Navigating Net Lease Investments in a High-Interest Rate Environment: Strategies and Opportunities

Introduction

As interest rates climb, many investors are re-evaluating their strategies, particularly in the real estate sector. Net lease properties, known for their stable income streams and lower management responsibilities, are attracting attention. This article explores how net lease investments can thrive in a high-interest rate environment and offers strategies and opportunities for savvy investors.

Impact of High-Interest Rates on Net Lease Properties

High-interest rates influence real estate by affecting property valuations and investor demand. When interest rates rise, the cost of borrowing increases, generally leading to lower property values as buyers adjust their price expectations. This cycle of Federal Funds Rate increases by the Federal Reserve has been no different.? While borrowing costs may be elevated causing lower cash flows at present, the value of the real estate has also declined offering attractive entry points.? For net lease properties, this means investors must be strategic in their acquisitions and consider long-term value rather than short-term gains.

Strategies for Success in a High-Interest Rate Market

With over 30 years in experience in Commercial Real Estate, I have seen several interest rate cycles. Here’s some strategies to keep in mind:

1. Diversify the Portfolio. ?Diversification is and will always be a key strategy. By spreading investments across various property types, geographic locations, and industries, investors can mitigate the risk of a downturn in any particular region or industry.?? We know that higher interest rates put pressure on all business, albeit in different ways.? Diversification helps cushion against the negative effects caused by a high interest rate environment.
2. Focus on High-Credit Tenants (Think Fortune 500 Companies). ??Properties leased to high-credit tenants, such as national retailers and government agencies, offer more security. These tenants are more likely to weather a high interest rate environment and meet their rental obligations, ensuring a steady income stream even as borrowing costs rise.
3. Ladder Debt Entry Points and Seek Flexible Prepayment Terms.? Never is the saying that you “marry the property and date the debt” more true than in times of high interest rates.? Given the attractive entry points (high cap rates) presented by a high interest rate environment, the choice is often whether to buy an asset and accept a higher interest rate loan, or pass on the opportunity waiting for lower interest rates.?? Unfortunately, once interest rates decline, property values generally increase reducing the appreciation potential.?Since this happens over time and not all at once, buying property over a period of time (essentially dollar cost averaging both debt and acquisition prices) can yield an attractive portfolio, particularly if cap rates decline slower than borrowing rates which is often the case.? It can also be an advantage on a long-term basis to acquire the property at a low point in value, and look for loans that either have a floating interest rate, will permit refinancing as rates improve, or are of a shorter duration.?? ?
4. Focus on Long-Term Leases and Built-In Rent Escalations. Long-term leases and those with built-in rent escalations provide predictability and more value. ?Longer lease terms add value in the net lease environment.? Since these agreements often include periodic rent increases as well, that will help offset the effects of inflation over time.

Opportunities in the Current Market

Net Lease properties occupied but high-credit tenants prove attractive investments even in a high-interest rate environment.

1. Identifying Undervalued Properties. High-interest rates lead to higher cap rates and reduced values.? The same high interest rates cause some investors to exit the market. This creates opportunities for those who can identify and acquire these properties at a discount, positioning themselves for future appreciation.
2. Benefits of Stable, Predictable Cash Flows from Net Leases. Net lease properties are valued for their stability. In uncertain economic times, the predictable cash flows from these leases become even more attractive. Where rents on multi-family units and other commercial properties rise and fall over time and expenses are subject to inflationary pressures, net lease investments maintain a stable income stream free from those issues.
3. Net Lease Structure Protects Against Inflation in Operating Expenses.? Since most Net Lease properties are triple net leases, (the Tenant pays the property taxes, insurance and all maintenance costs) the Tenant pays any increased property operating expenses over the term of the lease.? Inflation has recently driven up insurance, maintenance and other operating expenses but net lease landlords avoid a decrease in operating income due to these inflationary pressures.? ?
4. Exploring Secondary Markets with Less Competition. Secondary but growing markets often present less competition and better cap rates. Investors willing to look beyond primary markets may find lucrative opportunities in these areas with quality tenants. These markets can offer higher yields and potential for growth as they develop.

Expert Insights

Industry experts emphasize the importance of due diligence and market research. Investors should focus on tenant creditworthiness and lease terms. High-credit tenants and long-term leases with escalations where possible, are crucial to a successful investment strategy in a high-interest rate environment.

Conclusion

Navigating net lease investments in a high-interest rate environment requires strategic planning and a focus on long-term value. By diversifying portfolios, targeting high-credit tenants, and seeking opportunities in undervalued properties and secondary markets, investors can find success. The stability and predictability of net lease investments make them a compelling option even as borrowing costs rise.