By Bradley Feller, Associate Director
The low interest rates and slow economic growth that have gripped the United States since the onset of the Great Recession have made it difficult for investors to find yield in the capital markets. Returns on corporate and government bonds have plummeted to all-time lows while the equity markets have become a perilous venture characterized by extreme volatility in recent months.
Increasingly, investors are seeking to acquire net-leased real estate as a vehicle to achieve secure long-term returns that provide a yield superior to comparable credit bonds,?and real advantages that fixed-income assets cannot match.
As demonstrated in the chart below, capitalization rates (the annual rate of return on a real estate investment) for Walgreens leases with 23 years or more of lease term at time of sale have generally mirrored the downward trend of returns on corporate and government bonds since 2009. However, while bonds and treasuries have fallen precipitously since 2011, cap rates have not reacted as quickly. Currently the spread between long-term bonds and cap rates stands at 139 basis points?nearly as wide as it has ever been?offering investors opportunities to outpace investments in other fixed-return asset classes.
As the chart illustrates, cap rates have tended to lag behind movements in the bond markets by roughly six months. Given the rapid decline in bond yields over the past two quarters, it seems likely cap rates will continue to trend lower in the coming months.
Investments in single tenant, net-leased real estate are also significantly more tax-efficient than investments in treasuries or corporate bonds. While interest income from treasuries and corporate bonds is completely taxable, current tax code allows investors to shelter much of their rental income from taxes via property depreciation. That depreciation can often result in as much as 40 percent of a landlord?s annual income sheltered from taxes.
IRS Code 1031 also allows investors to defer capital gains tax following a sale. The code permits a purchase of like-kind property from the proceeds of a sale and exempts the owner from payment of any capital gains or recapture until the real asset is liquidated. As uncertainty grows about future income tax and capital gains rates, those considerations are likely to become more important. Net-leased real estate has another advantage over bonds: its tangible nature. Investors holding a defaulted bond have nothing left, aside from worthless paper. However, even if the tenant of a net-leased building goes bankrupt and defaults on the lease, the investor still owns the physical property and it retains its real value.
Because net-leased assets are fundamentally hard-assets, they give investors long-term protection against inflation. While net-leases are generally long-term in nature, they do eventually allow landlords the opportunity to renegotiate rental rates. The dollar is currently experiencing inflationary pressures which are likely to result in higher rental rates for commercial real estate. Upon renegotiation of a lease, landlords stand to gain by realizing those higher rates and preserving their real rates of return.? In addition, net-leased investments stand to become increasingly popular in coming years, demographically. As the enormous Baby Boomer population moves toward retirement, the demand for stable-yield investments is certain to grow. The need for consistent annual retirement income will force individuals to move assets from long-term, growth-oriented investments, into long-term, yield-driven vehicles. As corporate bonds continue to offer low yields, more and more equity will flow into net-leased investments as a haven to secure those stable retirement incomes.
Given the relative advantages of net-leased investments over fixed-income assets and growing investor demand for those assets, and a constrained supply of net-leased properties available for purchase, it is difficult to imagine that cap rates won?t stay at current levels or trend lower in the coming months and years.
Bradley Feller?is an Associate Director in Stan Johnson Company?s Chicago office. Stan Johnson Company is one of the nation?s leading commercial real estate brokerage and advisory firms that focus on net lease transactions. The net lease group deals?exclusively with the acquisition, disposition, and financing of single tenant real estate. Stan Johnson Company has a 25-year history and has completed more than $11.6 billion in transactions nationwide. A dynamic team?approach, refined marketing processes, and a foundation of integrity, professionalism and relationships create a winning combination that enables the firm to deliver consistent service and superior results to each client.?www.stanjohnsonco.com
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comparable credit bonds, as well as real advantages that fixed-income assets cannot match.
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