2011 Outlook on NNN Investments: part 1

Marcus & Millichap RetailResearch has released its 2011 Outlook report.  I always look forward to this report as well as the ULI Emerging Trends report — which I will report on in the weeks to come.

I wanted to highlight a few of the important points made in the Marcus & Millichap 2011 Outlook report concerning trends and overall asset  factors.  I will later post “part 2″ which will focus on sales and cap rates of various NNN properties cited in the report.

• The reports states that single-tenant net-leased properties with national credit-worthy tenants will remain the most sought after deals by both high net worth investors and REIT buyers, who will compete for the best properties. Cap rates have compressed 50 basis points in 2010 already (within this asset type that had little RELATIVE movement throughout the crisis). Slightly lower cap rates and small inventory of the best credit tenants will push acquisition targets to the next tier.
• Drugstores will slow new store openings but focus on improving current sites.  The report says that Walgreens is remodeling 5,500 stores, for instance.
• Discount stores and convenience stores will continue to perform well, in line with modified consumer spending that aims at the best deal.
• Big Box retail will continue to focus on expansion in smaller formats and in major urban markets, reversing the trend of suburbs only.  Walmart and Target, says the report, are planning to shrink new store size, and both are expanding grocery sections. Target’s first urban prototype will open in Seattle in 2012 with plans for 10 other cities.  Walmart’s new urban size will be about 20,000 SF, which is a tiny fraction of the Superstore size.
• Best Buy, an electronics Big Box store, reported a 60% jump in sales in the 3rd quarter of 2010. The report believes that consumer spending correction has run its course and a recovering economy will aid in a stronger retail sector in general, though uneven.
• Quick service food will outperforrm the food industry as a whole in 2011 as consumers continue to favor bargains. During the last two years of downturn, many fast-food chains introduced special bargain meals, further adding to and attracting consumer numbers.  For instance, Taco Bell brought out the $2 Meal Deal — 3 items for $2.  Through the 3rd quarter of 2010, fast food chains recorded an increase in morning traffic from the previous year, as more chains offer bargain breakfast deals.
• Because of less volatile and lower gasoline prices, the average monthly visits to convenience stores/gas stations increased in 2010. The report believes this will continue in 2011, with added jobs and slow recovery of the economy. Convenience stores continued to team with fast-food companies to offer product in-store.
• Casual dining locations took a greater hit than fast food in the downturn. This was due to lower consumer spending, payroll downsizing at the dining sites, capital market stress (credit lines for dining locations shrank or stopped) and competition. The report states that 2011 will be a turn-around year for casual dining, as the economy recovers.

NNN and our Current Economy

Many of my friends, family and clients are suffering through this horrible economic downturn. If they own investment property, they may have lost tenants in apartments, offices or shopping centers, find that they are negotiating with rent reductions, or may be dealing with a difficult refinance. In the troubled capital markets of today, getting financing or a refinance is not easy – and the terms are not as favorable as they used to be.

But I have noted that, with a few exceptions, the NNN properties have fared relatively well.  Yes, there are some problems, but in general and compared to the full spectrum of commercial real estate, most tenants are making their money rent payments as laid out in the lease, which are typically held up by a guarantor on the lease. And the guarantor is ideally a large company that can withstand the economy we are in now. 

The two examples I know of personally were both smaller fast-good chains with a personal guarantee from a party that failed… in one case, the restaurant closed, in the other case, the owners found a new tenant and negotiated a new lease.

I have also noted that while many asset types that may be for sale now are deeply discounted, NNN properties have not moved drastically in sales prices. This little niche tends to – in general – hold.  It always comes down to the tenant, their strength and sales, and location.

The Special Niche of NNN

I am often asked why investors buy NNN properties? What are the advantages and disadvantages?

“Triple net leased” or “triple net” refers to the lease which stipulates that the tenant is responsible for everything.  Tenants pay rent, taxes, insurance, and are responsible for the interior and exterior of the building.  NNN properties are entirely management free.  You own the property, with its tax advantages, and you receive an income check each month long term. 

New NNN leases with single-tenant retail tenants are typically 15 or 20 years in length. Depending on the tenant, there may be increases to the lease payments every five years, annual increases or no increases during the term.  Investors often like a very long lease, and no worries of shorter-term changes, vacancy or managing turnover that occurs in office buildings, apartments or strip centers.

What are typical NNN properties?  Burger King, Tire Kingdom, Walgreens, CVS, Starbucks, Publix, Applebee’s—this is a small sampling of the typical NNN property.  Some properties may be NN (double net), which normally means you are responsible for roof & structure and they are responsible for everything else.  I will blog about NN in another post.  Note that some office properties or government properties may be NN or NNN.

NNN retail properties may be found in valuable locations (corners, high traffic count roads).  But a study of the actual demographics, the population and its growth or decline in this area, the competition, etc. is important.  The best location in a smaller demographic may not beat the best location in an class A area.

Since there is no management involved, investors don’t have to necessarily acquire a local property.  They could diversify by buying in another area or state, seeking out the best deals (which may not be local).

In fact, some of my clients in Florida like to buy outside of the hurricane zone, while some of my clients in California like to buy outside of their earthquake zone or where the cap rates are better. (California typically has lower cap rates / higher prices for the same tenant deal).

Cap rates (capitalization = annual income divided by sales price) are a good way to compare apples to apples when looking at NNN deals.  Today cap rates of single-tenant retail are typically between 7.2% and 8.5%, while from 2005 to 2008 they were 6% to 7.5% (even lower in California).  Cap rates are often a function of the tenant’s credit, property, lease, guarantee in the lease and location—as well as the economy and interest rates. So, for instance, Walgreens is a strong, highly rated S&P tenant.  Their cap rates are usually among the lowest as the perceived risk is lower in owning one.  However, their 20 year leases have no increases during the base term, which could be a downside trade-off for an investor concerned about keeping up with inflation.

Financing is a big deal now – credit markets are constrained, loan to values are down and finding financing isn’t a piece of cake.  I work with great lending contacts who specialize in NNN.  My advice is to consider buying the highest rated tenant possible (a credit tenant with a corporate guarantee vs a franchisee or mom & pop guarantee).  With an  excellent tenant, you may be able to leverage 70% …maybe.  But most deals these days are closer to 60%-65%, or less if the lender has concerns over the tenant or their rating.  Some of my clients have been quoted 50% leverage! 

For investors considering an all-cash transaction, you will have more negotiating power to get a better deal.  Some are using this strategy, will hold the property until credit markets are improved and then plan to finance/refinance the property later.

Consider disadvantages: real estate is not liquid; if a tenant goes out of business, you will need to find a new tenant, though the location will probably be desirable; some of the stronger tenants have no rental increases over the initial term; financing may be difficult.

NNN Discussed in the Wall Street Journal

The Wall Street Journal ran a story on May 8th about NNN investments.  Entitled “Cashing In on a Real-Estate Boom. Most Commercial Properties are Slumping, but ‘Triple Net Lease’ Deals are Hot”, the author covers the NNN story.

Such ventures, known as triple-net-lease properties, are “the best-performing sector of the commercial real estate marketplace,” says David Bailin, head of global managed investments for Citi Private Bank, which serves ultra-high-net-worth clients. “It is the sector that lost the least value [during the recession] and rallied the quickest.”

I think most of the article is good, but I would not agree with the statement that NNN are generating as much as 12% today. For the kind of tenant (highly-rated) and lease length that most investors want, the typical cap rate is about 7.5% (range 7.2% to 7.8%).

Read the story here.

Regards, Kathy

Commercial Real Estate Report

A new commercial real estate newsletter with reports on various asset types and expert outlooks is now available to you, courtesy of RSS Advisors.  

RSS Advisors has created a commercial firm that focuses on education and works with experts in the field.  I have made arrangements to provide their newsletter to you!  

Click here for the RSS Advisors Commercial Real Estate Report.

  

 

 

 

 

 

 

 

Commercial real estate loans at issue

My colleagues at Commercial Affiliate, LLC have an interesting report on their website regarding problematic commercial loans. While these issues rarely touch NNN investors, they do occur in the commercial real estate world.  It could be helpful to share with anyone you know who is experiencing problems with their commercial real estate loan: 

http://commercialloanmodificationreport.com/ailing-lenders-and-borrowers-in-2010/

Regards,

Kathy Heshelow

NNN Tenants

Two subjects most often discussed by new investors in the NNN (triple net) niche are: the tenant and the lease. This post will address some issues around the tenant.

Typically, NNN deals are single-tenant retail properties with long-term leases in place (15 to 20 years). Many of the retail properties that you see in your area may fall into this category:  Walgreens, CVS, Jiffy Lube, Tire Kingdom, Burger King, Taco Bell, Applebee’s, Dunkin’ Donuts, Starbucks, Publix, Advance Auto, Target, Family Dollar, 7-Eleven and so on.

Investors choose these kinds of properties because they like a long-term (15 or 20 year) lease term with a “strong” tenant they can trust – and no management of the property. They want a tenant they don’t have to worry about, a tenant whose business is strong or solid. They want a tenant whom they can trust to make rent payments and meet their financial obligations under the lease. Of course, every landlord wants this!   But because NNN are considered fairly conservative investments with national tenants or companies, the returns are average or even low compared to real estate in which there is much management, shorter leases or which may be considered “value-add” or even distressed.  Your typical NNN deal is not distressed.

NNN Tenants Are Not Made Alike

Investors need to understand an important point about tenants:  the Taco Bell (as an example) that you are considering to buy may be run by a franchisee who has 3 other sites, and that franchisee may be the guarantor of the lease. This guarantee and the money behind it would be quite different from a Taco Bell with a corporate guarantee (in this case, YUM brands) which is a publicly-traded company operating 37,000 stores including Taco Bell, Pizza Hut, Kentucky Fried Chicken and other brands. 

 So, to clarify, a corporate guarantee may be (should be!) stronger than a guarantee from a “mom & pop” franchisee with perhaps a $1.5M net worth.

 There is a wide range of possibilities of tenants, and they are not all created alike.  The smaller franchisee site you are considering might be in a class A location that you want and the financials may look strong enough for you.  Or the non-corporate tenant may be a very large franchisee corporation, with hundreds of stores, a long track record and a fairly strong ‘corporate guarantee’.  Just remember that you have one tenant in this building you are buying, and so “all of your eggs are in this one basket.”  If you are financing the deal and the tenant fails, can you meet your debt payments before finding another tenant?

Also keep in mind that the purchase price and cap rate of the deal you are considering should reflect the range of tenant risk.  The property with the small franchisee operating five stores is frankly riskier than the corporate guaranteed store in which the lease guarantee states they will pay obligations even if your store closes (“goes dark”), and that guarantee is backed by a  billion dollar corporation. 

“Credit Tenants” or “Investment Grade Tenants”

Credit tenants, also known as investment grade tenants, are what many investors aim for.  What is a “credit tenant” or “investment grade” tenant? It is a tenant who has gained a rating by Standard & Poor’s (S&P) of “BBB-” or better. Credit tenants are usually publicly traded or large private entities with a strong S&P rating.  The rating is a current opinion of the corporation’s financial ability to meet its financial obligations. 

We know the rating agencies are under fire with the way they rated CDO pools. But when looking at public corporations, you will have access to the tenant financials and filings, and can make judgements along with the S&P rating more easily.

These days, getting your acquisition financed may be somewhat difficult. If financing is an issue, a credit tenant may be a better bet with the bank.

If the tenant is not a public company, a due diligence request should always be made for the company financials (last three years) and specific store sales. Running a Dun & Bradstreet report also may be helpful for tenants that are private or smaller.

There are many factors a buyer will consider when purchasing a NNN property, but the tenant [and the lease details - to be discussed in future] is one of the most important, in my opinion.

What is NN or double-net?

Yesterday in my discussion of NNN or triple net properties, I also mentioned that some investment choices in the single-tenant retail world are what is called NN or double-net. 

NN also refers, as you may guess, to the lease terms.  NN stipulates that certain areas of responsibility go to the landlord – unlike NNN where there are no areas of responsibility for the landlord to manage.  We see several variations on NN.  The most typical situation is that the landlord or investor will be responsible for “roof and structure”.  This means the landlord will be responsible for any repairs or replacement of the roof and any repairs to structure, which is most often described in the lease as exterior structure and/or slab. 

If an investor is looking to acquire a newly-constructed property, there may indeed be a roof warranty (10 to 20 years) and other warranties that could mitigate some of this risk.

A few well-rated tenants move more than roof and structure to the landlord side of the table. This could include HVAC replacement, for instance, or snow removal.  These types of NN properties do involve some management and tend to have a slightly higher cap rate / lower price than a NNN.  While the overall NN deal could be quite good, many of my clients tend to lean towards a full and absolute NNN leased investment.

Commercial Mortgage Delinquencies Rise in 1st Quarter

From National Real Estate Investor magazine, an article by Sibley Fleming:

Early 1Q Estimates: Bank Commercial Mortgage Delinquencies Rise.

Commercial real estate status in 2010?

As we will examine NNN (triple net properties) on this blog, we will also want to examine the overall commercial real estate world.  Each year, the “ULI (Urban Land Institute) Emerging Trends in Real Estate” report is published, which discusses and tracks trends and includes some forecasting.  The study is done jointly with ULI and PricewaterhouseCoopers. 

ULI is a pre-eminent international real estate forum. Their mission is to provide leadership in the responsible use of land and in creating and sustaining thriving communities worldwide. 

A few highlights from the 71 page report follow:

• After a year of ‘suspended animation’ in real estate, the bottom to the market may have hit and the trend will be to slowly recover.  However, there will be fall-out and problems over debt coming due.
• Transactions will begin to thaw for at least one reason: investors with cash take advantage of the best buying opportunities of our lifetime.
  
• Liquidity will rule, both for individual investors and for institutional buyers.  “REITs, equity funds and high net-worth individuals with dry powder reenter at the perceived market bottom, focusing on vulture deals for trophy properties…” (page 6)
  
• 2010 will be the test for a number of highly-leveraged owners, who will focus on asset management, creative leasing and dealing with lenders.  Some may walk away, but banks will also start to dispose of properties to clean out the system.
  
• Class A metro locations and well-rated credit tenant deals along with medical office are good bets.  Tenant demand exists in health care, technology, grocery-anchors, education, and apartments.
  
• Best Bets listed in the ULI report?  Cash deals (buyers rule); Quality deals (be selective) in A locations; Buy on cash flow and not on leverage-driven models (less yield but more solid); buy distressed debt and opportunity or vulture funds (page 11-12).

Thanks to ULI.  Interested parties may buy the full, detailed report on their website.