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Is It Time to Recalculate Net Lease Cap Rate Requirements?

With demand coming from all corners of the investment landscape, competition has been pushing down the cap rates on pure leased assets for some time now. But in an environment facing inflationary pressures and rising interest rates, is the tide turning?

According to The Boulder Group, as of the fourth quarter of 2021, cap rates for retail, industrial and office net lease properties stood at 5.88 per cent, 6.77 per cent and 6.80 per cent, respectively. Cap rates for retail and industrial properties were up slightly from third quarter numbers, while office cap rates were unchanged.

as part of WMREIn our annual Net Lease Investment Research, we asked respondents their expectations of where cap rates are going. More than half of investors (57 percent) expect an increase in the risk premium (that is, the spread between the risk-free 10-year Treasury and cap rates) over the next 12 months, representing a significant increase of over 42 percent. . That view in the 2021 survey. A third of investors expect the risk premium to remain the same and 11 percent predict a decline.

“If we have a rising rate environment, it’s ultimately going to impact cap rates,” says Mark E. West, a senior managing director at JLL Capital Markets’ Dallas office in the US, and co-leader of the firm. National Corporate Finance and Pure Leasing Group. Investors would have to alter the pricing to generate the desired yield. In addition, high inflation, rising interest rates and geopolitical issues surrounding the Russia-Ukraine conflict have created a lot of uncertainty in the market and rate volatility. It’s too early to tell yet, but it looks like the spread is likely to increase as the cost of debt continues to rise, he says.

Among the major property types, respondents reported the lowest average cap rate for net lease industrial at 4.8 percent, followed by retail at 5.3 percent and office at 5.6 percent — nearly 100 basis points lower than the Boulder Group data. Majority of the respondents expect the net lease cap rates to move higher across all the three property segments in the coming year.

Cap rates for most retail net leased properties have narrowed across the board, and sellers are now getting 10 to 15 percent higher prices than they were a year ago, says Chad Kurz, an executive vice president at Matthews Real Estate Investment Services. Huh.

Logically, if interest rates rise and inflation remains high, cap rates should follow. The other side of the equation is that cap rates are not driven purely by interest rates. Supply and demand is a big variable that will have an effect on cap rates. For example, borrowing costs have risen 80 basis points in recent weeks, with cap rates, in some cases, down 50 basis points — primarily due to supply and demand, Kurz says. “It looks like we may be in the seventh inning, but it all comes down to supply and demand, and there is such a strong demand from investors to buy passive net lease deals,” he adds.

“There is a lot of resistance in the market with respect to cap rates moving upwards for a couple of reasons,” says BJ Feller, managing director and partner at Stan Johnson Company. In addition to a supply-constrained market, another factor is the structural tendency of more under-leveraged or all-cash investors to transact in the market. “The good news about a market where the prevailing leverage is much lower than in the Great Recessions in 2008 and 2009 is that people are not necessarily resolving to leveraged yields,” he says. Demand for cash or low-leverage buyers can keep some cap rates from moving upward in interest rates.

The full version of Pure Lease Investor Research, brought to you by WP Carey, will be published in early April.

Survey Methodology: The WMRE Research Report on the Net Lease Sector was completed in March 2022 through an online survey distributed to the readers of WMRE. The survey received 232 eligible responses, with the vast majority at the executive level of vice president or higher. The respondents included a broad cross-section of industry participants from owners, developers, brokers and lenders. Private investors represented the largest group at 45 per cent. Survey respondents are active nationally, with the largest percentage active in South/Southeast/Southwest at 46 percent, East at 43 percent, West/Mountains/Pacific at 37 percent and Midwest/East-West North Central at 33 percent Is. International investors also represented 10 percent of the survey respondents.

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