Impact of Rising Interest Rates on NNN Values and Leveraged Returns
Updated: May 27
By David L. Church, CCIM
Inflation is raging at levels not seen in 40 years and interest rates for long term mortgages secured by income-producing properties are following the curve. Investors have flocked to triple-net lease deals with credit tenants for the past five or ten years because they offer predictable income streams, long-term occupancies, and essentially no management. The reward for sellers has been exceptionally low capitalization rates in the 4.00-4.25% range. I analyzed what I believe is a run-of-the-mill NNN deal and determined what the IRR and Equity Multiple were to an investor with a 10-year hold, the Base Case.
The Base Case assumed a NNN tenant with a first-year rent of $250,000, underwritten vacancy and management fees of 1.0% each, a 4.25% going-in cap rate with a terminal cap rate of 5%, a permanent loan with a minimum DSCR of 1.25x, a mortgage rate of 3.75% Actual 360, and a total acquisition cost of $5,888,300*. The equity required was $2,729,300. The resultant Leveraged IRR and Leveraged Equity Multiples were 5.96% and 1.71x, respectively.
If a seller demanded the same price for the property while the interest rate on permanent debt increased to 5.25%, returns to the investor are reduced substantially, the Static Price Case. The 1.25x DSC requirement reduced the permanent loan from $3,159,000 to $2,706,000, a reduction of $453,000. At the same time, the equity requirement increased by $446,100 from $2,729,300 to $3,175,400. The increase in equity drove the IRR and Equity Multiples down to 4.72% and 1.54x, respectively.
If an equity investor demanded the same IRR and Equity Multiple from the investment with the higher interest rate on permanent debt, the price of the property must decline, the Static Return Case. To maintain the returns, the price of the property must decline by $661,000 from $5,765,000 to $5,104,000. This translates to an increase in the going-in cap rate from 4.25% to 4.80%, or 55 bps.
I predict a lag between the increase in interest rates and a decline in the price of NNN properties, as sellers maintain that the rate increases are temporary. However, if interest rates remain at current levels or continue to increase, investors will seek out properties with more advantageous returns and sellers will reduce prices reluctantly to meet the investor requirement for higher leveraged IRRs and Equity Multiples.
*Total acquisition costs in each case includes the value derived from a direct cap, 1.0% transfer tax, legal & closing costs, third-party reports, title insurance, and a 1.0% loan fee.
David L. Church, CCIM is managing director at U.S. Realty Capital, LLC.