The Power of a Dollar: Is Inflation Outpacing Rents?
All investors chase one thing — high yields. But with cap rates low and the cost of debt up, many investors are struggling to find these yields. One strategy investors are implementing to make up for increased costs is rising rent rates, burdening the tenant rather than themselves. But what if an owner is stuck in a long-term lease, limiting the percentage of rent increases? Shorter-term leases typically obtained in industrial, multifamily, and self-storage investments allow owners to increase rent rates more often and have a better chance of keeping pace with the current market. New developments also have an advantage regarding rent rates as owners can evaluate the current market’s rapid growth and negotiate more favorable terms than older existing leases allow. As the market and economy continue to fluctuate, single tenant net lease (STNL) retail developers and owners will need to take a hard stance with tenants to include higher percentage increases to match industry averages. STNL’s passivity is a golden opportunity for passive investors and builders, but what is the trade-off of these long-term leases, and how can they be repositioned to better fulfill these investor’s needs?
The Ups and Downs of Retail
Retail had a sturdy and quick recovery from the aftermath of COVID-19. Consumers are active across many STNL product types, with quick-service restaurants tenants leading the way. The strong performance has been positive for STNL investors and has helped recover profits lost over the past two years, but with high inflation, that high-profit margin is at risk. As STNL businesses continue to thrive, the appreciation for STNL properties should increase. However, if the lease agreement hinders rent growth, appreciation slows. In most cases, contracts include an annual rent increase of one to two percent, which is much lower than the current market projections needed to combat inflation.
Although long-term leases are cause for concern for some investors during periods of high inflation, single tenant net lease investments offer plenty of value and benefits. Since the lease term average is over 10 years, the chance of vacancy and not collecting steady rent significantly goes down, providing security and a much more stable income source compared to other real estate investments. STNL assets are also an excellent option for owners looking for a more passive investment. Typically, the tenant oversees property upkeep and is responsible for the day-to-day operations of the space, taking the burden of everyday management away from the owner. The sector is great for investors looking to retire and not have the maintenance and management to attend to.
Waning Purchasing Power
Inflation hit a record high in the summer of 2022, reaching 8.5 percent in August. As inflation continues and consumers are forced to pay more, the purchasing power of the U.S. dollar decreases, and profits on goods, services, and investments are affected. Commercial real estate owners are increasing rents to make up for these higher costs, but the challenge arises when contracts don’t meet market standards.
Single tenant net leases average 10-25 years, meaning the owner gives up control of rental increases to fight inflation for passivity. In high inflationary markets, this loss of rent control may affect the feasibility of these investments. It is important to try and find different ways to regain power as an owner or developer.
“$100,000 in 2002 is equivalent in purchasing power to about $164,689.27 today, an increase of $64,689.27 over 20 years.” – Official Data Foundation
Because common STNL lease terms are long-term, it’s imperative developers and investors negotiate aggressive terms while signing new leases with tenants. While tenants are free to increase prices to combat increasing costs, their existing lease agreements often contain flat rates and small annual percentage increases that are difficult to renegotiate after the contract is sealed. Over the past five years, STNL daily rent has increased 22 percent in the U.S., but most existing leases do not reflect that type of prosperity. Knowing this national average increase, developers and owners can go to tenants and ask for significantly more than in previous markets. Instead of asking for 10 percent increases on a new development or sale leaseback, investors should ask for 15 percent and state the national average data that clearly shows the lease structure is on par with comparable investments. When lease terms come due, and negotiation occurs between landlord and tenant, the landlord should not be so quick to keep rents flat or reduce rents. The lease agreement should always favor the owner, with the tenant taking the brunt of inflation since they are able to adjust more than a long-term lease allows the landlord to.
“If an investor bought an STNL property in 2002 with a 20-year lease, chances are it would’ve had 10% increases every 5 years. The investor would’ve gotten a 10% increase in 2007, 2012, and 2017. Now at the expiration of the lease, the rent is only $133,100 when $164,689.27 was needed to keep up with inflation. The rent has lost 20% of its purchasing power.”
STNL Rent Growth Compared
Over time, commercial real estate sectors have earned the reputation of being a trophy investment, increasing in value and holding steady during financial and economic uncertainty. Rent growth is a primary indicator of a sector’s resilience and fruitfulness and is heavily considered by investors looking to plant capital.
- Average U.S. YOY Rent Growth
- STNL: $0.97, 4.4%
- Industrial- $1.12, 11.6%
- Multifamily- $109/unit, 9.4%
- Average U.S. Rent Growth 2018-2022
- STNL: 22% increase
- Industrial: 49% increase
- Multifamily: 26% increase
Unfortunately, declining purchasing power is expected to stay at least for the short term. This will affect all commercial real estate sectors, with some prevailing more advantageous than other. STNL buyers should ask themselves what the true cost of passivity is. Is the loss of control over rent increases worth the stability STNL offers? Moving forward, investment portfolios may transform as typical retail investors transition into assets with short-term leases.
On the other hand, investors looking to stay in the STNL space could combat inflation with higher annual increases written into new lease structures. All in all, precarious markets come and go, and real estate fundamentals are ever-changing. The key for investors is staying up to date on market indicators to make the best long-term decision possible.