The Single Tenant Triple Net (STNL) market has been on fire the last few years. A slew of new buyers are looking to acquire a STNL. Many of these buyers are first time purchasers of commercial property, and many are unsure of how best to analyze the strength of the investment.
STNL investments have gained in popularity as they offer many unique benefits. Unlike other real estate investments, a STNL does not require any landlord work/management. The tenant pays all of the expenses including taxes, insurance and repairs, making the investment truly passive. Unlike other passive investments, a STNL also can offer tax depreciation benefits for the investor. STNLs typically also offer a strong guarantee (sometimes corporate) and a long term lease usually.
Like a lot new investors, many buyers only focus on the cash flow of a property. This is a way to get oneself into a lot of trouble. As with any investment, there is a factor of risk vs. reward. The higher risk properties generally offer a higher return. Although return is important, after all, why you are buying a property, it should be evaluated with risk factors. What should an investor consider before buying a STNL investment: Location, Length of the Lease, Rental Increases, and Strength of Tenant.
We’ve heard it all before, when it comes to real estate; location, location, location. This is also true with a STNL. Location considerations to take into account (especially in tertiary markets that are not as in-fill as an inner city) are: How long has the tenant been at this location? Are there other traffic generators in the area? What are the traffic counts? Is the property in-line or on a corner? If on a corner, is it signalized? What does the area look like for growth?
If the tenant has been at a location for many years with a proven track record, this mitigates the risk vs. a new location, which has not experienced sales yet. Traffic generators in the area could be other retailers. Is the property an outparcel to a mall, shopping center, grocery store or other national big box retailer? These will add to the general drive-by traffic counts. Other neighbors who will increase value are: location of local schools/colleges, large employers in the area, and/or hospitals. A signalized corner location is the most desirable, followed by a corner location, and lastly an in-line/mid-block location. Also, what are the demographic growth trends for the area? Is the area expecting both economic and people growth, or is it on the downturn?
The length of the lease can impact value tremendously. Since shorter leases typically equate to higher risk. Depending on what the current rents are vs. market rate rents, and how sales at the location itself are doing compared to other system wide sales. They tend to trade at a higher CAP rate. Essentially, one of the reasons a person purchases a STNL property is for the cash flow and strength of the tenant. One way to measure the value of the property is utilizing a discounted net present value cash flow analysis to determine the added value the lease brings to the table.
Rental increases can affect the value of a property, especially with a long term lease. If the lease does not provide for market rate rent increases, or if it will not keep up with expected inflation rates, then this would affect the value of a property. To analyze how much, keep in mind typical rental increases, concessions for a tenant to exercise an option, and utilizing a discounted cash flow analysis compare the two (market rate increases, vs. discounted increases and/or concessions), and adjust the cap rate you would pay accordingly. This would make your overall return comparable.
Also, take a look at the strength of a tenant. There is a reason why McDonald’s consistently trades up to 250 basis points lower than their competitors. It is a combination of the lease structure (all corporate guaranteed), and the strength of the company. When evaluating a tenant’s strength, look at year over year average unit sales growth (not just total company, as that may be affected by new locations). If it is a franchisee, how many franchises do they own? Are all of their units guaranteeing the lease, or is there a parent company that owns the other units? Is the franchisee willing to, or already has, given a personal guarantee? Lastly, in addition to the actual tenant strength, look at their concept. Has it adapted to the changing times, and continues to grow, or is it stagnant?
Overall, there are many things that go into analyzing a STNL investment. It should not just be the cash flow / CAP rate. As with any other investment, there should be a risk vs. reward analysis done. If you go into it looking at all aspects, you will be able to mitigate the risks associated with any investment, while maximizing your return.
George Pino is the CEO of Commercial Brokers International Inc., and has been in Real Estate for over 30 years. Feel free to connect with him.