Safe-Haven Income-Producing CRE to Drive Second Half of 2022

Persistent inflation, a volatile stock market, and rising interest rates have created a new reality for investors making the second half of 2022 uncharted territory for investment. While there’s still a great deal of capital chasing well-located class A assets, this does not mean there will be the same record level of volume and pricing this year that the market experienced in 2021. The debt markets and various macro-economic indicators have and continue to shift dramatically. That’s why the second half of 2022 will see a flight to quality, safe-haven real estate assets. 

Looking ahead, SRS Real Estate Partners’ National Net Lease Group (NNLG) cites some trends that are likely to drive investment activity:

Trouble for Class B and C Assets – In a downturn, class B and C properties tend to be at risk, particularly those with problematic tenants, rolling leases and vacancy, while class A properties remain in strong demand. The NNLG notes that the firm is still securing capitalization rates of 3% to 4% on class A credit tenants, locations, and top MSAs. However, class B and C properties are being repriced. The days of buying a 4% or 5% cap rate and financing those assets in the low-to mid-3% range are behind us. There is an expansion of interest rates in excess of 150+ basis points from where they were last year. Contrast the interest rate movement with cap rates, which have moved approximately 25 basis points, and in some cases, haven’t moved at all. Due to the demand, the marketplace has been absorbing much of this rate rise in the second quarter and NNLG expects this to be the case through the balance of 2022. This deep negative leverage will likely not be sustainable long term, as there are only so many all-cash buyers in the marketplace and leveraged returns drive transaction volume and capital allocations. The catalyst of this downward change has been the extraordinary increase in the 10-year treasury due to inflation and other macro factors. The yield on the 10-year note hit an almost decade high of 3.48% in June of this year, and 2022 started with the 10-year at 1.66%.  But the overall size of the market, liquidity, and capital (both debt and equity), pursuing income producing real estate continues to be very robust, and there is substantial demand for hard assets. 

1031 Placement Remains Strong – The 1031 exchange market continues to drive market activity, particular for assets under $20 million. Transaction volume is surprisingly strong, resulting in a wide buyer pool of 1031 investors. These groups, motivated by deferring taxable gains, have limited time to place funds and thus do not have time to wait for market adjustments. These investors must place funds now, and they continue to be very active and are accepting low yields, in many cases, negatively leveraged returns. Expect some changes to the size of the 1031 marketplace as rates take hold throughout the real estate sector.

Necessity-Based Retailers Remain Strong – Rising interest rates are one more reason that necessity-based durable retailers continue to perform well. As the Federal Reserve continues to try to normalize inflation, the clear risk of a recession is becoming more pronounced. During such periods, real estate investors seek tenants and markets that are better able to withstand a downturn and often revert to value-oriented and well-capitalized tenants.  These sought-after uses include food, grocery, and pharmacy. Durable tenants can resist a potential downturn, which underscores the value of a hard commercial real estate asset and flight to quality tenants. Also, the retail industry bounce-back from COVID lock-downs proved to the market that brick and mortar is here to stay – but has evolved to an omnichannel play. This bodes well for both retail and industrial property types. Demand for grocery-anchored centers should remain at elevated levels, although price misalignment is taking place in this sector due to interest rates. 

Matthew Mousavi is the managing principal and co-founder of SRS’ National Net Lease Group