NET LEASED PROPERTIES
©2009 Lloyd D. Hanford, Jr., MAI
Long term, net leased properties have long been the darlings of the real estate investment world, particularly among the smaller investors. However, years of observing that market suggests that these investments are not well understood by the investors particularly with regard to the risks involved.
For years, the primary focus of investors has been on the capitalization rate or yield with “credit tenants†commanding the lowest capitalization rates. Emphasis on credit has been misplaced as clearly demonstrated by virtue of different factors. First, a high credit company may be “bought out†via a leveraged buy out that encumbers the company with a mountain of debt that may ultimately eliminate any creditworthiness and may lead to bankruptcy. Secondly, adverse economic times can quickly erode both the capital of a company and lead to a substantial decline in revenues that further jeopardize credit standing. As has been clearly shown in the recent months, many businesses have failed and rejected some or all leases in bankruptcy proceedings. Financial institutions, once believed to be substantial tenants, have failed and closed their doors. Retailers have gone out of business. Businesses in bankruptcy have been able to re-negotiate leases at a substantially lower rent under the implied threat of lease rejection if unable to do so. The bottom line here is that the credit of the tenant may not be as important in the investment decision process as once believed and may not warrant significantly lower capitalization rates than those available from lesser credits.
Fast food outlets like KFC, drug chains like Walgreens, Rite-Aid and CVS, as well as bank branches have been very popular with investors with historic capitalization rates being among the lowest in the market. The market activity in the past suggested that all were treated somewhat alike in that the investment focus was on the income. However, each property type has its own unique characteristics that should be analyzed by investors to a greater degree than has been exhibited to date.
A characteristic of many fast food outlets is a relatively special purpose building that frequently represents an under-improvement of the land because of the necessary parking. Thus, any analysis of these properties, in addition to location, should focus on land value and its potential growth over time as well as potential alternative uses of the improvements. If the improvements have limited alternative uses, then investors should focus on land value as the justification for making the investment. If the improvements have alternative uses then focus should be on the market rent for the property and the value that may be implied by that rent. In many cases, where the improvements are small in relation to land size, the contract rent, on a square foot basis, may well exceed any measure of market rent for alternative purposes. This result should place more attention on the value of the underlying land.
Single tenant retail properties are usually just “boxes†with no limited specialized interior improvements. In addition to location, the relationship of contract rent to market rent is an essential analysis. Often, rental being paid exceeds the indicated market rent. As in the fast food properties, it is important to identify the demand that would exist for the property if it were to be vacated and the rent that would be probable from an alternative user.
A common element of most single tenant commercial properties is an initial long term lease at a fixed rent. The fixed rent acts as an inhibitor to value growth as value growth is dependent on income growth. Also, many long term commercial leases contain renewal options at either the same rent or a very slightly increased rent. This type of provision also limits value growth and, historically, has resulted in rent, over the long term, falling far behind market rent. When this occurs, the tenant builds a substantial leasehold interest which does not revert to the benefit of the property owner until the lease ends.
Single tenant office properties present different problems. There are basically three types of single tenant office properties: general office, high tech office and medical office (includes doctors offices, surgical centers and specialized medical centers like radiology ets). In general offices, tenant improvements are usually fairly standard and, in many instances, can be re-used by a successor tenant with minor modifications. However, in the other types of office, highly specialized tenant improvements and configurations of space are the norm. The tenant improvements are often priced into the rent being paid and are usually far more costly than standard office improvements. Thus, when a tenant vacates these specialized facilities, it is probable that the interior improvements will either be outmoded or will not meet the needs of alternative tenants. In either case extensive new tenant improvements would be needed. More importantly, the market rental value of the space without the specialized improvements is at risk of being substantially reduced. This caveat applies to most special use, single tenant properties but usually not to the same extent as in high-tech,scientific or medical facilities.
Larger net leased properties, such as major office buildings, “big box†retailers or super-markets like Costco and Safeway are not discussed because they are more commonly purchased by very high net worth investors and/or institutions. However, these larger properties, in addition to location, require analysis of the relationship of contract rent to market rent as well as an analysis of alternative uses and demand if the single tenant vacates.
Regardless of the type of property, before committing a purchase, investors should have a firm understanding of the market rent for the property and the alternative use possibilities as well as having an exit strategy firmly in mind. The exit strategy should consider when the property might be sold, the type of purchaser that would buy it and the price it might fetch (a measure of profit) with comfort that this exit would meet investment objectives.
