How the Net Lease Market Lost Hundreds of Billions of Dollars

The stock market was up 26% in 2023 and increased 20% in 2024, seemingly hitting all-time highs every week. The price of single-family homes across the country has also continued to grow despite the rise in interest rates, reaching an all-time high in the Summer of 2024 at $427,496. The cost of gold recently reached an all-time high, up over 30% since the start of 2024. But it’s not just the prices of these assets that are increasing; you see it when you go out to eat or purchase groceries. Everything seems to be more expensive today.

Well, everything except one thing: commercial real estate. While many people argue that commercial real estate has performed well and the catalyst for the negative headlines is merely office space, that isn’t what the numbers say. Owners of net lease assets have likely seen hundreds of billions of dollars of their net worth wiped away over the past two years—it has been a challenge for nearly everyone in the commercial real estate industry, especially owners.

 

The economy, and specifically commercial real estate, had benefited from a significant bond bubble over the past forty years as declining interest rates drove property values upwards. In 1981, a $1M investment in long-term treasuries generated over $150,000 annually. By 2021, that same investment in long-term treasuries yielded only $10,000. The “cap rate” for treasuries gradually dropped from 15.00% to 1.00%, which caused cap rates across all commercial real estate product types to decrease.

 

Net lease assets, often considered bond-like assets with fixed-rate leases, performed relatively well, and owners enjoyed not only the cash flow but also the wealth appreciation resulting from lower interest rates.

 

This led to substantial gains across all spectrums of real estate. It was a simply strategy:

1. Buy real estate
2. Interest rates go down
3. Cap rates go down
4. Property is worth more money

 

Unfortunately, this strategy, specifically within the net lease market due to fixed rate leases, has largely become a thing of the past. With interest rates starting at a lower benchmark today than 40 years ago, interest rates would need to turn negative to have similar valuation increases for bond-like assets over the next 40 years. Many real estate investors should rethink their real estate strategies for success in the next 40 years.

 

Unrealized gains have recently received media attention as politicians push for more taxes, including the potential to tax unrealized gains. Most people are familiar with the definition of unrealized gains, which is a potential profit or gain on paper from an investment that has yet to be sold for cash. Within the commercial real estate world, investors use the 1031 exchange to not only defer their capital gains but also depreciation recapture taxes upon a sale. For example, an owner purchases an 8-unit multifamily property in 1999 for $2M and sells it in 2024 for $7M. By exchanging into a like-kind investment, they not only defer their gain but also defer their depreciation recapture.

 

However, the unrealized loss is something that investors of net lease properties have likely never experienced on a large scale. Unfortunately, investors who have purchased net lease assets over the last few years are seeing widespread unrealized losses across the industry. For owners with net lease assets, their properties are likely worth 10% to 40% less than just 2 years ago. While most have not sold the property and taken the actual loss, it still exists on paper as their equity is less today than it was a couple of years ago, even if they don’t want to admit it.

 

The Decline of Property Values

It’s impossible to get an accurate number of how significant the losses have been, but we can start by adding up the numbers. According to Costar, here are some real-life examples of deals that were sold between 2020-2023 and then re-sold or are currently being marketed for sale in 2024:

 

Walgreens Purchased for Nearly $5.65M in Q1 of 2023

• The property is currently being marketed for sale at a price under $3.5M
• A loss of over $2M or roughly 61% lower price than just over 18 months ago

 

Dollar General Purchased in June of 2022 for $1.77M

• The same property recently closed at a sales price of $1,230,000
• A loss of nearly $450,000 or roughly 40% loss

 

Popeye’s Sold for $2.2M in August of 2021

• The same property recently traded in September of 2024 for $1.66M
• A loss of $540,000 or a loss of 32.5%

 

A Raising Cane’s Sold in August of 2022 for Nearly $8.5M

• The same Raising Cane’s just sold for $7.5M
• A loss of nearly $1M, or roughly 13%

 

A Dutch Bros Sold in 2021 for $1.93M

• It recently sold for $1.67M
• A loss of $260,000 or roughly 15%

 

These examples are not outliers; they are representative of a broader trend. These properties have not been vacated or had major issues arise in the last few years; the market has just shifted substantially. For most stabilized net lease assets, they have seen a loss in value over the last several years. What is interesting to note in the examples above is the discrepancy between the percentage of losses from one asset class to another and how certain net lease assets have, relatively speaking, outperformed other assets.

 

$250B Lost in Net Lease?

Once again, it’s impossible to calculate the total losses in equity the net lease market has experienced over the last several years. There are many moving parts, and this methodology doesn’t account for every factor. However, for the fun of doing the exercise, here are some well-educated guesses.

 

In 2021, Tractor Supply assets were trading at a 5.00% cap rate but have since shifted to around a 6.50% cap rate, a decline of 30%. With an estimated average rent of around $250,000, the value of a Tractor Supply property was roughly $5M. As of December 2022, Tractor Supply operated 2,147 stores, placing the total value of all Tractor Supply assets at approximately $11M. At a 6.50% cap rate in 2024, each Tractor Supply is now worth roughly $3.85M, and the total value of those stores would be around $8.25B. This reflects a loss of around $2.75B for owners of Tractor Supply assets.

 

CVS properties traded at a 4.75% cap rate just a few years ago. With an estimated average rent of $300,000, these properties were valued at approximately $6.3M. Fast forward to today, those same stores are now trading at a mid-6% cap rate and are worth $4.6M each. With 9,674 stores at the end of 2022, this represents a total loss in value of $16B across the entire portfolio of CVS assets. Walgreens, which had 8,700 stores in 2022, has likely seen an even greater decline in value among owners.

 

The same is likely true for Dollar General. With nearly 20,000 stores, it has probably seen a loss of nearly $8B. Family Dollar and Dollar Tree fall in the same boat, with a probable loss of around $8B. AutoZone, O’Reilly Auto Parts, and Advance Auto Parts have also seen billions of dollars of value loss from owners. According to Statista, there were approximately 198,000 quick-service restaurants in 2022. Suppose each of those is down around $250,000; that is a loss of $50B.

 

This trend is not limited to just one sector: daycares, restaurants, fitness centers, grocery stores, home improvement, and the list goes on and on; they have most likely seen a substantial loss in equity and have significant unrealized loss compared to their valuations from 2021. When you add all those numbers, the total is likely north of $250B of value wiped out by rising interest rates over the past two years. In 2021, Costar estimated that the total value of all retail was $2.9 trillion. Assuming about 35% are STNL assets, this is a decline of about 25% for property values.

 

According to Real Capital Analytics, the total volume for retail real estate (including multi-tenant) was $57B in 2023. So, there was more money lost to rising interest rates than actual transactions that sold in 2023.

 

Where do we go from here?

“A rising tide lifts all boats, and rising interest rates lifts all cap rates,” predicted Chad Kurz in a 2022 article of the net lease market. The idea behind this statement is that the increase in interest rates will negatively impact all commercial real estate values. Highlighting this loss of value in the commercial real estate industry serves two purposes: first, to learn from recent market conditions over the last several years, and second, to gauge where the market might be headed. Ideally, this will allow owners to make better decisions not only in the short term but also in the long term.

 

Potential Troubles Ahead

While the Fed has cut overnight borrowing rates by 50bps, treasuries have inversely reacted, increasing 50+ bps. With 20%+ gains in the stock market, putting money into long-term bonds at 4% fixed for the next 10 to 30 years is challenging for many investors. The other reality is the increase in the supply of bonds hurts pricing, both from a supply and demand equation and the fact that the debt to GDP ratio is also higher, which theoretically increases the risk of those same bonds. The biggest trouble ahead is interest rates remaining high, which would negatively impact the commercial real estate industry. The most damning thing that can come from higher rates, while relatively unlikely but possible, would be a recession caused in large part by the commercial real estate industry.

 

With current market conditions, it is challenging to sell a property for owners with high LTV debt placed on their property when interest rates were at historic lows. For example, an owner who purchased a Dollar General in 2021 for $2M at a 5.50% cap rate and put $800,000 down on the asset is now facing difficulties. The rent hasn’t increased over the last three years, the lease term has diminished, and rates have increased. The assets’ value likely stands around $1.5M today, and any amortization is eaten up by closing costs.

Upon sale, the owner would have $300,000 in equity to reinvest and purchase a $1.5M investment, which represents an 80% loan-to-value. This situation poses significant challenges for completing the exchange, making it difficult, if not impossible, to proceed with the sale. Therefore, many owners do not sell even if they realize owning a 10,000-square-foot box with 1,000 people in a 5-mile radius might not be the safest long-term investment.

 

If rates do not decrease, the problem is merely pushed out for a later date. Suppose rates stay around 6.50% and an owner is set to refinance in 2026, 5-years after purchasing the asset, they may need to come up with additional capital just to refinance, as the debt-service-coverage-ratio and the new loan-to-value may not align with lender requirements. On a Dollar General, perhaps this is only a couple hundred thousand dollars. But, on a drugstore, this could be a million dollars, and on some larger big-box assets, this could be millions of dollars.

 

Considering the owners of Walgreens properties, many may have seen their property value drop 50% from what they purchased the property for just a few years ago. Walgreens properties commonly traded at 5.00% cap rates in 2021, whereas today, they are likely to sell at a 7.50% cap rate. Even those who purchased assets a decade ago might find that selling today would bring in less proceeds than their initial investment when they purchased the asset. Not only have rising interest rates negatively impacted these owners, but poor company performance and potential store closures have as well. Therefore, if the property has an existing loan, there may not be equity remaining in the asset today. With no rental increases scheduled, the only way for value growth lies in the company to turnaround performance and a significant drop in interest rates.

 

For those that exchange into an asset, selling and cashing out isn’t a simple option due to the taxable gain from the original investment, along with a likely significant depreciation recapture expense and even potential mortgage boot. However, with minimal equity in the deal, completing the exchange would require additional out-of-pocket equity.

 

The nightmare scenario exists where assets are forced to be sold amid higher rates, supply increases, and banks pull back from the market due to distress with existing loans, the vicious cycle could cause commercial real estate to be the catalyst for a recession.

 

Hope on the Horizon

For the net lease industry, many investors secure loans with fixed terms of 5, 7, or 10 years. Given that interest rates reached historical lows in the summer of 2020, the earliest refinancing for these loans would occur around the summer of 2025 for most owners. Inflation readings have decreased from their peak, and the Fed recently cut overnight rates. For a market that is still on unsteady ground, this is hope for the commercial real estate industry. Perhaps by the time these low-interest rate loans begin coming due, rates will be substantially lower than where they are today. The fact that rates increased so sharply and have the potential to decrease sharply might provide for a relatively soft landing for the net lease market. By the time loans begin coming due, ideally, rates are significantly lower than where they are today.

 

When looking at historical trends, the net lease market is still trading at low spreads, highlighting that buyers are underwriting for lower rates in the very near term. For example, large funds are still purchasing Tractor Supply assets in the mid-6% cap rate, which is just 200bps above the 10-year treasury for a roughly 20,000 square foot box, NN lease, in a tertiary market with little alternative users if they were ever to vacate and the upside of only 5% rent increases every 5 years.

Not to mention, the NN lease requires expenses that bring the true cap rate down even further. When looking at recent sales transactions, very few private (mom and pop) type owners have purchased Tractor Supply stores. Thus, it appears that these large funds are either bidding against themselves or they are pricing in a significant decrease in interest rates in the near term. Without these institutional clients holding up the market, it appears that cap rates would move another 100bps for these assets.

 

In looking at historic spreads, there is also credibility to the fact that there is increased investor demand for net lease assets today compared to prior years which explains the lower spreads today. Historically, the spread for net lease assets used to be in the 200 to 500 basis points above the 10-year for most net lease assets. Whereas today, those spreads are 0 to 350 basis points above the 10-year treasury for most net lease assets. Using the example above, perhaps the new spread for Tractor Supply is 200 basis points instead of 300 basis points.

For 7-Eleven, the new spread is just 100 basis points and most quick service restaurants are just 50 basis points. If increased demand is explaining the historically low spreads, this would be fantastic for the overall net lease market, as even a slight decrease in interest rate would help decrease cap rates and thus increase value. Regardless, the good news is that refinancing will become easier if rates come down. For banks, their unrealized losses from existing loans at lower interest rates will also come down, providing for more aggressive lending, which will help the overall market as well.

 

The Biggest Mistake in the Market

Recent years have provided a valuable lesson for the commercial real estate industry. When interest rates are decreasing, it’s time to buy, and when they increase, it’s time to sell. The commercial real estate bubble from 2020-2022, followed by the burst in 2023-2024, offered insights for investors to learn from.

 

Many investors, including experienced professionals, did not foresee the loss of value in net lease properties over the past few years. For example, in May 2022, a prominent developer at ICSC had an offer brought to them on a portfolio of deals at a 4.50% cap rate, unfortunately, they rejected that offer. Why? Well in the summer of 2021, they had sold one of their stores at a 4.25% cap rate.

Despite the discussions on the correlation between interest rates and cap rates—and the fact that rates had risen by 150 basis points, making this a favorable offer relative to market conditions—the developer was unwilling to reconsider. By early 2023, they had listed one of the properties at a 4.75% cap rate and according to Costar, it traded in late 2023 above a 5.50% cap rate. This sale resulted in a price being over 20% lower than the previous offer presented by Matthews™.

 

The same conversation happened with a large company contemplating a sale-leaseback program. Given the historical data presented, Matthews strongly recommend that they market the assets as soon as possible. They had a better idea; they’d wait to begin marketing the properties and then spread out the sales over the next several years.

 

This decision cost them and their shareholders millions of dollars. These conversations with successful real estate professionals weren’t exceptions to the market but a widespread viewpoint across the industry. This is not to bash the owners but to get a better understanding of the overall market. We all make mistakes but there are valuable lessons that can be learned, especially during challenging times.

 

The biggest mistake seen across the market is not learning from previous mistakes. These owners continue to chase a bad bet. The actor in the movie that takes his last $5,000 to Las Vegas and wins a million dollars to pay off the mafia for his previous bad bets is just a movie, it’s not a reality for most professional investors. As Kenny Rogers sang, “you got to know when to hold ‘em, know when to fold ‘em, know when to walk away, and know when to run.” However, the common objection we see every day is an unwillingness to transact because owners cannot get the same value for their property as it was worth a couple of years ago or, even worse when they purchased it originally, even if that was a decade ago.

 

Here’s what we see all too often: an owner purchased a Walgreens on a flat lease, even as the market cap has plummeted from $90 billion to $10 billion over the past decade. With less lease term remaining than at the time of purchase, they still believed it would appreciate in value. They hold onto the store, paying $400,000 in rent and below-average reported sales and have no clue what market rent is for their asset or the cost of re-tenanting the property in the event the tenant does vacate.

 

Or, they own a Dollar General in a remote area of the U.S. and refuse to sell until it returns to the price they paid in 2021, back when treasury yields were at 1.00%, the lease term was at 15 years, and the global pandemic was driving dollar store profits across the country.

 

Or, they own a big box in a secondary market paying 40% above market rent with few alternative uses and significant expenses to re-tenant, if they can find an alternative user, but they want more money for it today. If you ask them if they would purchase the same deal today, they respond with “absolutely not.” However, they continue to own a property they wouldn’t purchase today and thus, chase their bad bet.

 

There is an opportunity cost to not do anything in a down market. Let’s assume the best-case scenario comes to fruition…the year is 2052, self-driving vehicles transport people from one place to another, drones deliver your groceries direct from the farm to your front door, robots prepare your dinners, Barron Trump is running for president against Taylor Swift, Nancy Pelosi is still in office and the largest shareholder of Nvidia, and your Family Dollar property is worth what it was worth in 2022. It’s time to sell the property and exchange it for another asset, finally! Meanwhile, the asset the owner should have exchanged into in 2024 is worth $5M more, after all, it’s 2052! This is the opportunity cost that so many owners do not take advantage of.

 

Long story short, it’s wise not to chase a bad bet or hold a bad investment just because you lost some money on it. You win some, you lose some, we all do. REITs are a good example of this! They unload assets they have concerns over and recycle that money into assets they are more bullish on. They transact in favorable and unfavorable market conditions, understanding that investments that once seemed great can become poor investment a few years later. Owners should focus on the core real estate fundamentals, the lease will eventually expire, and the underlying real estate will be the lasting asset.