Navigating Higher Borrowing Costs for CRE

The net-leased retail market, known for its long-term leases, stable tenants, and predictable cash flows, has encountered challenges in recent years due to rising borrowing costs. We will examine the impact of these higher costs on the market, exploring the effects on both buyers and sellers. Additionally, it investigates how strong property performance contributes to fewer listings and discounts, creating a dynamic landscape for investors. These challenges have contributed to market volatility, requiring investors and developers to adapt with innovative strategies. Understanding the implications of these changes can help stakeholders make informed decisions and capitalize on emerging opportunities.

The Impact of Rising Borrowing Costs on Commercial Real Estate

The rapid increase in interest rates over the past three years has significantly impacted commercial real estate financing. The 10-year Treasury rate surged from 1.63% in January 2022 to 3.71% in November 2022, reaching 4.77% in January 2025. Because commercial real estate financing rates are typically tied to the 10-year Treasury yield plus a spread, borrowing costs have climbed substantially. This all comes during a Federal Reserve rate cutting cycle, creating a unique situation in economic history, with the 10-year yield climb as the federal funds rate eases.

Net Lease Retail Investment Slows Amid Rising Borrowing Costs

Source: Real Capital Analytics

The Federal Reserve’s interest rate hikes aimed at curbing inflation have impacted the commercial real estate market, including the net-leased retail sector. While the year started strong, investor activity declined to $5 billion in Q4, representing a 3.7% quarter-over-quarter drop and a 5% year-over-year decrease. Annual investment sales fell to $21.2 billion, down from $27.6 billion in 2023 and significantly lower than the 2021 peak of $35.2 billion. Higher borrowing costs have resulted in a slowdown in transaction volume and a recalibration of cap rates. This can be attributed to several factors:

Reduced Purchasing Power

Higher interest rates translate to increased financing costs for buyers, reducing their ability to acquire properties and potentially impacting their return on investment. This effect is particularly pronounced for larger transactions that require more financing, as the higher cost of capital extends the ROI timeline.

Impact on Investment Strategies

With higher interest payments, investors experience a reduction in cash flow from rental income. This can make it more challenging to meet financial obligations and achieve desired investment returns, leading investors to reassess their strategies and potentially seek alternative investment options.

Negative Leverage

As interest rates rise and property values decline, investors may find themselves in a situation of negative leverage, where the yield on the property is lower than the interest rate on the loan. This can erode profitability and make it less attractive to invest in net-leased properties. Negative leverage deals do occur, largely with investors planning for a future refinancing that brings the borrowing costs below the yield on the asset.

Impact on 1031 Exchanges

The net-leased retail market heavily relies on 1031 exchanges, which allow investors to defer capital gains taxes by reinvesting proceeds from the sale of one property into another. However, higher interest rates have dampened 1031 exchange activity, further slowing transaction volume. To elaborate, the increased cost of financing associated with higher interest rates can make it less appealing for investors to utilize 1031 exchanges, as the higher financing costs may outweigh the potential tax benefits.

How Higher Rates Impact Investors

Rising interest rates directly reduce investor cash flow by increasing financing costs. For example, purchasing a $10 million property with a 65% loan-to-value mortgage at 3.75% interest would result in a $20,312 monthly interest payment. If the interest rate rises to 5.75%, that payment increases to $31,146, reducing cash flow by nearly $11,000 per month.

Buyers

Higher borrowing costs present both challenges and opportunities for buyers in the net-leased retail market. Increased financing costs can make it more difficult to acquire properties and achieve desired returns. However, the inverse relationship between interest rates and asset values can lead to lower property prices, creating opportunities for savvy investors to acquire assets at a discount.

Buyers with capital reserves may find it advantageous to invest now while cap rates are higher and before the Federal Reserve potentially lowers interest rates. Once rates decrease, increased competition and potential yield compression may make it more challenging to secure properties at favorable prices.

Sellers

For sellers, higher borrowing costs have led to downward pressure on property values and a decrease in potential buyers. This can make it more challenging to sell properties at desired prices, particularly for those with high loan-to-value ratios on their assets.

Sellers may need to adjust their expectations and consider offering more competitive pricing or exploring alternative financing options to attract buyers in this environment.

Strong Property Performance and Its Implications

Despite the challenges posed by higher borrowing costs, the net-leased retail market benefits from strong property performance. This is driven by several factors:

• Long-Term Leases: Net leases typically involve long-term lease agreements with creditworthy tenants, providing a stable and predictable income stream.
• Tenant Responsibility for Expenses: In a triple-net lease structure, tenants are responsible for most operating expenses, including property taxes, insurance, and maintenance, reducing the landlord’s financial burden and risk.
• Resilient Retail Sector: The retail sector has demonstrated resilience, with strong consumer spending and limited new construction contributing to low vacancy rates and rising rents.

This strong property performance has implications for both listings and discounts:

Fewer Listings

With properties performing well and generating stable income, owners are less inclined to sell. This contributes to a decrease in the number of listings available in the market, further tightening supply and potentially driving up prices.

Fewer Discounts

The strong performance of net-leased retail properties reduces the need for sellers to offer discounts to attract buyers. This is particularly true for properties with long-term leases and strong tenant credit, which are highly sought after by investors seeking stable and predictable returns. It’s worth noting that determining the appropriate discount rate for leases can be complex due to the lack of readily available information on factors such as the fair value of the underlying asset and expected residual value.

The combination of strong returns for owners and higher costs of entry for buyers is the main force limiting transaction velocity in the net-leased market.

Outlook

The outlook for the net-leased retail market in the coming months and years is cautiously optimistic. While uncertainty around interest rates and broader economic conditions persist, several factors point to potential growth and stability:

Potential for Increased Transaction Volume

As the market adjusts to the higher interest rate environment and the bid-ask spread narrows, transaction volume is expected to increase.

Continued Demand for Industrial and Retail Space

The industrial and retail sectors, which underpin the net-leased market, are expected to remain strong, supported by e-commerce growth and resilient consumer spending. Millennial aging also suggests family creation may speed up, a massive tailwind for retail spending.

Impact on Development

Retail developers have been building less since the Great Financial Crisis, and these construction totals are expected to fall even further in 2025.

Potential Increase in Sale-Leaseback Volumes

As corporate borrowing costs remain high, increased sale-leaseback volumes are expected in the coming years.

Looking Ahead: Thriving in a Challenging Market

While high borrowing costs have created obstacles, they also separate developers and investors who adapt from those who struggle. Developers who strategically acquire land during downturns and maintain shovel-ready projects for when costs stabilize will be well-positioned for outsized rent growth and long-term profitability.

For investors, focusing on income-generating, recession-resistant assets and value-add opportunities will be crucial. Conducting rigorous due diligence and partnering with experienced sponsors will help mitigate risks and maximize returns.

Conclusion

The net-leased retail market is navigating a dynamic landscape shaped by higher borrowing costs and strong property performance. While higher interest rates have presented challenges, such as reduced purchasing power for buyers and downward pressure on property values for sellers, the sector’s inherent stability and resilience provide a foundation for continued performance growth, despite limiting transaction velocity.

The market is currently characterized by low vacancy rates, rising rents, and increasing cap rates. These conditions reflect the ongoing interplay between higher borrowing costs and strong property performance. Looking ahead, the outlook is cautiously optimistic, with potential for increased transaction volume, continued demand for industrial and retail properties, and exploration of new property types. However, uncertainties around interest rates, inflationary pressures, and competition from other asset classes remain.

Investors and stakeholders need to carefully assess market conditions, adapt to the evolving landscape, and focus on core fundamentals to succeed in this environment. The net-leased retail market is poised for continued evolution, and those who can navigate the challenges and capitalize on the opportunities will be well-positioned for success.