The tight and highly competitive net lease market may see a slowing of activity due to a recent rise in interest rates, a trend that some expect to continue for some time to come.
The rate for the 10-year Treasury note has been rising since mid-May, swaying the dynamics of net lease transactions. In the past few decades, hikes in rates have been relatively rare and brief. The most recent increase “clearly impacts single-tenant net lease transactions,” says Bill Hughes, senior vice president and managing director at Marcus and Millichap Capital Corp. in Irvine, Calif. The impact is more pronounced on the pricing of investment-grade properties that have lower cap rates, Hughes says, though other properties may also see prices move.
“You may see a slowdown in investment grade for a few weeks until both sellers and buyers accept the new world,” Hughes says of the upswing in rates. “I think they will come back together.”
Effects of the rate hike may spread throughout the network of net lease stakeholders. Developers may see profits fall, and “you've got to wonder whether the economic dynamics for those companies will remain the same and whether they’ll continue to be as aggressive in developing properties and expanding their product line,” says Hughes.
“If interest rates go up, our borrowing costs go up, and we’d like to maintain a certain spread and profitability,” says Gregg Seibert, senior vice president of investments at Spirit Realty Capital in Scottsdale, Ariz.
Eventually, buyers and sellers will come to absorb the impact, and landowners and the construction industry will feel ripples as well. “It’s going to have some multiplying effect on the market,” Hughes says.
The effect has already become evident on stocks of net-lease REITs, such as National Retail Properties and Realty Income Inc. Both have seen declines over the past weeks. Stock values of the five largest net-lease REITs fell 11 percent from May 21 to June 18, according to the Wall Street Journal.
A June 18 Wall Street Journal article highlighted the decrease in stock values and cited concerns among some investors that REIT managers may be challenged to attract new tenants in the event that a retailer could vacate numerous properties.
“There are a lot of new companies in this space that are not time tested,” Jerry Ehlinger, a chartered financial analyst and seasoned member of Deutsche Asset & Wealth Management’s RREEF real estate division, said in the article.
In the longer term, most economists expect the Federal Reserve to slow down on quantitative easing later in the year, says Hughes. It’s likely that the market already reflects that expectation, but even greater pullback could occur if the economy continues to grow into 2014, and interest rates could climb even higher.
“I think everyone believes that in 2014 we’re going to see a continuing increase in interest rates,” Hughes says. “That will put additional strain on values, particularly in investment-grade single-tenant transactions.”
The lowest-price products with the lowest cap rates are likely to feel the greatest impact, Hughes says, with investors eventually adjusting to the changes and resuming trading after accepting the new circumstances.