Using the yield curve to buy NNN properties
Last year, investment volumes dropped significantly across asset classes, and triple-net lease properties were no exception. Research shows that NNN sales volumes fell over 60% year-over-year in 2023. Next year, however, NNN investment is expected to rebound!
The yield curve has been inverted since 2022, but research indicates that any economic implosion following a yield curve inversion is a lagging phenomenon. Investors that take cues from yield curves consider both: the 10 year-3 month spread as well as the 10-2 year spread, since both yield spreads have inverted and preceded all six recessions since the 80’s.
Here’s a quick primer on cap rates and yields. Due to higher interest rates, investors have become increasingly sensitive to yield. It is the primary metric investors are watching in this market. In the bond market, investors often focus on a bond’s yield to measure a bond’s annualized return. With bond yields, issuer credit quality is the fundamental risk characteristic that drives pricing. Thus, bonds issued by investment-grade rated issuers trade at lower yields than bonds issued by non-investment grade issuers. In the NNN market, investors use capitalization rates (known as “cap rates”) to measure expected yield on investment. Thus, cap rates are regarded as proxies for bond yields within the NNN market.
Undoubtedly, over the last twenty five years, net lease cap rates have compressed. However, the compression has been more modest than the compression of bond yields over the same period. And even today as bond yields hover around 5%, investment-grade net lease deals are still trading at higher yields, although now the spread is 1% or less. This puts NNN strategy in a different light.
We are recommending that NNN investors stick tight to core fundamentals in this interest rate environment. By focusing on net lease assets with investment-grade tenants and strong real estate profiles, we believe that investors can still create reliable cash flow at higher yields with lower risk. NNN cap rates are edging up, but since the Fed is likely to ease off higher and longer interest rates hikes, net lease sellers are pricing this in and keeping prices sticky. Thus, net lease investors could target newly constructed triple net assets located in strong, gateway markets and minimize re-leasing risk. Or, consider assets with sale leaseback potential including the car wash, QSR and C-store sectors. Triple net assets with strong cash flow engines, and capital needs, can tap sale leasebacks to grow fast.
Robert Gamzeh and his team at the Triple Net Investment group pride themselves if offering out-of-the-box solutions to clients. Uncertain times call for creative solutions. We know NNN markets well enough to understand the intricacies of financial engineering. Give us a call even if you have engaged an advisor, 202-360-3050.