Net Lease Investors Beware: Rising Cost of Debt May Accelerate

Experts advise net lease buyers to avoid volatile high-leverage CMBS deals.

In a conference session that focused on capital markets, panelists warned attendees at GlobeSt Net Lease Spring to prepare for the likelihood that the Fed’s medicine for inflation may not come in small, easier-to-swallow doses. 

“Interest rates go down slowly, but they go up quickly, and that’s what’s going to happen. You’re going to see these big steps, two 50-basis-point increases this year,” Ralph Cram, president of Envoy Net Lease Partners, said.

Larger interest rate hikes will shock the net lease market, Cram predicted.

“This is going to change how a lot of deals are structured, and I really don’t see people coming to grips with that. In the last two weeks, we’re already starting to see some deals fall apart,” Cram said. “I really doubt that people see the impact of where (rates) are going to go.”

“Some of the deals that have been purchased are probably under water today,” Robert Khodadadian, president and CEO of Skyline Properties, said. “No broker wants to talk about it, no buyer wants to talk about it, but if the rates are under water, you’re effectively (subsidizing) the rents.”

Khodadadian said he currently is negotiating a deal in which the buyer suddenly dropped the amount of their offer in anticipation of the increasing cost of debt.

Greg Burns, managing director of Stonebriar Commercial Finance, said it will take a few months for net lease dealmakers to adjust to the cost of debt increasing from 2.5 percent to an estimated 7 percent.

“People have been on the price side of the leverage in negotiations for the past two years. It’s going to be six to nine months on the price side before the reality sets in,” Burns said.

“People need to be in discussions right now about how they’re going to hedge against interest rate increases,” he added. “It’s really easy for a deal to go upside down and for you to lose money.”

Several speakers warned that the Federal Reserve’s rate hikes will increase challenges for structured finance asset classes like commercial mortgage-backed securities. CMBS offers buyers higher leverage, but more risk from an increase in the cost of debt.

“CMBS is volatile, so it’s worth looking at other structures,” Cram said.

“I’ll be watching the apartment transactions in the next six months to see if they slow down considerably” as a result of interest rate hikes, he said, adding that he’ll also be paying close attention to the 1031 market for signs of a slowdown.