The latest Net Lease Sector Update from Green Street offers further evidence to their previous concerns that credit losses are becoming an increasing problem.
Spenser Allaway, a senior analyst on Green Street’s research team and sector head of the Self-Storage and Net Lease sectors, and Harsh Hemnani, an analyst on the Net Lease and Ground Lease sectors, note that the first quarter closed out with credit losses reaching about 100 basis points annualized, in contrast to the 75-basis point HHAlllows of 2022.
The bond market, which tends to be a strong predictor of net lease portfolio credit losses, is pricing wider spreads. That points to even higher NL credit losses over the next 12 months, according to the authors. Green Street is projecting same property net operating income (SP-NOI) to be lower than the long-term sector average. Higher debt costs helping to pressure margins combined with economic uncertainty, keeping a close eye on tenant credit will be important.
Net lease REITs are gaining advantage in deals as “elevated debt costs keep most levered buyers on the sidelines.” In addition, as the cost of debt has increased and turmoil in banking has reduced availability of capital, net lease becomes a more alternative financing strategy and “source of perpetual capital for tenants.” Acquisition spreads were also the widest since mid-2020, something likely to continue through this year.
REITs have been acquiring long-lease properties to their portfolios at a “robust” pace, reducing the impact of expirations in the near term. But that isn’t without some potential problems. With economic uncertainty and pressure come sub-par leasing outcomes, like vacates or rent recapture of about 80%, as Green Street points out.
Net lease REITs protect themselves to some degree with an average 40% inflation protection build into leases, critical for maintaining long-term cash flow. But inflation-linked leases also tend to have rent increase caps of 2% of less. At current and projected inflation rates, that means a reduction in real cash flows.
Also, cap rates have remained about the same as they had been, with acquisition activity and demand maintaining them.