Advisers are increasingly concerned with rising interest rates. As Scott Colyer astutely observed in his recent InvestmentNews article, the risk is essentially measured by two types of risk — credit risk and duration risk. Mr. Colyer considers duration risk a serious threat to fixed-income investors who have been chasing the yield curve down its long descent, and describes the bond market as looking like the “textbook definition of a bubble.”
Nontraded real estate investment trusts have, ironically, been a major beneficiary of this same search for yield. Capital flows into nontraded REITs nearly doubled to $20 billion in 2013, and the estimates for 2014 reach as high as $30 billion. This is ironic because many of these programs present a strikingly similar duration risk to that which their investors are seeking to avoid.
As interest rates fall, the value of bonds can rise dramatically, and the inverse is true as interest rates rise. The same holds for certain commercial real estate — namely flat-rent triple-net-leased properties.
A triple-net lease is so named because the landlord receives the rent “net” of all expenses. These leases are generally long-term, usually 20 to 25 years, and backed by a top-tier credit tenant such as Walgreens or CVS. Sounds like a great deal, right?
Well, for the past five years they have been. As of this writing, the average distribution rate for all nontraded REITs that are open to new investors is greater than 6.5%, and there has been a recent surge in “liquidity events” that have allowed investors to cash out shares at or above their cost basis. The question net lease sponsors don't want you to ask is this: How was this performance possible, and is it sustainable and repeatable?
Well, all real estate is valued using capitalization rates: The “yield” an investor is willing to accept with respect to the net operating income generated by a property. A cap rate is similar to a bond's yield. As cap rates fall, all things being equal, the value of a property rises to reflect the new yield investors seek for the risk presented. The corollary effect is falling values as rates rise.
Cap rates follow long-term interest rates. As Treasury yields have plummeted, cap rates have followed. Consequently, real estate values have risen.
In the post-recession flight to safety, the asset du jour for most nontraded REITs has been net-lease properties. The perceived safety of this asset type made for a compelling investor pitch: contractual, long-term income backed by investment-grade tenants. Investment-grade tenants, of course, demand the best lease terms, which typically contain minimal or no rental increases.
This isn't to say that net-lease sponsors did wrong by their investors. Many successfully returned their investors' original principal and then some, while generating an income stream that simply could not be created using traditional fixed-income securities. What's problematic is what may come next.
Interest rates will not stay low forever, and neither will cap rates. If an asset with a flat-net rental income was purchased at a cap rate lower than that at which it will be sold, investors will lose money. Even a 50 basis point rise in cap rates could wipe out 20% of an investor's investment.
The solution, of course, is to raise rent or enhance the property's value. But wait — net lease properties have contractual, fixed, long-term income streams. In a rising-rate environment, that represents the hidden duration risk. The structure leaves the landlord unable to adjust rent, and the long-term agreement leaves the owner unable to convert the property to a higher use.
How systemic is this problem? Surprisingly so.
According to WealthManagement.com, 77% of all nontraded REIT portfolios are invested in exactly this type of triple net lease, and 60% have no contractual rental increases. The problem is compounded because many properties were financed with cheap floating-rate debt to generate yield.
As rates rise so will the cost of servicing that debt. I call this the “double whammy” of triple-net leased assets: As interest rates rise, these nontraded REITs will be unable to sustain the level of distributable cash and at the same time, as cap rates rise, these assets will fall in value. Obviously, not the results investors are seeking.
Investors who bought into nontraded REITs with high flat-rent net lease holdings financed with floating rate debt will likely face the double whammy of decreasing distributions and cashing out at a substantial decrease in value — suffering the duration risk they were seeking to avoid in the first place.
Luckily, investors have choices, and some nontraded REITs do not invest in “flat” triple-net leases.
Jacob Frydman is chairman and CEO of United Realty.