By Justin Arasin, Head of Capital Formation and Product Development, US Realty Advisors
& David Grazioli, Managing Partner, US Realty Advisors
Net lease real estate and private credit have gained prominence among investors seeking stable returns with reduced volatility. Amidst recent US commercial real estate challenges, the appeal of potentially less risky real estate strategies like net lease has risen. Simultaneously, traditional corporate lenders are tightening their belts, leading to a growing interest in private credit as an alternative debt funding source.
Although they share some characteristics, net lease real estate and private credit diverge significantly in areas such as taxation, inflation protection, bankruptcy protection, and capital appreciation. This brief case study delineates the distinctions between net lease and private credit investments, illustrating how a strategic blend of both may offer a balanced source of income with reduced volatility.
Income Taxation
Net lease real estate investments generally involve long-term, 15 to 20 year leases, with tenants responsible for property expenses like taxes, insurance, and maintenance. This ensures a steady, growing stream of passive income for landlords. The building is occupied by a single tenant that is credit worthy in nature and deems the asset as critical to their business operations. From a taxation standpoint, net lease income often benefits from favorable tax treatment, including depreciation deductions and capital gains treatment upon property sales.
In contrast, income from private credit investments, like loans or bonds, may be subject to ordinary income tax rates, potentially leading to higher tax liabilities and lower tax-adjusted returns for investors.
Inflation Protection
A key advantage of net lease real estate investments is their inherent inflation protection. Net leases typically include provisions for periodic rent escalations, usually fixed annual increases or increases tied to inflation indices like the Consumer Price Index (CPI). These built-in increases help maintain long-term purchasing power of rental income, mitigating the erosive impact of inflation on investment returns. They also serve as an elevated form of yield even if interest rates decline. In addition, hard assets like real estate have historically fared better in inflationary periods due to their intrinsic value.
Private credit loans, on the other hand, have little to no call protection, even though they are typically floating rate. Therefore, in a tightening spread or declining rate environment, lenders are likely to be repaid early or to receive lower interest income.
Considering the topics of taxation and inflation, we believe blending these two asset classes can create a well-balanced yield segment in portfolios, offering an alternative solution alongside short-term cash investments vulnerable to inflationary erosion.
Bankruptcy Protection
In the case of a tenant’s bankruptcy, we believe that risk mitigation is different in the net lease space and, therefore, can serve as a diversifier to private credit exposures.
First, bankruptcy law prioritizes rental payments to landlords, requiring tenants to pay rent in full as an administrative expense (i.e., pay current and before any other payments are made by the entity filing bankruptcy), unless and until such time as the lease is rejected. These payments ensure that, even during the bankruptcy process, the predictable and consistent cash flow that is characteristic of a net lease investment is not disrupted. The same cannot be said for private debt, as both interest and principal payments on debt are suspended until the bankruptcy proceeding is concluded. In addition, net lease assets that are operationally essential are highly unlikely to be rejected, as the continued use of the property is critical to the tenant as well as its customers and creditors (Figure 1). Indeed, the focus of most bankruptcies is to jettison leases on underutilized properties and to restructure unsecured debt.
Second, the very nature of a net lease investment— the ownership of real estate—is unaffected by a tenant’s bankruptcy. If a lease is affirmed, any lease defaults must be cured and kept current. If a lease is rejected, the tenant is required to pay all rent to the date of rejection and, importantly, to surrender the premises to the landlord on the date of rejection. After seamlessly obtaining control of the property, without the expenditure of costly legal fees, the landlord is not only free to sell or re-let the property, it also has an unsecured claim equal to the greater of (i) one year’s rent or (ii) 15% of the balance of the contractual rent (not to exceed 3 years rent in the aggregate).
Private credit investments lack such protections and thereby expose creditors to a higher risk of capital loss since lease affirmations do not directly affect debt repayment obligations. The outcome depends on various factors, including the debtor’s financial restructuring plan and court decisions, potentially diminishing recovery prospects for creditors.
Capital Appreciation
Net lease cap rates have remained relatively stable over the last 20 years, hitting a low of approximately 6% and peaking slightly above 8%. In the current real estate cycle (Figure 2), we believe prudent net lease managers have the chance to purchase net lease properties at lower prices compared to the last several decades, therefore offering potential upside moving forward that enhances return outcomes alongside private credit allocations.
Coupled with this unique opportunity around entry point, net lease properties have also historically demonstrated resilience amid economic uncertainty and market volatility, thanks in part to their long-term call protection. This differs from private credit instruments, as noted earlier. Triple-net leases with creditworthy tenants and fixed-rate financing seek to provide reliable and predictable cash flows, heightening their investment attractiveness, regardless of the interest rate environment and particularly in times of uncertainty.
Overall, we believe the historical stability of net lease real estate, combined with attractive valuations for carefully underwritten transactions, presents an enticing entry point for investors seeking income-generating assets with defensive characteristics.
Conclusion
Net lease real estate and private credit have emerged as prominent alternatives within the investment landscape, offering investors stability and reduced volatility. The increasing appeal of potentially less risky net lease assets, coupled with the tightening stance of traditional lenders, has led to a growing interest in both options as important investment solutions to consider. Despite sharing some characteristics, these two investments diverge in areas such as taxation, inflation protection, bankruptcy protection, and capital appreciation. Therefore, we believe a strategic combination of net lease and private credit investments can be viewed as a way to strengthen and diversify a portfolio.
About the Contributors
Justin Arasin joined USRA in December 2023 as Head of Capital Formation and Product Development. He most recently came from Nuveen, where he was Head of Alternative Investments. Justin began his career in 2005 as a Client Portfolio Analyst within Goldman Sachs Asset Management and throughout his 20-year career has covered all investor types. Mr. Arasin is a graduate of Siena College with a B.S. in Finance and Minor in Economics (Summa Cum Laude).
David Grazioli joined USRA in 2007 and was promoted to Partner in 2014 and became Managing Partner in 2022. He is responsible for overseeing the firm's operating and investment activities. During his tenure at USRA, Mr. Grazioli has originated and closed over $7 billion of corporate sale-leasebacks, build-to-suit, renovate-to-suit, and ground lease transactions. Mr. Grazioli is a graduate of the School of Management at Boston College (Bachelor of Science, Accounting and Finance).
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