Due to the quick jump in interest rates, many commercial real estate properties have significant and unexpected headwinds. Hopefully, you don’t own an empty commercial building that you were planning on refinancing soon. Some of the very best multi-family programs had to be written down by 20-30%, and that was on the safer types of multi-family; the riskier multi-family programs fared even worse.
According to CBRE, there was a global office vacancy rate of 12.9% at the end of March, which was almost the same as the highs in 2009 and 2010 after the global financial crisis. While the vacancy rate is nearly the same, the economic situation is better this time, leading to the assumption that work from home after the pandemic had an impact that may continue into the future.
So, where is it safe to invest? Interest rate risk is still on the table; there are cracks in the economy and last election year we had a pandemic, so anything is possible.. One answer for safe investments may be long-term net lease investment of essential retail companies with top-quality tenants and only their top-performing stores.
Components of Net-lease Investments:
Net-lease
Net lease requires the tenant to pay, in addition to rent, some or all of the property expenses that normally would be paid by the property owner or landlord. These include expenses such as property taxes, insurance, maintenance, repair, operations, utilities, and other items. These expenses are often categorized into the three nets: property taxes, insurance, and maintenance. In the US, a lease where all three of these expenses are paid by the tenant is known as a triple net lease.
In other words, a triple net lease is like ordering a combo meal where you serve the tenant the burger but they have to pay extra for the fries, cheese, drink, and maybe even the ketchup packet. Taking many of the costly variables of owning a property off the table makes it a much safer place to invest.
Essential Retail
Retail tenant demand has maintained momentum due to several years of industry transformation and larger retailer consolidations in higher-quality locations, despite varying degrees of health from economic indicators. According to Coresight Research, US store openings outpaced store closings by over 1,500 stores in 2022, and just under 1,000 stores so far through 2023.7 Leasing activity has generally remained positive across North America, Europe, and Asia/Pacific.8
There are “must haves” and “like to haves” in life. Essential retail is a “must-have”. Think grocery store, top-tier location for a Pharmacy, blood dialysis, kidney centers, and blood testing locations. Remember all the retail businesses that stayed open during COVID-19? Those are the types we see in essential retail portfolios. Must have retail tends to be safer than like to have retail stores, they are more protected from failing.
Top Quality Tenants
When you own a property and lease it as a net-lease agreement, all the variables are the tenant’s problem. Insurance on the tenant. Property taxes on the tenant. Groundskeeping on the tenant. That is all good, but those are also reasons you need a high-quality tenant who can absorb those costs without going bankrupt. When looking at essential retail opportunities, we only look at the top rate tenants and ensure that the home office backs the lease on the property.
Top Performing Stores
Location matters. Putting the legwork to look at the trends in the area has historically been the best way to underwrite a location. Top performing stores are typically in geographically advantageous locations with growing populations, low crime, and demographics that support the type of essential retail we are considering. After that, you want only to lease top performing locations so they have a high chance of remaining open. Even with a master lease still paying the rent, it is hard for a closed store to grow in value over time. While the role of retail locations has evolved, and most consumers enjoy utilizing a hybrid approach that offers them convenience, many have expressed they feel less inclined to order from an online location that doesn’t have a retail store.
How to Invest?
Some people directly own a standalone net-lease property. Owning one property tends to be riskier than we are comfortable with, so we recommend a portfolio of these so you get a tenant, location, and type of retail diversification. We tend to use a DST or a private REIT structure. Both are not exposed to the stock market and have liquidity locked up for 3, 5, and sometimes 8 or more years. Investors need to determine if liquidity is a greater concern than income and growth in a vehicle not exposed to the stock market. Economic issues like inflation, interest rates, and insurance costs are still present in this type of real estate, but the net-lease aspect makes it mostly the tenant’s problem. The biggest flaw of net lease is that long-term leases (typically 20 years) have only rent bumps in the lease. So your income won’t have crazy growth since most rent bumps are 2-4%, depending on other terms. However, in this topsy-turvy world we live in, it’s worth considering.
Frederick Hubler is the founder and CEO of Creative Capital Wealth Management Group, a retainer-based wealth strategy firm specializing in alternative strategies located in Chester County, PA.
Securities are offered through Arkadios Capital. Member FINRA/SIPC. Advisory services are offered through Creative Capital Wealth Management Group. Creative Capital Wealth Management Group and Arkadios are not affiliated through any ownership.
This material was created for educational and informational purposes only and is not intended as tax, legal or investment advice.