What You Need to Know About NNN Retail and Rising Rates

Recognizing the Resilient Appeal and Changing Prices

Triple-net (NNN) leased retail assets have long been a point of entry into the asset class for many inexperienced commercial real estate investors. NNN retail properties are often solitary structures with one or occasionally two retail tenants, and they are typically free and clear of virtually any landlord obligations.

If there is graffiti or a roof leak, the tenant is not calling you, according to Andrew Bogardus, executive director in the net lease group at Cushman & Wakefield. You still receive a check each month while they take care of it themselves.

These assets are especially enticing in low interest rate circumstances when investors find it challenging to obtain meaningful income through other safe investment options, such as government bonds, due to their simplicity.

But what happens to the market for NNN retail properties when interest rates increase and suddenly a Dollar General in rural Louisiana’s 5% cap rate is in direct competition with a similar yield on a six-month Treasury note? And what should investors search for while examining the wide variety of NNN-leased properties on the market?

Bogardus gave LoopNet a brief overview of NNN retail assets’ fundamentals and the present competitive landscape.

What to Look for in a Retail Property with NNN Leases
Bogardus claims that smaller investors interested in NNN retail properties frequently search for a 1031 exchange possibility. They may be selling a property that requires more work, such as “a single-family home they rent out or a four-unit apartment building that they’ve been managing themselves,” and they are seeking to buy a property where they can simply “collect a check” each month.

or “mailbox money,” as Bogardus put it.

There is a NNN retail property for practically every type of investor, from banks to auto chains. Bank branches, quick service (or fast food) restaurants, automotive supply businesses, drug store chains, supermarkets, and discount retailers are some of the most typical types of retail tenants occupying these locations.

Investors that are interested in purchasing one of these assets should consider the property’s general location. Ideally, it should be near retailers that complement it in a high-traffic, high-visibility area. Even among those tenants, there is a hierarchy. Big-name, national shops often attract the most investor interest and are provided at the lowest cap rates. According to Bogardus, trendier and more well-liked customers, like Chick-fil-A or In-N-Out Burger, will command more attention and higher pricing than their less well-liked siblings (like Arby’s or Sonic Drive-In).

The normal length of a lease for a NNN retail property is between 10 and 20 years, with yearly increments. However, investors should be aware of how much time is remaining on the lease because, according to Bogardus, the more time left on the lease, the more desirable the property will typically be.

Who signs the lease is another issue that needs to be addressed., Bogardus asked rhetorically. Investors should be aware of whether their potential property is leased to a corporately owned store or a franchisee, according to Bogardus. Corporate-owned properties are seen as preferred due to their good credit standing.

For NNN retail investors, it is crucial to comprehend the stability of the current tenant because the only obligation building owners have is to lease the property once more in the event that the current tenant vacates the premises.

The Present Retail NNN Lease Property Market
As one might anticipate, the market for NNN lease properties has been significantly impacted by the rise in interest rates, which has increased the yield on a variety of safe investment options.

Since early September [2022], “we’ve seen demand fall off significantly,” Bogardus added. It has moved much more slowly.

According to Bogardus, investors might anticipate getting a loan for a NNN retail property in the region of 3%–3.5% prior to the increase in interest rates. However, the cost of debt has increased significantly and quickly in the current environment, and investors are now looking at interest rates between 5.75% and 6.25%.

Bogardus emphasized that in order to maintain the same cash-on-cash return, the cap rate must increase.

But strangely, cap rates on NNN retail assets have remained unchanged. According to Bogardus, the majority of institutional investors are currently looking for cap rates on these properties between 6% and 6.5%, although sellers are still committed to obtaining cap rates of approximately 5%.

“We have a big disconnect,” Bogardus remarked.

This discrepancy is typical of a situation that has been occurring in the real estate market across asset classes and regions, where sellers have been hesitant to give in to the current interest rate environment and recognize the effect it has had on cap rates.

The effects of that difference may be felt even more sharply in the NNN market because most NNN buyers are more focused on attaining a stable, consistent return than they are on long-term appreciation or potential future upside. The largest threat to profitse an unexpected vacancye still exists, so why incur the risk when a similar return can be obtained through other means? NNN retail buildings unquestionably present owners with fewer hazards than many other real estate investments.

Nevertheless, Bogardus thinks that cap rates will eventually catch up to interest rates. Sellers can determine where they need to be with the cap rate once interest rates stabilize.

Until then, Bogardus emphasized that the 1031 exchange market for buyers of NNN investments is still highly active. They are attempting to purchase a property with a long-term lease and a national tenant in order to delay paying taxes.

Additionally, he noted that the sites inhabited by the more well-known and reliable retailers listed earlier continue to have robust business. The cap rates must increase if the shop, though, “doesn’t have as good of a reputation, or perhaps it’s a franchisee instead of a corporate-owned store.”

Nonetheless, the rise in interest rates is posing problems for both banks and CRE.

It is objectively absurd to be struck in the head by an acorn and believe that the sky is falling, as occurred in the classic folktale. Yet, considering what would happen to CRE lending after two banks fail quickly after one another, particularly in light of the experience of the global financial crisis, isn’t inherently absurd. Nonetheless, it might not be logical.

Although both banking and CRE face challenges from a rapidly rising rate environment, Moody’s Analytics recently stated that when looking at the real cross-exposures of the sectors and structural differences between now and 15 years ago during the Global Financial Crisis (GFC), the conclusions are less sensationalistic and more nuanced than some headlines suggest.

Rising interest rates have already slowed deals and driven valuations lower, the business stated. There will be some CRE loan defaults as refinancing rounds approach. For instance, Veritas Investments, Chetrit Group, Columbia Property Trust, and Brookfield have all missed payments on loans this year. According to M&T Bank, 20% of its office loans are in trouble.

But the details of how these processes might manifest themselves are complicated. For instance, several cite statistics that claim local and regional banks own 70% to 80% of CRE debt. The vulnerability and distribution are more intricate.

However, just 13.8% of the debt on income-producing properties is held by the 135 US regional banks, which are commonly regarded as those with assets between $10 billion and $160 billion, according to Moody’s. The Federal Reserve (Fed), which classifies the top 25 banks as “large,” has 12.1%. 9.6% of the total is held by the 829 community banks (with assets between $1 billion and $10 billion), while the remaining 3.2% is distributed among the 3,726 extremely small neighborhood banks (with assets under $1 billion).

That is to say, the U.S. The CRE debt market is larger and more complex than is typically thought, and major banks as well as a number of non-bank lenders, including mortgage REITs, life insurance companies, and private bridge lenders, may intervene to cover any eventualities.

The distribution of CRE loans among banks was more heterogeneous than was frequently noted, as Marcus & Millichap had recently argued. While acknowledging that some loans would default, John Chang, senior vice president and national director of research and consulting services, said in a business video that most loans wouldn’t.

Yet, there are indications that the stability of banks is continuing. According to Moody’s Analytics, “developments in the Fed’s lending initiatives over the past week have been credit positive and point to likely stabilization.” The total balance sheet of the Fed decreased by $28 billion to $8.76 trillion, and the amount of money the Fed lent to the banking industry fell by $11 billion to $153 billion. The amount of outstanding loans from the Fed’s discount window decreased this week from $110 billion to $88 billion on the asset side of the balance sheet.

We are ready to assist investors with Santa Ana commercial properties. For questions about Commercial Property Management, contact your Orange County commercial real estate advisors at SVN Vanguard.

Ashley has been a realtor since 2016, she helps investors identify distressed properties and increase their high returns through property management, leasing and sales. Her top skills are her abilities to identify the client’s needs and create an investment strategy to get the best returns on their investments. She helps her clients leverage their funds within their investment needs and provides value by showing them how their investment dreams can become a reality. She also works with long term owners, strategizing how they can hold their property longer to fit their family goals and to help them maximize the value of their long-term investment strategy.
Ashley leads with value.

Over the course of her career, Ashley has built lasting relationships with her clients. Past clients have said they really felt like Ashley cared about them and their needs. Her top priority is making sure her clients walk away feeling happy about how she handled the deal and pleased with their investments.

Ashley resides in Corona with her husband, two boys, and one daughter. Whether its Friday movie night, family game nights on Saturday, dance recitals, gymnastics and volunteering in her kid’s classroom, she is in high demand from her home life to her business yet she has a way of making you feel like you’re the only one.

Brock Smith is an advisor with SVN Vanguard | Industrial Group. He specializes in advising landlords and tenants in the sale and lease of industrial buildings and land throughout Southern California. Brock has a commercial construction background, specifically in Sales / Project Management for large Design Build projects across the country including hotels, apartments, hospitals, casinos. Prior to joining SVN, he was with Ashwill Associates. Brock is a Loyola Marymount University alum and currently resides in Lake Forest with his wife, two daughters, and dog.

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1. INTEREST RATE IMPACT ON BANK SECURITIES AND CAPITAL

After recent distress in the banking sector, there is a risk that many of the small and mid-sized banks that hold the bulk of US commercial real estate loans may see a credit crunch, dampening liquidity in the sector.
According to Goldman Sachs, roughly 80% of all bank loans for CRE come from regional banks, which are most likely to see a tightening of credit and lending standards following the collapse of Silicon Valley Bank.
CRE fundamentals remain strong relative to the broader US economy. Still, any upcoming refinance activity must factor in higher interest rates and the shifting demand profiles of CRE sectors. This will be of particular concern for low-interest office loans coming due, which will have to contend with higher rates and lower long-term demand.

2. 2023 SCE HOUSING SURVEY

Households are increasingly expecting home price growth and rents to decline over the near term, according to the New York Fed’s latest Survey of Consumer Expectations Housing Survey.
Households expect home prices to grow by 2.6% over the next 12 months, down from 7.0% one year ago. Current forward-looking sentiment, which relies on survey data taken in February, is the lowest since the regional bank started conducting the survey in 2014.
On the other hand, five-year forward expectations rose to 2.8% from 2.2% last year.
Rents are expected to increase by 8.2% over the next 12 months, which is still a robust estimate, but is down from 11.5% last year. Meanwhile, renters place their probability of owning a home in the future at 44.4%, a tick up from the 43.3% registered one year ago.
Respondents expect mortgage rates to rise to 8.4% one year from now and 8.8% in three years.

3. JOBLESS CLAIMS

Initial jobless claims rose higher than expected during the week ending on March 25th, totaling 198,000, which is 7,000 claims above the previous week. Economists forecasted claims to grow to 195,000 during the week.
While the four-week moving average for initial claims have been steadily rising, they remain relatively benign in the face of higher interest rates and slowing economic activity. Specifically, while forward looking unemployment rate projections continue to rise, employers have been slow to lay off workers, a potentially good sign for the labor market as recession fears grow.
Continuing claims, which run on a one-week lag, rose by 4,000 during the week to 1.68 million, slightly below estimates.

4. Q4 GDP FINAL NUMBERS

The Commerce Department slightly revised down its Q4 2022 GDP numbers in its third estimate, released on March 30th. The final metric was marked down to a 2.6% annualized rate, down from the 2.7% previously reported.
According to the report’s analysis, the downward revision primarily reflects downward revisions to exports and consumer spending. Imports were also revised down, which had an upward effect on GDP.
Overall, last quarter’s growth was driven by increases in private inventory investment, consumer spending, non-residential fixed investment, and government spending.
Based on the Atlanta Fed’s GDPNow tracker, growth is estimated to have accelerated during the first three months of 2023. GDPNow currently projects a 3.2% annualized growth rate for the US economy in Q1.

5. MORTGAGE RATES FALL

According to Freddie Mac, mortgage rates fell to their lowest levels in six weeks during the week ending on March 30th. The 30-year fixed rate fell to 6.32%, down ten basis points from one week prior.
After reaching a high of 7% last September, mortgage rates declined to close 2022 and fell as low as 6% in January, prompting an 8% jump in pending home sales that month. Rates began to rise again in mid- February as the market priced some uncertainty around the Fed interest rate policy path. The downtrend follows a cautious 25 basis points rate hike by the Fed, which, combined with recent financial market distress, has many forecasting a pause or reduction in interest rates soon.
Mortgage rates are also declining right as the spring homebuying season begins, which is likely to entice many who have been on the sidelines in recent months back into the market. However, low inventory will remain a challenge and will likely place some upward pressure on home prices if rates continue to trend lower.

6. INDEPENDENT LANDLORD RENTAL PERFORMANCE

The on-time payment rate in independently operated rental units improved by 186 bps between February and March, coming in at 84.9% and reaching a new post-pandemic high, according to the latest Independent Landlord Rental Performance Report by Chandan Economics. March’s full payment rate is forecasted to land at 94.3% — which would also be a new high.
National on-time payment rates have now held above 81% for six consecutive months — a first in the life of the Chandan Economics-RentRedi tracking.
Washington holds the highest on-time payment rate of any state in the country, coming in at 92.8% in March.
On-time payment rates picked up across all price points in March, with low-priced rentals seeing substantial month-over-month improvement. Meanwhile, 2–4-unit rental properties held the highest on-time payment rates of all sub-property types in March, coming in at 85.6%.

7. NEW & PENDING HOME SALES

New single-family home sales rose to an annualized rate of 640,000 in February, up 1.1% from January but down by 19.0% year-over-year. It was the third consecutive month where new home sales rose, partly due to a moderation in mortgage rates that has fueled recent homebuying activity.
Regionally, the South and West US saw transaction increase in the month while the Northeast underperformed.
Pending home sales similarly grew for the third consecutive month during February, climbing by 0.8% month-over-month, according to the National Association of Realtors. Year-over-year pending transactions fell by 21.1%.
NAR Chief Economist Lawrence Yun sees the concurring upticks as evidence that the “housing sector’s contraction is coming to an end,” as both sales indicators alongside construction activity have trended up in the past quarter.

8. HOME PRICES

Home prices continued to decline through January 2023, according to the latest update to the S&P CoreLogic Case-Shiller US National Home Price Index. Compared to June 2022’s peak, average home prices are down 3.0%. Still, measured year-over-year, home prices remain up 3.8% through January.
Miami (+13.8%), Tampa (+10.5%), and Atlanta (8.4%) reported the highest year-over-year increases within the 20 cities tracked by the index, with Charlotte (+8.1) following close behind. San Francisco, Seattle, San Diego, and Portland registered negative year-over-year growth.
Before seasonal adjustment, 19 cities tracked reportedly registered a decline in home prices, while 15 cities tracked registered an increase. However, in both seasonally adjusted and non-seasonally adjusted figures, January’s performance was notably better than December’s.
Regionally, the Southeast (+10.2%) remains the strongest region for growth, while the West (-1.5%) remains the weakest.

9. CONSUMER SENTIMENT

According to preliminary estimates for March by the University of Michigan, consumer sentiment fell for the first time in four months to an index reading of 63.4. The first estimate for March sits roughly 5% below February’s mark but remains 7% above this time last year.
All index sub-components worsened during the month, mainly due to persistently high prices of goods and services and financial uncertainty.
Notably, roughly 85% of responses for the current estimate were made before the collapse of Silicon Valley Bank and other financial market stress, which may signal a downward revision in future updates.
Year-ahead inflation expectations fell to 3.8% in March, the lowest reading since April 2021. Long-run inflation expectations also declined, falling to 2.8%, only the second time in the past 20 months that the metric dipped below 3.1%. Both expectations metrics remain elevated above their pre-pandemic normal ranges.

10. MAY RATE-HIKE PROBABILITIES

According to the Chicago Mercantile Exchange’s Fed Watch Tool, futures markets are relatively split on forecasts for May’s policy meeting. The majority of markets (52.9%) are pricing in a pause in the Fed’s interest rate hikes, while a weighty minority (47.1%) expect a 25 basis points hike in May. The current federal funds rate sits at 475-500 basis points.
Recent US bank failures swung what was initially a firmly hawkish forecast in early March into an increasingly dovish one leading up to the Fed’s March 22nd policy decision. Many investors are betting that the financial market distress, alongside slowing inflation, will encourage the Fed to pause rate increases to provide liquidity to the market. Futures markets now anticipate that the committee will hold rates steady until the September 2023 meeting, when markets expect the Fed to begin loosening again.

SUMMARY OF SOURCES

(1) https://www.trepp.com/trepptalk/deep-dive-bank-capital-securitiesinterest-rates-fed?utm_campaign=trepploan&utm_medium=email&
hsmi=251654661&_hsenc=p2ANqtz-_uVh7mjFt5IoVvTPpqOczEN4R8Lp9CIf2sh_OTwZkfsEz9jupbdabjVVKmv85Wn4G3bRyzMvyZMuK1IsLM9V7dWB5O3Q&utm_content=251654661&utm_source=hs_email
(2) https://www.newyorkfed.org/microeconomics/sce/housing#/
(3) https://www.dol.gov/ui/data.pdf
(4) https://www.bea.gov/news/2023/gross-domestic-product-fourth-quarter-and-year-2022-thirdestimate-
gdp-industry-and
(5) https://freddiemac.gcs-web.com/news-releases/news-release-details/mortgage-rates-decreasethird-consecutive-week?_ga=2.192574442.139966936.1680208347-887801833.1680208347&_gac=1.258158200.1680208347.CjwKCAjw5pShBhB_EiwAvmnNV5Ved0ucPaeTCLE6YVjTluDbSfoN-HS6YypEPOi59J2h1C63DVBH7xoCiwIQAvD_BwE
(6) https://www.chandan.com/independent-landlord-rental-performance-report
(7) https://www.nar.realtor/newsroom/pending-home-sales-grew-for-third-straight-month-up-0-8-infebruary
(8) https://www.spglobal.com/spdji/en/index-family/indicators/sp-corelogic-case-shiller/sp-corelogiccase-
shiller-composite/#overview
(9) http://www.sca.isr.umich.edu/
(10) https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html

SVN | VANGUARD is pleased to announce and welcome new SENIOR VICE PRESIDENT CAMERON JONES who will be leading our Industrial Product Group in Southern California markets. “We are pleased to have Cameron join the firm. Cameron brings nearly 17 years of commercial real estate experience and expertise in industrial real estate advisory to our team said Managing Director, Cameron Irons.

“Joining the innovative national platform of SVN enables me to seamlessly elevate the client experience on both local and national levels. This strategic move empowers me to utilize my market knowledge, harness cutting-edge technology, value added services and tap into an extensive network of advisors enabling me to continue to create opportunities and solve problems for my clients. I’m also excited to be reunited and work with Cameron Irons our Managing Director, for whom I owe my initiation into the CRE brokerage business some 17 years ago.”

Before joining SVN | VANGUARD, Cameron was a principal and partner at Ashwill Associates commercial real estate brokerage. Cameron focused on industrial product and land redevelopment opportunities, advising owners, occupants, and investors in the acquisition, disposition and leasing of properties throughout Southern California and nationally.

For details about any industrial property needs, contact Cameron Jones at 714.240.7078 or cameron.jones@svn.com.

About SVN | Vanguard

SVN | Vanguard with offices in Orange County, San Diego, and South Los Angeles County is a full service commercial real estate brokerage. We provide Sales, Leasing, and Property Management to clients throughout Southern California. In association with SVN’s 200+ offices nationwide combine a comprehensive national footprint with local decision making, expertise and market-leading execution. All SVN® Offices are Independently Owned and Operated.

On Wednesday, the Federal Reserve published its February 2023 Beige Book. The good news is that the situation hasn’t gotten much worse. Which might not seem like much of a consolation, but given the direction things have been going—more rate hikes seem imminent as a result of Fed Chair Jerome Powell’s congressional testimony.

According to the most recent Beige Book, the economy gained some impetus in the first quarter. This can be attributed to stable manufacturing activity and growth in retail sales, according to a report from Oxford Economics. The consequences for monetary policy, however, are minor because it also suggests that wage pressures and consumer price inflation will continue to moderate.The national outlook for commercial real estate activity was solid, with some growth in the industrial market but persistent stagnation in the office market.

According to the Federal Reserve Bank of Boston, the commercial real estate market in the First District has remained largely stable since the beginning of 2023. The industry still experiences low vacancy and high lease demand, although it has recently leveled off. Food and drink are in reasonably high demand. Large-format retailers and department stores have more open positions. Most contacts anticipated a decline in future commercial real estate activity, with the industrial market outperforming other sectors.

Markets in New York were “little changed” at the beginning of 2023. Office availability and vacancies increased significantly in northern New Jersey and New York. Although vacancy rates and retail rents are both marginally down, development has stabilized to some extent.Market players in commercial real estate continued to report stable current construction activity but observed more weakening of the pipeline as more projects were delayed, canceled, or redesigned, according to a report from Philadelphia.

The demand for non-residential buildings in Cleveland slowed, and new projects are frequently self-funded. Real estate developers also blamed decreased demand on consumers’ growing worry over high interest rates and the status of the economy in general.

The CRE activity in Richmond remained constant from the December data. Rent costs have moderated in several sectors, and overall commercial real estate activity has slowed moderately this period due to lessened construction, leasing activity, investment volume, and asset values.Lower-tier office, multifamily, and some retail CRE development in Atlanta decreased. As more firms compelled employees to return to the office, the negative trend in the office sector slowed further; yet, elevated levels of sublease space remained a barrier to market recovery.

Between December and February in Chicago, not much changed. One contact highlighted substantial interest in retail space that had previously been held by large box tenants as evidence that the need for high-quality space was still strong. Overall, prices and rentals increased a little bit, while vacancies and the number of spaces available for subleasing also increased a little bit.Conditions in St. Louis were inconsistent, with low office demand but high industrial demand. Retail has improved, and for the first time since the pandemic began, several projects are “back in demand”. But a lot of projects are on hold as investors wait out the uncertainties surrounding rate increases.
Minneapolis remained steady since the last report, similar to some other areas, with offices struggling as vacancy rates increased as some significant tenants downsized. Industrial activity also remained robust in this area.The situation for multifamily developers in Kansas City worsened from already poor levels. In addition to interest rates, another issue is the unpredictability of the rents that operators can demand.

In Dallas, apartment leasing is “sluggish,” while occupancy and rental rates have stayed stable. Although many people are worried about the building pipeline, with rising capital costs and stricter underwriting, office demand is “lackluster” and industrial demand is still strong.

In San Francisco, CRE activity remained basically constant. With low rates and many vacancies, office demand is still poor, and according to a survey from Nevada, companies showed more interest in acquiring commercial facilities than renting them.

The February jobs data on Friday and the CPI figures on Tuesday are the next challenges.

Consumer spending on goods for personal care, wellness, and consumables has not decreased.

Investment forecasts for the single-tenant net lease sector look strong going forward. As household demand for necessities in retail continues to be robust and retail sales data demonstrates that consumers are spending heavily in areas like grocery, personal care, and wellness products.

In a recent study by leading industry professionals, analysts observed that this behavior has the potential to produce record monthly sales totals across various necessity-based categories throughout the year. These projected record sales will have favorable implications for a single-tenant market which is already on a strong foundation to do fare well.

After an eight-quarter period during which tenants absorbed more than 100 million square feet, availability in the STNL sector was historically limited as 2023 got underway. According to researchers, discount restaurants, grocery stores, and medicine stores all have seen extensive demand. Reports state that “restrained development indicates single-tenant availability may hold firm or compress over the near term if additional vendors grow their businesses and backfill available space,” but the approximately 8.8 million square feet of single-tenant space that was under construction at the beginning of 2023 amounted to just 0.1 percent of the existing stock.

All of this is encouraging for investors since it shows that net-lease retail ownership is stable according to basic spending measures. Sales prices for average STNL properties have increased by about 16% over the last five years, and high-credit tenants and buildings with long-term leases in place continue to be investor favorites. According to Marcus & Millichap analysts, “buyers seeking long-term cash flow and less management-intensive properties may capitalize on high pricing in other sectors and move equity into single-tenant assets with high-credit tenants.”

Our Orange County commercial real estate brokers will help you every step of the way in finding the right commercial real estate investment property, contact us for details.