Are interest rates moving up? Predicting the shifting of the economy and the actions of the Federal Reserve may not be possible, but today’s low rates indicate that an upward movement is eventually going to happen. When it does, holders of net lease REIT investment need to be ready.
These seemingly safe, if not incredibly profitable, investments are normally considered rock solid, so why the caution? Economic conditions have led to a high proliferation of flat lease contracts, that is those that do not include annual rent increases. While this type of contract may have been necessary on the part of the lessors, it could have a significantly adverse effect upon investors.
Blue Vault Partners and Resource Real Estate has performed research that indicates that serious decreases in the value of net lease REIT investments is practically guaranteed if interest rates were to rise. According to this study, a large majority of REIT portfolios include net lease properties, and over half of those contracts include zero rent increase contracts. Called flat leases, these contracts lose value as soon as expenses, such as interest, rise.
Since many investments are debt financed, there is risk that the loan used to purchase the net lease REIT will end up having a higher variable rate than what is being earned. With income contractually stagnant, profit margins will wither away.
As the value of these investments decrease due to the lack of profit potential, investors will also suffer from reduced equity in situations where sales are attempted. Even if an investor is happy to hold the REIT investment and wait patiently for happier days to return, they may run into difficulty. As the value of the holding decreases, it may be difficult to refinance under modern banking standards.
Some of these net lease REITs that were originally purchased and financed under more lax financial constraints about 10 years ago will raise challenges as debt matures. Equity requirements are higher – as are interest rates. An investment that is currently secure and profitable, may become a loss when refinancing is required.
The value of these properties will continue to fall due to the no rent increase clauses, making it even more difficult for the owners of these contracts to sell or finance them based upon their original value. Investors in commercial real estate will understandably shift their focus to more reliable investments, depressing the value of these REIT contracts even further. Once net lease REITs are no longer the risk-free, acceptable return investment that they once were, they are bound to fall from favor.
If rates stay low, net lease REITs may continue to provide a safe, passive investment opportunity. Just how long can investors gamble upon historically low rates? Those who are involved in flat rent net lease contracts should be on their guard.
