The Not So Passive Realities of Net Lease

Commentary by Noah Shaffer, a key player in 3 Properties’ transactions and leasing projects. Noah, the youngest broker on our team, founded the USF Real Estate Society as an undergraduate student ultimately leading to the founding of a formal real estate degree program at the University of South Florida. Noah is currently pursuing his MBA and CPA designations.

 

Key Mishaps of Real Estate Investors

 

Net lease ownership is commonly misconceived as a passive real estate ownership process. This misconception often leads to poor investment returns and investment decisions during the ownership process. Here are a few significant aspects of net lease ownership that lead to the largest financial repercussions to investors:

 

The Structure of the Lease

My Tenant Will Adhere to Their Lease Obligations

Your tenant’s core focus is on building strong operations for their brand at your location. The real estate is your responsibility as the owner, and the owner should actively manage the premises according to the terms of the lease. This will prevent any ultimatums from your tenants, and allow for seamless lease renewal process. Buyers should be certain of all landlord responsibilities. The lease is often written by the tenant’s lawyers, and buyers should hire a transaction attorney to ensure they do not have any hidden day-to-day or infrequent obligations.

 

Justifying Investment Decisions and Property Strategy

 

The decision to purchase a real estate asset at the current cap rates in the market must accurately reflect the risk level and time commitment commanded by the property. Buying a Wawa ground lease at a 4.50% cap rate in 2018 simply because the Wawa five counties oversold for the same cap rate in 2016 is not a well-founded valuation. Purchasers of net lease properties often fail to correctly analyze the effect the credit of the tenant has on the property’s overall risk. Despite both being “Investment Grade”, there is a vast difference between Wawa’s BBB- Fitch rating in 2011 and Chase Bank’s A+ S&P rating.

 

As an investor, you must properly analyze the financial statements of the lease guarantor to determine their likelihood to continue operations for the term of the lease. Failure to do so may result in you owning a Toys-R-Us or Mattress Firm 3 years after you purchase the property. Trends in consumer preferences are leading to rapid swings in tenant creditworthiness. As a landlord, you must analyze your tenant’s financials every 6 months and understand how changes in tenant financials positively or negatively affect your property’s value.

 

Understanding Investment Requirements and Property Position

 

A higher offer is just around the corner. Sellers are hesitant to accept offers to purchase their property at capitalization rates higher than comparable properties. We are currently emerging from one of the strongest economic climates in the past century and the next few years propose uncertain times. Economic signals, including rising interest rates, signify a weakening of the economy and a corresponding increase in capitalization rates on the horizon. Should you decide to hold the property rather than sell, be prepared to hold it for four or five more years. It is important to understand what the position of your property will be in four or five years should you have to hold.

 

There are some important questions to ask yourself to give a framework for your decision to hold out or sell now: Will I need liquidity within the next five years? How many years will remain on the lease if I am forced to hold the property for five years? How will the decrease in lease term affect the property value? Will my tenant renew their lease? What tenants would replace them in the property if they decide to vacate or go out of business? What will the turnover cost me as the landlord?

 

While asking these questions at the decision point for disposing of an asset, these questions should be asked on a recurring basis throughout your ownership of the property in order to maximize your return on the property.

 

As a landlord, you must provide focused attention to your net lease assets despite their somewhat passive nature. Failure to actively manage your site may lead to you being handed a dilapidated building at the end of your lease, and failure to understand the economic climate may lead to poor timing for your real estate acquisition or disposition.