Understanding Single Tenant Net Lease Financing for Construction

Contributors
Jordan Arzi
Director, CRE
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In the realm of commercial real estate, single tenant net lease financing is an effective tool for developers and investors looking to fund new construction projects. This financing method, particularly in the form of a triple net lease, offers unique advantages and considerations that can make a construction venture pencil. Let's delve into the details of single tenant net lease financing and its relevance to construction projects.

Why Now?

There is a void in the market between the expansion plans of tenants and the availability of financing. Meanwhile, banks have pulled back on lending due to their outstanding commercial real estate exposure and liquidity constraints.

According to an article in Forbes on trends reshaping retail: "In December 2023, the retail vacancy rate across the U.S. was 4.6%, the lowest level recorded by the CoStar Group since they began tracking it in 2007. On the supply side, construction started on just 46 million square feet of retail space in 2023, compared to 82 million in 2022.This decline is due to increased financing costs, reduced capital availability, and still-elevated input costs such as land and materials."

 

What is Single Tenant Net Lease Financing?

Single tenant net lease financing, often referred to as a triple net (NNN) lease, is a type of arrangement commonly used in commercial real estate. Under this lease structure, a tenant agrees to pay not only the base rent but also the property taxes, insurance, and maintenance costs associated with the property. This type of lease is typically long-term and stable, making it attractive for financing new construction projects.

 

How Does it Apply to Construction Financing?

For developers seeking financing for new construction, securing a single tenant with a triple net lease can be instrumental in lowering borrowing costs. Here’s why:

1. Pre-Lease Agreements: Developers may negotiate a lease agreement with a tenant even before construction begins. This lease commitment provides assurance to lenders and investors, mitigating risks associated with vacancy post-construction.

2. Stable Cash Flow: The predictability of rental income from a single tenant under a triple net lease reduces uncertainty for lenders, making it easier to secure financing at more favorable terms.

3. Lower Risk Profile: Lenders often view single tenant net lease properties as lower risk due to the long-term lease commitments and the tenant’s responsibility for property expenses.

 

Key Considerations for Construction Financing with Single Tenant Net Leases

While single tenant net lease financing can be advantageous for construction projects, there’s more to the underwriting of the loan than just having a triple net lease. Lenders will also assess the following:

1. Creditworthiness of Tenant: The financial strength and creditworthiness of the tenant are crucial. Lenders assess the tenant’s ability to fulfill lease obligations over the long term.

2. Lease Terms and Length: Longer lease terms are generally more favorable for financing. Lenders prefer leases with stable, long-term income streams.

3. Property Location and Type: The location and type of property (e.g., retail, industrial, office) can impact financing terms.

4. Exit Strategy: Developers should have a clear exit strategy in place, especially considering the long-term nature of single tenant net leases.

Today’s Single Tenant Net Lease Financing Market 

Peachtree is seeing a variety of projects across the spectrum, from standalone quick service restaurants to grocery anchored centers. Currently, our team is favoring deals with experienced developers and strong national tenants.

Why Peachtree?

  • Flexible Financing Options: Multiple and single net lease financing across retail, industrial, and medical
  • Innovative Solutions: Flexible capital to support complex deals.
  • In-House Loan Servicing: Dedicated servicing for a streamlined process.

Single tenant net lease financing, particularly through triple net leases, is a valuable tool for financing construction projects in commercial real estate. By securing a lease commitment from a creditworthy tenant, developers can leverage stable income streams to obtain financing on favorable terms at lower interest rates.

As a nationwide balance-sheet lender, Peachtree Group is ready to facilitate your business plan and get your deal done. Learn more about Peachtree Group’s triple net lease financing terms and get a quote.

Need immediate assistance? Contact Jordan Arzi, lending@peachtreegroup.com

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Summary of the Economy:

  • The U.S. economy is performing well with steady growth. First-quarter growth was around 1.3-1.4% annualized GDP, but underlying indicators suggest stronger performance, with the Atlanta Fed projecting 3.1% annualized GDP growth for Q2 2024.
  • Unemployment is low at 4%, with recent job gains of 272,000. The private sector, especially healthcare, is driving job growth, leading to a more sustainable employment market and supporting consumer spending.
  • Strong employment ensures income stability for consumers, driving sustained consumption, which constitutes about 70% of GDP.
  • Inflation has decreased from its peak but remains above the Federal Reserve's target. The Fed prefers the Personal Consumption Expenditure (PCE) Index over the Consumer Price Index (CPI), with the current core PCE inflation rate at 2.7-2.8%, still above the 2% target. While adjusting the target inflation rate from 2% seems highly unlikely due to the Fed’s strong commitment and public trust in this goal, a more flexible approach within a defined range might be possible. This allows     the Fed to address inflation without formally changing the target, leveraging the current economic strength to be patient and let inflation decline over time.

Federal Open Market Committee’s Perspective:

  • The Federal Open Market Committee (FOMC) is committed to making decisions on interest rates and monetary policy without political influence. Over a decade of attending meetings, Dennis has rarely seen political considerations come up. However, by tradition, the FOMC avoids action in the meeting immediately before a national election to prevent any appearance of political bias. Under Jay Powell's leadership, if necessary, the FOMC would act in September, but current conditions likely won't force action until after the election.
  • While different policies implemented by the elected candidate could shape the economy in the long term, the election itself is not anticipated to have an immediate impact. However, if post-election circumstances lead to significant disruptions, it could give the Federal Reserve pause at their November meeting.
  • If inflation doesn't improve or disinflation stalls at around 2.7-2.8%, the Fed may need to raise rates further. Conversely, consistent positive disinflation data     could lead to rate cuts by year-end. There are several scenarios to consider:
    • Sticky Inflation: If inflation remains high, the Fed might raise rates toward the end of the year or early 2025.
    • Disinflation Resumption: Positive disinflation data could lead to rate cuts in November or December.
    • Economic Slowdown: If the economy shows signs of faltering and businesses anticipate a recession, resulting in layoffs and reduced consumer spending, the Fed might cut rates to stabilize the situation.
    • Financial Instability: A financial stability event, similar to the Silicon Valley Bank incident last year, could prompt the Fed to cut rates to address underlying banking system issues, especially in commercial real estate.
  • The FOMC's narrative is that the economy is gradually slowing down. The employment picture remains very positive and strong, though it is rebalancing and not as robust as in 2022 and 2023. Inflation is still elevated, but the FOMC believes disinflation will resume, allowing them to begin easing policy restrictions by the end of the year. However, all of this depends on how the data comes in and the overall economic picture painted by the upcoming months. Upcoming Fed meetings are scheduled for July, September, November, and December. Policymaking remains cautious, with an emphasis on waiting for clear trends in inflation data before making further changes.

 

Geopolitical Risks:

  • Geopolitical events can significantly impact financial markets and potentially change the economic outlook for the U.S., at least temporarily. These events, often unexpected, can disrupt equity markets and influence the economy.  However, the Federal Reserve tends to be largely oblivious to geopolitics. Despite being close to the State Department, the Fed staff, mostly PhD economists, focus primarily on domestic issues and rarely consult with experts on geopolitical matters. This domestic focus means that while geopolitical events are serious and can influence the economy, they are not heavily factored into the Fed's policy decisions or economic projections.

 

Monetary Policy:

  • The balance sheet is a central tool for monetary policy. When interest rates hit zero during the Great Recession and the pandemic, the Fed used quantitative easing (QE) to stimulate the economy by increasing bank reserves, which supports lending and adds liquidity to financial markets. This led to the significant expansion of the Fed's balance sheet.
  • Currently, the Fed is slowly reducing its balance sheet to withdraw stimulus from the economy. This process, known as quantitative tightening, aims to find a new balance that provides ample bank reserves and liquidity without disrupting credit markets. The Fed approaches this carefully to avoid financial instability, such as the incident that occurred during a previous tightening attempt. This balance sheet adjustment is a critical but often behind-the-scenes aspect of monetary     policy.

Fiscal Policy:

  • Fiscal policy, especially deficit spending, boosts demand and contributes to inflation. During the pandemic, significant stimulus measures supported households and businesses but also added to inflationary pressures. However, inflation is a global issue and not solely caused by domestic fiscal policy.
  • Federal Reserve Chairman Jay Powell acknowledges the unsustainable fiscal situation due to high debt levels but avoids criticizing Congress. The Fed factors in fiscal policy as one of many economic influences, recognizing its role in supporting growth, which can conflict with the Fed's inflation control efforts.
  • The Treasury's debt issuance strategy affects the bond market and banks holding these securities. Fiscal and monetary policies often create conflicting pressures, but the Fed incorporates these effects into their economic assessments and decisions.

 

Banking Sector:

  • Banks, particularly regional and community banks, have significant exposure to commercial real estate, making up around 40% of the market. While national banks have less exposure, the real estate market downturn has affected all banks, with properties like office spaces experiencing severe value declines and multifamily properties down by nearly 30% from their peak values due to high interest rates. Despite Federal Reserve Chair Powell's reassurances about the banking system's     stability, there are concerns about the real-time recognition of crises. Historical precedent suggests that crises often go unnoticed until they are well underway.
  • The upcoming maturities of approximately $850 billion in commercial real estate loans present a potential risk. The exposure is dispersed across various financial entities, which is somewhat reassuring. However, small and regional banks are particularly vulnerable. The failure of a significant regional bank due to real estate exposure could have severe economic repercussions, unlike the manageable impact of community bank failures.
  • Banks are currently managing the situation by extending loan maturities, effectively buying time to stabilize individual properties. While this approach can mitigate immediate issues, it also reduces banks' lending appetite. A significant reduction in credit availability, particularly for small businesses that rely on smaller banks, could trigger a recession. This dynamic highlights the delicate balance between managing existing problems and maintaining sufficient credit flow to support economic activity.

Commercial Real Estate:

  • The near-term and long-term valuations of commercial real estate, particularly in hospitality, will depend on market fundamentals. The office sector faces significant challenges due to the rise of remote work, which could reduce long-term demand for office space. Companies are still figuring out their office policies, with some adopting hybrid models.
  • The retail sector is affected by online shopping, and the hospitality sector is recovering from the pandemic but hasn't fully rebounded. There are no major issues expected in hospitality unless there is overbuilding.
  • Office spaces were already saturated pre-pandemic, and suburban offices now struggle to find tenants. Many offices remain underutilized, with some businesses likely to stay remote. Converting office buildings to apartments is often not feasible due to technical constraints.
  • The multifamily housing sector continues to show strong demand and remains a stable area in commercial real estate.