Cap rates for single tenant net lease (“STNL”) retail properties are coming off ofrecord lows.The historically lowinterest rate environmentover the past several years injected massive amounts of capital into the STNL market and contributed to a significant supply and demand imbalance. High-net-worth investors, 1031 exchange buyers, public and private real estate investment trusts (REITs), and family offices all competed for a limited supply of STNL retail properties.As a result, the cap rate spread between lesser quality STNL properties (with shorter-term leases and lower credit tenants) and top tier STNL properties (with long-term leases to investment-grade credit rated tenants) narrowed. At the peak of the market, STNL properties of all quality were selling for similar aggressive cap rates.Over the last several months, cap rates have risen across the board as various headwindshave impacted the market.As the market continues to adjust, we expect to see cap rates continue to rise. However, pricing for STNL properties in Colorado will remain strong with net lease investors continuing to pay premiums for top tier properties in major markets.
1031 exchange investors are historically the most aggressive buyers for STNL retail properties due to their shortdeadlines and looming tax liabilities. Many of these buyers are transitioning out of management intensive or non-income producing properties, and replacing them with STNL properties that are subject to long-term passive net leases. With transaction volumes declining in the other real estate classes, there are less highly motivated buyers in the marketplace. Additionally, as the Federal Reserve attempts to combat high inflation with ongoing interest rate hikes, financing these transactions has become increasingly difficult and has led to fewer buyers in the marketplace. With fewer aggressive buyers, inventory has begun to build compared to the level current of demand. As such, the cap rate spread between top tier STNL properties and lesser quality properties has shifted noticeably.
Even though cap rates for STNL properties are rising, they remain well below pre-pandemic averages. From 2017-2019, there were 334 STNL retail properties that sold in Colorado. The average cap rate during this period was 6.37%. Beginning in 2020 and extending through 2022, 321 single tenant net lease retail properties were sold in Colorado. The average cap rate during this period dropped by 70 basis points to 5.67%. So far in 2023, there have been 27 single tenant retail transactions in Colorado. The average cap rate for these transactions was 5.79%, 58 basis points lower than the 2017-2019 averages.
Net lease investors continue to seek top tier STNL properties that feature long-term leases, investment-grade rated tenants, new construction, and well-located real estate in major metros. STNL investors are willing to sacrifice some yield for the stability that these properties offer. As evidenced, six STNL retail properties have sold below a 5.00% cap rate in Colorado in the first quarter of 2023, compared to seven in the first quarter of 2022.
Moving forward, we expect price discovery to continue for STNL retail properties as various headwinds continue to impact the real estate market. Rising interest rates, prolonged inflation, and fears of a recession in the second half of 2023 will continue to apply upward pressure on cap rates. We anticipate cap rates to further widen between top tier STNL retail properties in major metros and lesser qualityproperties in tertiary markets. High-net-worth individuals and 1031 exchange buyers will continue paying premiums for strong credit and recession resistant tenants.
As featured in Colorado Real Estate Journal.
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