NNN Portfolios vs Bonds – A Credit Arbitrage Opportunity
By John Golden, VP Acquisitions
Since launching the Rising Investor Platform, we have taken a broader look at investment opportunities for our investors, including the single-tenant NNN-leased space. In doing so, we have come to the conclusion that a diversified portfolio of NNN properties can offer a yield premium with a lower risk profile than corporate bond funds of similar credit profile. This can create a form of credit arbitrage, creating premium yields in NNN investments with a similar or lower total risk compared to bonds.
Before comparing yields of NNN properties and corporate bonds, we should look at the different risk profiles of each. If one of the two investment options has most of the risk load, we would of course expect that investment to command a risk premium.
NNN leases are typically structured with annual or every-five-year rent increases at either fixed percentages or at CPI. This provides protection from inflation as the absolute dollars paid in rent increases throughout the investment period. Further, property expenses are completely borne by the tenant, so inflation risks on the expense side are typically completely mitigated. On the other hand, bonds are typically paid back at a flat coupon through maturity, so in an inflationary environment, real yield gets worse over the investment period.
Interest Rate Risk
As we all learned in Finance 101, interest rate fluctuations have a direct impact on the price of bonds in the open market. The change is often immediate. NNN real estate, a less liquid market, is less susceptible to changes in value attributable to interest rate fluctuations. Cap rates will certainly widen as the risk free rate increases, but generally the spread of cap rates over interest rates tends to compress first.
NNN investments are equity-based real estate investments, which adds a layer of complexity to the cash flows from an investment grade tenant. There is always the chance of a tenant not renewing and having to deal with a vacant building for a period of time.Some NNN leases also require the landlord to maintain the roof and structure of the building. However, some NNN leases can be structured as “absolute” NNN leases, where there is zero landlord responsibility. These are most similar to bonds in that the real estate specific risks are completely mitigated.
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Corporate bonds are typically publicly traded securities in highly liquid markets. Whole investment firms exist to trade debt on a minute-by-minute basis. As we all know, real estate on the other hand might take some time to exit in a pinch. Luckily, credit rated single-tenant NNN investments are some of the most liquid types of commercial real estate. The NNN investment market does not require as much local market knowledge to invest compared to other forms of commercial real estate, thus making the NNN market open to a wide buyer pool of investors from all across the country. The cap rates are easy to comp out, improving the market information and making it easier to transact.
While single-tenant NNN assets are slightly less liquid and might require you (or a management company) to keep an eye on them, their value is significantly less likely to be adversely impacted by an inflationary period or interest rate volatility.
Now that we have a framework around the risk profile of the two investments, the yield comparison is rather simple. Using data from the St. Louis Federal Reserve and net lease brokerage firms, Rising calculated the spread between corporate bond yields and average NNN lease cap rates across a Retail, Office, and Industrial portfolio since 2004. The result is a long-term average spread of 2.6%, with a current spread of approximately 3.7%, a considerable premium after adjusting for the risks discussed above.
Source: The Boulder Group, St. Louis Federal Reserve
These cap rate / yield spreads are further widened after tax considerations. Investment real estate is subject to depreciation which can drastically reduce taxable income. For example, using straight-line depreciation over a 39 year period and a 70/30 purchase price allocation to building/land, the first 1.8% of total yield would be tax-free. With a 37% marginal tax rate, that would result in an additional 67 bps of yield compared to comparable corporate bonds. Income from corporate bonds is 100% taxable and only municipal bonds have any tax-free yields, though their yields are often tighter to account for this.
We think that a diversified, credit backed NNN portfolio can offer a risk-adjusted yield premium compared to bonds of identical credit rating. We are currently exploring such aggregation for credit-focused LPs and our Rising Investor Platform. Please reach out to our team if you have any questions or interest in investing.
If you are an accredited investor and interested in gaining access to small-, medium- and large-sized investment opportunities, apply to the Rising Investor Platform: https://www.risinginvestorplatform.com/