Current Capitialization Rates VS Future Interest Rates

My partners and I are considering the purchase of a Walgreen's property to diversify our portfolio. The capitalization rate on the property is 5.75% with a 20 year lease. What will result if interest rates go back to being around 5-6%+ in the next few years, or at least before the 20 year lease expires?
In Market Conditions - Asked by Armaan H. - Nov 30, 2012
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Answer(s)

dave l.
Appraiser
Laytonsville, MD

If overall capitalization rates go up, which they probably will when mortgage rates increase, the value of your cashflow will be worth less as investors will want a higher rate of return than you do presently. Also, consider that mortgage rates will also increase so if you're leveraging the purchase, try to get a long term fixed-rate loan. Your yield could very well be eaten up if mortgage rates go up to 5.75% or more.

Dec 4, 2012
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mike k.
Owner/Investor
Middle Village, NY

It doesn't seem like the great investment you thought it was huh. However, don't forget that the Walgreens lease will have escalations which will increase your cap rate and hopefully keep you above rising interest rates and rising inflation.

Dec 4, 2012
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Aristithis L.
Developer
Chicago, IL

Your yield over time will be a function of how much debt you place on the property and the characteristics of the debt you place on it now. Placing long term, fixed financing, that will fully amortize will have a different effective risk profile for the overall investment then say floating, interest only, 5 year balloon debt facility.

Dec 4, 2012
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Joseph D.
Broker/Agent
Lakewood, CO

In an increasing interest rate environment, a flat income long term lease like the older Walgreen stores makes sense for estate planning where 1031 money put into the Walgreen income stream acquisition gives current income for the older property owner exceeding bank rates, and very likely a lower valuation (due to higher interest rates) when the estate is valued for his/her heirs. Otherwise, it can be like buying retail and selling wholesale.

Dec 5, 2012
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Keith C.
Broker/Agent
Fair Oaks, CA

It depends on if you are borrowing any money to purchase the income stream. It if is all your money, you just need to ask yourself if you are comfortable with a 5.75% return on your cash investment.
If you are borrowing cash to acquire it, there are many other variables to consider such as interest rate increases. If interest rates increase, prospective purchasers of your walgreen's property will be evaluating your property against other investments with a better yield.
I think the Walgreen's deal only works if you are using your own money to buy it and you are ok with a 5.75 rate of return. Otherwise, why lock yourself up in a long term situation where your costs will increase and you are stuck at a 5.75 rate of return? Each time your underlying mortgage rate increases, it squeezes your rate of return on the 5.75 cap rate.
I am not even factoring in the time value of money and discounted cash flow analysis. I wouldn't do it unless you are just risk adverse.

Dec 5, 2012
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Randal C.
Broker/Agent
El Paso, TX

A NNN deal like Walgreens can be an excellent investment. The cap rate is lower than other investment vehicles because your risk is much less. The returns arent as good as a typical value add deal, but you don't have much for head aches or management wows. I am a commercial agent that has invested myself for 30yrs I recommend dividing your investment dollars into 2 groups. Group 1 in a stable environment Group 2 into a more risky but high growth group. Your CPA and your wives will love group 1, you may like more group2. They both have merit.
Dont be afraid of Walgreens as they typically have superior locations and a stable income. These are easy to fund. Just make sure you have long term fixed rates. Leave the creative finance for your group 2 investments. But remember putting all your chips into the speculative arena is very risky. I learned this the hard way and lost millions. Thank god I had a few stable deals to fall back on. A good broker will always look after your long term interest and not just a fast deal.

Dec 6, 2012
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REMAX F.
Broker/Agent
Sugar Land, TX

Nobody has mentioned here that the property value is going to increase with rent escalations as well, if you have a 10%escalation over 5 years, just for argument sake, that means the property value would have gone up by almost 10%. So if your down payment was 25% then you would have an almost 40% increase in your equity in the 5 years. That is why people snap up these properties like hot cakes.

Dec 7, 2012
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Ken A.
Broker/Agent
Austin, TX

If you are investing cash in this property and are happy with the 5.75 CAP rate it is a reasonable investment.
If the interest rates climb to 5-6% there will be more opportunity to earn a higher return with your money.

May 21, 2013
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