Interest Rate Volatility Causes Uncertainty in Net Lease Market

Interest Rate Volatility Causes Uncertainty in Net Lease Market

Cap rates for single tenant properties remained near historic lows for retail, office and industrial sectors in the second quarter of 2013 due to the continued high demand for this asset class.

Net lease retail and office cap rates compressed to their lowest levels since 2006 while industrial cap rates remained at levels similar to the previous quarter. The compression for retail and office properties is primarily derived from the low interest rate environment that existed in the first half of the second quarter.

Retail properties remain at the forefront of investor demand as evidenced by the premium cap rates compared to office and industrial properties (54 and 100 basis points respectively).

Although cap rates continued to compress in the second quarter, the overall supply increased 14 percent across all three sectors for the first time in the previous five quarters. However, the majority of properties added to the market are vintage buildings or properties with lease terms below ten years as owners attempt to take advantage of the low cap rate environment.

Additionally, shopping center owners added supply to the market by bifurcating single tenant parcels as a significant arbitrage opportunity exists due to the cap rate differential between single tenant properties and retail centers.  

Transaction volume in the net lease market remains high as equity fundraising continues at a strong pace. With substantial capital available and limited opportunities, institutional funds are exploring different avenues of capital deployment to reach acquisition goals.

Different strategies include acquiring properties with shorter term leases, properties tenanted by small or non-investment grade companies with solid financials or bundling large portfolios of properties priced below $2 million to take advantage of economies of scale.

In addition, the excess capital raised has caused some significant mergers, acquisitions and large portfolio purchases recently in the net lease market such as American Realty Capital Trust IV & American Realty Capital Properties’ $4.5 billion buying spree since May or the merger between Cole Credit Property Trust II and Spirit Realty Capital.

Throughout the second quarter of 2013 the 10 Year Treasury yield increased by 32 percent, creating uncertainty in the net lease market. Increasing rates will cause investor returns to decrease if cap rates remain unchanged and will create a more challenging fundraising environment. Cap rates for properties with rental escalations in the primary lease term will be in the highest demand as a hedge against inflation will be provided. Rate volatility will sideline many investors in the near term as price discovery occurs and the impact that future interest rates will have on the values of net lease properties remains the central focus for investors. 

Randy Blankstein is President of net lease advisory firm The Boulder Group.