
A higher cap rate means larger ROI but may also indicate a bit more risk. A lower cap rate means less ROI, as well as potentially lower risk. Please note, the cap rate is not the same as the cash-on-cash return, which is pre-tax cash flow divided by the total amount of cash invested.
If you take out a loan for your NNN property, the interest rate on the debt has more to do with the return on investment (cash-on-cash return) and long-term value of the investment, rather than your specific cap rate. Nevertheless, fluctuating or low-interest rates can affect overall market cap rates, just as they affect consumer spending at your NNN tenant’s business and economic growth.
Opinion varies on the importance of individual cap rate to interest rate correlation and the effect it has on your financial goals. There is so much more to NNN investing than these two factors.
Example: $100,000 (Net Operating Income)/$1,667,000 (Purchase Price) = 6.00% Cap Rate
How do Interest Rate Fluctuations Affect NNN?
Let’s get into more detail on interest rates in CRE, namely NNN properties. Neither interest rate fluctuations nor a loan on the property directly comes into your cap rate equation, especially if you are a cash buyer, but they can affect the outcome of your overall investment strategy.
Low-interest rates may change industry-wide supply-and-demand by encouraging developers to build new buildings and inspire buyers to enter the market to take advantage of low rates. This may drive down cap rates and create high competition for buyers in the marketplace. This demand is furthered by 1031 buyers who must buy something to fulfill their exchange and are often willing to pay a premium to lock-up.
Rising Interest Rates
If interest rates rise significantly, the economy as a whole may react. Consumer spending may slow and some NNN properties may be affected. However, if you choose a needs-based tenant, like dollar stores, fast-food, and pharmacies, even if interest rates rise, your cap rate could be higher and more stable over a tenant and/or company that may be influenced by a slowing economy.
Cap rates may adjust with interest rates, but if they do, they tend to lag 6-12 months behind, which is one reason they have not changed much. Additionally, interest rates have gone up and come back down within that time frame, leaving cap rates steady.
The Primary Cap Rate Factor – Location
Location, more than interest rates or any other factor, is what we consider the primary cap rate influencer.
- Great locations command higher rent and provide the security of being easily re-tenanted.
- They command a premium cap rate as they are highly sought after by investors seeking the safest long-term investments.
- Prime locations are often in high-density, high-income areas with good exposure along major retail arteries with strong traffic counts.
Lease term, credit of the tenant, and lease type (NN vs. NNN) are other major influencers of cap rate.
Despite interest rates hovering at all-time lows for years, minor rate increases, and fears of rate surges, cap rates have not changed dramatically in decades. This allows us to confidently satisfy both the most conservative and aggressive investors.
To Wrap it Up – Today’s Interest Rates & Cap Rates Make it a Superior NNN Market
Investing in a NNN property now, with interest rates low and cap rates stable, is a strong financial move to diversify your portfolio. At Westwood Net Lease Advisors, decades of experience have taught us that no matter where interest rates linger or the economy moves, there is typically a shortage of NNN properties because they are long-term, stable, income-producing investments. Great properties sell fast, which is why we review the national market and connect with colleagues daily to find ideal properties for our clients.
When you’re ready to start your NNN lease property search, a Westwood buyer’s advisor is here to help. Your advisor will evaluate a selection of properties and the tenants to determine an appropriate cap rate for each. Then he or she will explain the various factors that determine the cap rate value and how the properties align with your goals. Contact us today for your free consultation, 314-997-5227.