Triple Net Leased Properties May Soon Be Overassessed

As a result of inflation, the 2022 battleground for real property tax appeals for Triple Net Leased (“NNN”) properties may be all about applicable cap rates. The compression of cap rates used to acquire NNN properties is being stalled by rising inflation, thereby causing values to fall in some cases. This trend will accelerate as high inflation becomes chronic. Will property tax assessments reflect that market change? Will assessors begin to bake in the negative impact of inflation into their valuation models? Probably not, and certainly not without a timely appeal.

The voracious appetite of risk conscious investors for net-lease products has propped up values for several years now, but if inflation continues to push the 10-Year Treasury up, cap rates will follow. Assessors have aggressively valued this asset class for ad valorem property tax purposes. They have not loaded their cap rates with local property tax rates because the tax burden is not on the owner, but the tenant. The perceived lack or reduced risk in these investments has led many assessors to lower cap rates to the same level as multifamily residential; these assessments are inflated. This should be of particular concern to the tenants of NNN properties who pay these real properties taxes because that is one of the three Ns.

Commercial real estate isn’t exempt from the effects of inflation—no business is, but in this industry, it typically manifests in two places, both as a positive and a negative. The positive effect of inflation on commercial real estate tends to show up as increases in market rents and in what tenants can pay. The negative effects will most often show up in operating expenses, not to mention the overall erosion of the purchasing power of the income stream being received by the owner as inflation erodes the value of the dollar. On fixed-rate triple-net lease properties, however, an owner will rarely have the opportunity to increase a property’s rental income to offset rising costs. That makes inflation a major challenge for NNN investors and owners.

During normal inflationary periods, commercial real estate is impacted the same as any other industry. Accordingly, higher costs are typically passed down to the next consumer. Inflation on a multifamily investment, for example, is passed down to the renter, which means they pay the landlord more money in rent. On a net lease investment, the problem is that most rents are prenegotiated many years in advance and, thus, are set in stone with very nominal increases for the term of the lease.

A NNN lease could have a fixed rate for decades. While the tenant pays for maintenance of the property, the buying power of the rental income is reduced during inflation. On such a lease, if the landlord collects $300,000 in rent during 7% inflation, their rent is now only worth $280,000 compared to what it was a year ago, in “today’s dollars.” Unfortunately, the landlord has no option to increase the rent, and that $20,000 of spending power is likely reduced forever. When you apply that impact and discount year after year, you can forecast what even a couple of years of a high-inflationary environment will do to the value of the income stream on a relatively fixed rental schedule.

Not all NNN leases have a fixed rate. Many include regular increases throughout the life of the lease. A lot of net lease investments have increases throughout the lease, but still, many do not, and comparing it to recent inflation numbers, those increases are relatively low. Increases do help to offset inflation but may not offset it entirely. For example, a 2% annual or a 5% step increase every five years is common on some NNN assets, but the most recent rate of inflation last year was 8%. “One way to take advantage of rental increases throughout the lease is to leverage real estate, a 2% annual increase in rent could equate to a 6% increase in net cash flow.” However, some investors would then be subject to refinancing risks in the future.

There is typically a market lag between interest rates before an increase or decrease in cap rates occurs, but we are quickly approaching that tipping point. If inflation continues, that could change quickly. The Federal Reserve has announced multiple increases in base interest rates to lower demand, which will impact pricing. If inflation and interest rates continue to increase for the foreseeable future, that will likely have a big impact on values. That would be troubling because a lot of net lease investments are comparable to fixed income assets.

What has this got to do with real property taxes? The key components for any real property valuation for assessment purposes are estimates by the assessor of net operating income (NOI), risk adjusted cap rates, and below the adjustments for existing adverse conditions and lease up cost at the subject property. If you select a cap rate that is not market supported and inflation adjusted for a NNN property, the resulting assessed value may be inflated.

Just as adjustments for the negative impact of COVID-19 were needed in 2020–2022 for many properties impacted, so must we be vigilant that NNN properties are not inadvertently overassessed for a lack of adjustment for the impact of inflation. There is every indication that a return to 2% inflation will not occur soon, and so for the next few years, NNN property owners and their tenants need to carefully review their proposed real property assessments once issued and appeal in a timely manner.