The Ground Lease Is Priced Below the Treasury

The Federal Reserve raised the federal funds target range by a quarter point to 3.75 to 4 percent on September 16, by a 12-0 vote, per the FOMC statement. Per the Fed's H.15 release, the 10-year Treasury yield was 5.31 percent on October 5. The Boulder Group's second-quarter net lease report had the 10-year settling near 4.40 percent, with McDonald's and Chick-fil-A ground leases asking 4.45 percent.

Our position: a pad priced at a June cap rate has not been repriced yet. The 10-year moved about 90 basis points in a quarter. The June ask on premium ground leases sat on top of the Treasury then. It is about 86 basis points under today's yield. If we were carrying a land contract signed on summer exit math, we would re-run the exit this week, before the buyer does it for us.

The retrades have started

Investing.com reported October 6 that commercial real estate buyers are demanding price cuts on deals agreed before rates moved. Per that report, the pressure began when bond yields rose in late summer and increased after the September hike. Two of its examples are in the Carolinas. A bank participating in a $45 million construction loan for a more than 90 percent-leased North Carolina retail center pulled out because of market conditions; per CRE Daily, Marcus & Millichap found a replacement lender. And a roughly $10.2 million sale of a 65,000-square-foot property in Greenville, South Carolina closed in September after the seller agreed to cut the price by $100,000.

Per the same reporting, the FTSE Nareit All Equity REITs Index fell more than 8 percent from late August through October 2, and 11.42 percent of loans in commercial mortgage-backed securities were with special servicers in August, the highest share since February 2013.

The North Carolina loan is the detail we would underline. A center more than 90 percent leased does not have a leasing problem. It had a capital problem.

Spreads, not cap rates

Per Boulder's Q2 report, corporate QSR cap rates averaged 5.85 percent and franchisee QSR 6.85 percent. Against the June 10-year, that was roughly 145 and 245 basis points of spread. Against the October 5 yield, it is about 54 and 154.

We do not know where third-quarter cap rates will print, and we will not guess. Net lease buyers price against their debt, and exchange buyers price against what their cash earns elsewhere. A ground lease yielding less than a Treasury needs a reason to hold its price: credit, term, rent increases, the real estate itself. Plenty of pads have those reasons. We would not assume every pad holds its June number.

The arithmetic on a hypothetical pad: $100,000 of annual ground rent capitalized at 4.45 percent is about $2.25 million. At 5.25 percent it is about $1.90 million. Same rent, about $340,000 less value.

What we watch for

We do not expect ground rent to follow the 10-year. Tenants set rent from store economics. When the exit cap moves and the rent does not, the difference lands on the land price or on the developer's margin.

We re-run the exit at the current Treasury on anything not yet closed. A land contract with a long inspection period and a summer price is a renegotiation with no date on it yet.

We watch construction lenders, not only buyers. The North Carolina loan shows a lender can step out of a well-leased project. A pad that needs a construction loan carries that risk until the money is funded.

We watch Boulder's third-quarter report for the premium ground lease ask. If it holds near 4.45 percent with the 10-year above 5, the premium for the best paper is real. If it widens, we would read that as the repricing reaching the top of the market.