One of the most popular property types in commercial real estate are “triple net,” also known as “NNN” deals. These are typically single-tenant retail properties leased to tenants with high credit ratings on “net, net, net” terms (hence the NNN acronym), meaning the tenant is responsible for real estate taxes, insurance, and all maintenance.
At first glance these triple-net deals appear to be the perfect investment. They are typically new or nearly new, have no management responsibilities, a long-term lease to a quality tenant, stable cash flow, attractive financing, and the unique tax benefits only real estate provides.
The advantages have fueled a tremendous growth in demand from investors on every level. They appeal to part-time investors looking for guaranteed income with no management responsibility, and they provide an attractive exit strategy for those with mature portfolios. As with any investment, there are many factors to consider in valuing and structuring the deal.
First, like frozen food, you “pay” for the convenience of no management duties and stable, long-term income in the form of lower returns than with a more hands-on, high-maintenance project. Prices start in the range of a 6% cap rate for the highest rated tenants, up to perhaps 8.5% – 9% for lesser credit quality or those with short lease terms.
[Note: A cap rate is the percentage of return on the investment as if it were bought with all cash. The lower the cap rate, the higher the price.]
Investors who use debt financing can produce leveraged returns in the 10% – 12% range. But as we will see, income is not the only determinant of value.
Second, and often overlooked, is the wide range of risk exposure for NNN properties, even those with investment grade credit ratings. Contrary to popular belief, these are not “risk-free” investments, and in fact require a level of understanding beyond that of more typical real estate investments.
Risk is always present
In evaluating any NNN deal, be aware that all “credits” are not equal. A company’s credit rating is determined by one of the three ratings firms (Standard and Poor’s, Moody’s, and Fitch), and those with a rating of BBB- and higher (S&P scale) are considered “investment grade.”
Examples of the top-tier tenants include Walgreens (A+/Stable), CVS (A-/Stable), Wal-Mart (AA/Stable), and Home Depot (AA/Stable). Not coincidentally, these are also the properties with the highest valuations (lowest cap rate), and they set the upper standard for valuation.
Generally, as the tenant’s credit rating declines, so does the price of their property. But the mere fact a tenant has an investment-grade credit rating does not mean it is risk free.
The ratings establish the relative risk of default for a particular company, but no investment except a federal bond has a zero default rate. This point is illustrated by the following chart of default rates of rated retail credits over a fifteen-year period:
|
Original Rating |
Default Rate %* |
|
AAA |
.52% |
|
AA |
1.31% |
|
A |
2.32% |
|
BBB |
6.64% |
|
BB |
19.52% |
|
B |
35.76% |
|
CCC |
54.38% |
(*percentage of defaults by issuers rated by Standard and Poor’s over the past fifteen years based on the rating they were initially assigned. Source: Standard and Poor’s Corp/Business Week, 2002)
Note that the increase in default rates first doubles, then triples, with each step downward in the credit rating.
Understand the tenant
To an investor assessing risk, this brings up questions pertaining to the health of the tenant’s business model and financial strength and requires an additional level of due diligence.
Criteria may include the number of stores, debt to equity ratios, operating margins, stability of management, and the outlook for their industry sector. If you’re thinking that that sounds a lot like evaluating a stock, you would be right.
In leasing them your property, you are essentially providing capital to the business, and their continued success has a direct bearing on the long-term health of your investment. Past history and future prospects are both relevant.
For example, drug stores are considered a growth industry due to the aging demographics of the population. Well-managed brands like Walgreens and CVS/pharmacy receive superior ratings while Rite-Aid, another big player in the sector, has had problems in the past and a change in ownership. Their rating of B+/Negative reflects that history and a higher level of risk.
Some sectors are more vulnerable to future changes, which may pose significant threats to the tenant’s health. As an example, rental video stores are in a precarious position directly in the path of technology.
If broadband delivery of movies and games over the Internet becomes the new paradigm, it won’t make much sense to rent hard-copy DVDs–or to keep operating stores that do so–when the same product can be delivered without production, packaging, transportation, and inventory costs.
As a result, the ratings of notable players, such as BLOCKBUSTER (B/Negative Watch) and Movie Gallery (B+/Stable), are well below investment grade. There are also “sleeper,” non-credits out there who may not have an investment-grade rating, but are poised for rapid growth or enjoy significant operating efficiencies.
DOLLAR TREE is one example of a well-positioned, well-run company that doesn’t even have a credit rating because they have no significant debt. Yet their 2004 sales were over $3 billion with healthy profit margins, and they are opening new stores at a rapid clip across the country. But even with a thorough understanding of the tenant’s business fundamentals, NNN due diligence is not complete.
Real estate rules still apply
Regardless of the tenant’s credit rating, triple-net deals are still subject to standard real estate due diligence, including location, local market conditions, building size, quality and use, and the lease terms.
The objective is to not only determine the current value, but to quantify the best-case and worst-case scenarios for the future, including the possibility of the property being vacant, known as the “as-dark” value.
Obviously a property in a poor market or poor location can be difficult to re-lease. A fact of real estate life is that no two markets are exactly alike, so a thorough understanding of the local market conditions and the property’s position in the market is critical to establishing value.
Just as location determines its competitive position within a market, local trends in population demographics, employment, and income affect the marketability of a property compared to similar properties in other markets. With standardized lease terms and cookie-cutter buildings, the market factors become the major differentiator between properties.
Specialized buildings (think fast-food restaurants and oil change stores), even those in good locations, can hold significant risks in the “as-dark” scenario. They can be very difficult to adapt to other uses and often must be razed for total redevelopment, lowering the residual value of the property.
Even standard “vanilla-box” type buildings may require significant up-fit or refurbishment to be competitive if the space is vacated after long use. These costs must be accounted for in the overall valuation analysis.
The lease itself is perhaps the most important piece of the NNN puzzle. It is the buyer’s responsibility to read, interpret, and understand the lease terms, and most leases are complex documents. They are always written by the tenant and heavily biased in favor of the lessee. They can contain land mines of unexpected expenses, cancellation clauses, or toothless default penalties.
For properties with expiring leases or renewal options during the contemplated hold period, the risks increase. Few investors will consider closing a NNN deal without the counsel of an attorney experienced with the specific due diligence issues inherent to tenant-written leases.
Capitalized income value vs. as-dark value
Current practice for valuation of NNN deals is based primarily on the capitalized income stream. As a result, actual cost is often ignored. It is common to see deals priced at $400 per square foot and higher for buildings that cost $100 per square foot or less to build.
This disconnect is often swept under the rug of the credit-tenant lease, but if we look past the income stream to the intrinsic value of the property at the end of the hold period those warm fuzzy feelings can quickly turn cold.
A real-world example
As a case in point we’ll use Dollar General stores. I do not intend this to disparage the company in any way. They’re a great company with a strong balance sheet, a BBB/Positive credit rating, and a business model that would seem to be recession proof. I use them because their stores are popular with investors and there are a lot of them on the market.
The standard Dollar General building is an 8,125 sq. ft. steel building on a concrete slab with a brick facade on the end wall, typically located in tertiary and rural markets on a one-acre site in a second- or third-tier location (i.e., a block or so off the main retail drag, or perhaps in a marginal neighborhood, or both). Most would be considered “location-challenged.”
Their standard lease has double-net (NN) terms. The landlord is responsible for parking lot maintenance and dollar-limited HVAC service–about $2,500 per year for both. Hence the pricing is not as high as true triple-nets. Asking cap rates are in the 8% – 8.5% range
They sign a ten-year primary lease term with three five-year options. Rents range from about $6 – $8 per sq. ft., flat for the primary term, with 10% bumps in each option period.
If we run the numbers in the middle of the income range at $7 per sq. ft. rent, less $2,500 annual maintenance and Cap-Ex reserves (about $1,220 per year), the NOI (net operating income) is $53,155. (8,125 sq. ft. X $7 = $56,875 – $2,500 – $1,220 = $53,155 NOI)
Using the upper range cap rate of 8.5% produces a sales price of $625,000, or $77 per sq. ft. Available finance terms are typically 25-year amortization, 10-year call, non-recourse, 80% LTC (loan to cost) with a minimum 1.2 DCR (debt coverage ratio), and a fixed rate–around 6.75% in today’s market.
If we put 20% in the deal ($125,000) and finance $500,000, the debt service is $41,455, which yields cash flow of $11,700 for a pre-tax 9.4% leveraged return. For the typical passive investor that beats mutual funds or CDs, or even corporate bonds with a similar rating.
The lease has a corporate guarantee, and the depreciation will shelter all or most of the cash flow kicking the after-tax return calculation up to 11% – 14% depending on the tax bracket. What’s not to like?
Dirt(y) thoughts
Well, I look at that deal with an old-time “look at the dirt” mind set, and the worst-case scenario at the end of the hold period. Unless the “dirt” aspects are in line with the valuation based on income, the end-game math is brutal.
If the tenant leaves at the end of the primary term, mind set own an empty steel building that costs about $50 per sq. ft. to build, on a land parcel worth maybe $100,000 with a total developed cost of about $506,250.
Assume 2% annual inflation and the replacement cost in ten years is about $600,000, less depreciated useful life of $125,000, equals an as-dark, end-of-lease value of about $475,000 for a steel building in a second- or third-tier location.
Call me a cynic, but that sounds like a future auto body shop. But the question is whether the income over the hold period offsets the low residual value. Let’s do the math:
The cumulative cash flow over the first nine years is $105,300 (pre-tax). The mortgage balance will be about $390,000, leaving equity of about $85,000, less sale costs of say 7%, leaving $51,750 in proceeds plus the tenth year cash flow of $11,700.
The total cash flow and sale proceeds are $160,750, less the initial investment of $125,000, leaving a total return of $35,750, or about a 2.8% annual return and 4% IRR (internal rate of return). Now we’ve got to wonder if a body shop can pay enough rent to cover the debt service of a new loan.
Add to that there is no near-term or intermediate exit strategy. Since the rents are fixed there is no upside value unless demand were to exceed supply, which is not likely either. There is a lot of the product available, and Dollar General recently announced (12/05) that they intend to open over 800 new stores in 2006.
That’s a ton of new supply, and existing properties will compete against the new stores with full lease terms in the resale market. That rules out a quick flip entirely, and any appreciation over the long term entirely depends on local market conditions.
Now we can see that what looks like a sure thing is not so sure. We’ve got some work to do in making our decision, and thorough due diligence on the tenant, the market and the property makes the difference between a great investment and an albatross.
Triple-nets DO have a place
I do not mean this to be a negative diatribe for triple-net properties. My own portfolio holds several, and the benefits are real. These deals can be a solid assets and well-positioned to build wealth over the long term if you understand the sources of risk, the overall marketability of the property, and value accordingly.
Above all, don’t let the bright lights of a credit-tenant deal blind you to the fact that it is still real estate and the fundamentals do apply.