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.

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.

“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.