Contributing Author: Sean O’Shea
As many much smarter ‘guys’ than me (and smarter women, too) are reviewing the last year; and struggling with Forecasts for 2019, at this time, there has been a lot of discussion about Fed Policy on rates and their impact.
Bloomberg had a recent interview with the legendary hedge fund and financial advisor, Stanley Druckenmiller, who was reviewing the last ten year era; and he was critical, then, (2009); and now, (2019) regarding rates and the liquidity implications of the unwinding of QE policies.
We think some useful language, is to characterize ‘asset bubbles’ or the asset inflation that these policies may have created as a real thing. Actually, many are referring to this period as the ‘Bernanke-Yellen Asset Inflation’ period.
While most of these folks are talking about the run up in equities and the S&P; are there implications for real estate valuations, too? We think, “Yes”.
Question: Do we think the same can, in fact, be said of the last ten years of compressed cap rates, fueled by the Fed’s historically low interest environment which has allowed investors to have, both, conventional commercial real estate debt sources and some of the new ‘shadow banking’ sources, from various Commercial Real Estate debt funds, as contributing factors with lower rates?
Going back to the Great Recession, there have been all kinds of new debt vehicles and structures being presented when more traditional credit sources dried up.
So, many who have been active, most particularly in the NNN sector of the real estate industry; have witnessed very slim spreads for some time, now. Even at lower leverage in their debt structures, the returns have been much closer to “Bond-equivalent returns”, while safer, more stable and predictable, they have been very modest, if we are going to be thoroughly honest in our appraisals of NNN sector performance.
We maintain an 80,000 proprietary database of net lease properties throughout the country, which tracks both historical and current offerings. With these low spreads, it was ‘almost amusing’, almost,when inputting a new NNN asset in the database, with existing assumable “Interest Only” debt, structured to afford maximum cash flows in the face of the low cap rates, we would often note, internally for the file, particularly, if loan-to-value ratio (LTV) was substantially more than 50% LTV, we would note, in Loan Section of our tracking: “An Invitation to a future foreclosure”!!!
An investor’s ability to achieve their best debt executions in the net lease sector, in our experience, is based on (a) Tenant Credit; (b) Lease term; and (c) Solid commercial locations; and usual underwriting criteria.
There have been some new investment vehicles and new opportunities, like the “Blend ‘n’ Extend” strategy being exercised by a number of commercial tenants for a number of their assets. This is an effective way to exploit the lower coupon rates, aslong as they last. When the original base lease term has run off, with less than 4-7 years remaining terms, many credit worthy tenants are open to a new lease negotiation process that serves to reduce and lock in their occupancy costs with a recast longer term lease for the Tenant.
For the Investor/Owner/Landlord: This results in a recast lease format for new 15-20 years term, with revised escalations, which presents a viable ‘Win/Win opportunity’ for both, Tenant and Owners: Tenants can lock rent rate for new extended term; Owners can secure new current market debt solutions, at the most favorable terms based on the new longer term to exploit the debt market options.
So, we have a New Year; a new day; while our economy is very encouraging, it is not unreasonable for tenants and investors to reconsider and reframe their solutions to address future market uncertainties with renegotiated leases.
Making timely provisions for a rainy day, when the sun is shining is a conservative value, which deserves acknowledgment.
Downsizing and recasting tenant space and rental budgets will be the new normal, in my humble opinion.
One note of caution in the next two years, there appears to be the possibility of ‘Stagflation”, that is to say, inflation with limited actual growth. Those who are old enough to remember Carter Administration era; will recall the problem. It may be compounded, now, by being in a more global economy, that the slow growth around the world, will have its predictable impact on U.S. Economy, even if we are relatively stronger. We think there is a more ‘fragile balancing act’, than appears to the less informed observers.
Stay tuned; we monitor these implications for US real estate investments, very closely, as a result.
The O’Shea Net Lease Advisory
734 Silver Spur Road, Suite 200
Rolling Hills Estates, CA 90274
(310) 433-8851 – Direct
(310) 388-0212 – Fax
CA LIC #01438647