Commercial Investment Real Estate May/June 2017 - Page 16

FINANCING FOCUS In Sync Triple-net leased properties are closely hewing to 10-year Treasury note rise and fall. Will this trend continue? or the last fi ve years, cap rates have been compressing from an average of 7.19 percent in 2010 to a low of 6.35 percent shortly before the 2016 U.S. presidential elec- tion. This has been due primarily to falling interest rates, which refl ects the historically low rates on the 10-year Treasury note. In the fi nancial realm, the 10-year Treasury is the bench- mark rate on which many assets either directly or indirectly derive their value. Since triple-net leased properties with investment-grade, credit- rated tenants are much closer to fi nancial transactions than many real estate investments, it makes sense to expect these properties will react more to swings in interest rates. However, research shows triple-net transactions have traded in a fairly tight range of 350 to 540 basis points above the 10-year Treasury during the last several years. This compares to investment-rated corporate bonds, which are priced based on the 10-year Treasury with spreads closer to 100 to 150 basis points due to less risk and greater liquidity. The spread above the 10-year Treasury bill is just a premium attached on the required rate of return of commercial real estate buyers to properties. It is largely a function of real estate’s relative illiquidity as compared to bonds. This compensates buyers because they cannot turn the prop- erty into cash as quickly as they can sell the bond, resulting in more market risk. For example, CVS Health, which is rated by Moody’s as Baa1, is selling at a 6.34-percent cap rate, while Dollar General with a Baa2 rating by the same agency is selling at a 7-percent cap rate. Other factors come into play, such as lease terms and conditions such as length of term. F 14 May | June 2017 The spread widens and narrows as a function of supply and demand of triple-net assets relative to the 10-year Treasuries. The fourth quarter of 2016 saw the spread narrow considerably. Rather than demonstrating an increase in demand for NNN assets, however, this difference was more likely to be the time lag between interest rate moves and their effect on property values. Usually, more than 60 days elapse before commercial real estate professionals experience transactions closing that refl ect the new interest rate changes. Even before the 2016 U.S. presidential election, the members of the Federal Reserve had indicated that a rate hike was likely. The 10-year Treasury note had largely refl ected the market until an unexpected rally after the election caused an almost 60 bps increase above pre-election levels. As the triple-net market reacts to the higher 10-year Treasury, cap rates will rise to maintain the proper balance of the risk-based premium. As the triple-net leased markets stabilize, commercial real estate professionals will see a new equilibrium close to the historical spread. Should the Federal Reserve continue with gradual increases in interest rates, the market will adapt by making slight adjust- ments, which will be refl ected in the movement of cap rates. However, most analysts are predicting that 2017 will see two interest rate adjustments by the Federal Reserve in response to rising employment and higher infl ation rates. It will take time for the triple-net transactions currently in due diligence to work through settlement and for the newer compa- rable sales to start to show the minor corrections. In the current economy, a rate hike would not cause much change in cap rates. COMMERCIAL INVESTMENT REAL ESTATE by Ryan Lorey, CCIM