Given the volatile economy and the variations in published reports, triple net lease investors have been asking us for advice, trying to guess where cap rates are heading, and wanting to know if NNNs are still viable investments. As always, we do our best to educate and avoid conjecture; we focus on what’s happening right now and look at historical data that might point to a particular pattern, and advise our clients based on their unique goals.
To help commercial real estate (CRE) investors understand current cap rates and market trends and make informed decisions, in this article we answer:
- Single Tenant Triple Net Lease Cap Rates 2022: What This Means for You
- How Are Cap Rates Affecting the Market?
- What About the Cap Rate Spread?
- Are Triple Nets at Any Cap Rate a Hedge Against Inflation?
Cap Rate Update: Triple Net Lease Investment Market Trends
Single tenant net lease capitalization rates (cap rates) remain relatively stable despite the Federal Reserve raising interest rates by 50 basis points in May and another 75 in June, the inflationary economy, and investing fears. The good news is that at the start of Q3, a few types of triple net lease properties have come on the market with slight cap rate increases, while most range between 4.50–5.75%.
No matter where average cap rates sit, it is important to point out that triple net cap rates can range greatly based on the location. For example, some investment-grade properties in overlooked states, such as Missouri and North Dakota, can have higher cap rates than the more popular, high-demand areas, such as Florida and Texas, yet the majority are corporate-guaranteed, long-term leases with low risk, just like anywhere else.
Jason Simon, Westwood Net Lease Advisors Vice President, explains, “We’ve recently sold Dollar Generals in southern states at 4.40% and 4.50% cap rates, while some Midwest and East Coast Dollar Generals have come in at 5.10% to 5.50%. Does that mean one is better than the other? No. The value of the investment depends on many factors, including your goals.”
“We cannot emphasize this enough – the cap rate is only one measure for determining the risk and quality of the investment,” Simon says. “In the case of triple net lease properties, the cap rate does play a critical role in the overall internal rate of return (IRR) but also includes a number of other factors, such as the tenant, location, depreciation, and lease terms, which typically include rent escalations over the course of ten to twenty years. Also, there are zero landlord expenses when you own absolute triple net lease properties. Other types of commercial real estate may offer 7.00% to 9.00% cap rates, but when you calculate actual risk, management, and expenses, your income and IRR can be greatly reduced.
When buying an absolute triple net lease property with cash, cap rate compares the purchase price of the property to the income (rent) it generates. Therefore, your ROI is simply the cap rate, or rent received, as there are typically no landlord expenses.
How Are Cap Rates Affecting the Market?
Despite compressed cap rates and higher interest rates, there is still a lot of competition for essential triple net lease investments. Cap rates are not stopping 1031 exchange buyers looking to trade out of high-maintenance, less reliable real estate, investors leaving the stock market, and those new to the market who want dependable income-producing investments. These buyers are keeping the market busy.
We are also seeing an increase in the number of all-cash buyers stepping forward seeking slightly better returns for using their cash. And sellers have begun contributing to the speed of sales; many are willing to negotiate to meet buyers where they need to be to accelerate closing the deal.
If you’ve let compressed cap rates slow your triple net investing decisions, we want to assure you that, depending on your situation, cap rates need not be a deal-breaker. When you work with an experienced Westwood Net Lease Advisor, we can assess your financial goals and work with you to find the triple net lease property that fits your objectives. We wouldn’t want to see anyone miss an opportunity to invest over something that might not largely affect the bottom line.
What About the Cap Rate Spread?
Moving into Q3, lower-priced triple net lease properties are seeing slightly less cap rate compression than higher-priced properties because they tend to attract cash buyers. Remember, the advertised cap rate on a triple net lease property is calculated on an all-cash basis and is just one measurement of the equity return on investment, as Simon mentioned earlier.
By contrast, investors who want higher-priced net lease properties with new commercial mortgages may see reduced returns due to the cap rate to interest rate spread or the “cap rate spread.” The cap rate spread measures and compensates CRE investors for the additional risk assumed by taking on debt. When the spread widens, investors are more highly rewarded.
Since interest rates have climbed closer to average industry cap rates, and cap rates tend to lag six months or so behind interest rates, those using financing are seeing an impact on leverage. Fortunately, lenders are more willing to lend for high-quality, lease-guaranteed triple net properties with more favorable interest rates over multi-tenant and gross lease properties because they are low risk.
Historically, in economic downturns, cap rates have increased and widened the spread, thereby keeping demand for essential business properties up.
Are Triple Nets at Any Cap Rate a Hedge Against Inflation?
Yardi Matrix Research Director, Paul Fiorilla, noted a recent study by Greg MacKinnon, Research Director at Pension Real Estate Association, that found “commercial real estate performance has been good during periods of high inflation and returns are much more closely correlated to growth than inflation.” He also said, “The evidence seems to indicate that high inflation over time is a lesser problem than low growth and not critical to commercial real estate.”
Net lease investment properties offer a steady cash flow and usually outshine stocks over long periods of time. We have recently witnessed what wild stock market swings can do, leading to a total wipeout of equity, sometimes in days or weeks. The stock market investor is helpless when these situations occur and can’t get out fast enough before losses mount.
This is not the case with sensible net lease investments. A triple net lease investment’s value, at any cap rate, will not deteriorate in minutes. A strong, creditworthy tenant in a prime location with a long-term, guaranteed lease that pays you a monthly income that does not go down –– it usually goes up –– can hedge against inflation and protect you from market swings and any unforeseen challenges in the economy.
Additionally, tax advantages, such as a 1031 exchange and different types of depreciation, and low/no maintenance or landlord expenses simply add to the value of the tangible real estate investment that can be sold at any time, usually at a profit.
Westwood Net Lease Advisors have helped NNN buyers through recessions and can say with confidence that triple net lease investments are the CRE least impacted by the economy. They are a practical hedge against inflation. Recession-proof, pandemic-proof essential retailers, medical clinics, fast food, gas and convenience stores, and early childhood learning, for example, are needed as much or more in a down economy than other business types, which speaks to the low-risk nature of triple net ownership.
To maintain a certain percentage of wealth against the fluctuations of stocks and bonds, it’s wise to diversify with triple net lease investments.
To Wrap It Up –– The Importance of Cap Rates to your NNN Investment Strategy
Commercial real estate cap rates are an important initial metric for providing an idea of an investment’s risk. Advertised cap rates for reliable NNNs tend to be lower than gross lease real estate because there is less risk. There are also fewer expenses and less maintenance (if any at all), and you own a tangible asset, usually on prime real estate, that can be sold at any time. Absolute triple net lease cap rates are only one measurement of an investment’s risk and profit potential, and often have little to do with the actual IRR, which can range between seven and nine percent once all factors are calculated.
It is no secret why successful investors diversify with dependable, income-producing net lease real estate to hedge against inflation and stock market swings. Triple net lease properties are a profitable, worry-free investment that often becomes more valuable during inflation.
If you’d like more in-depth information on cap rates, the current market, and which type of triple net investment would be best suited to your goals, please reach out for a no-obligation conversation. Our buyer representation is free. 314-997-5227.
