From Walgreens to 7-Eleven’s to Family Dollar, the choices of triple net properties seems endless. It is even overwhelming with the amount that is actually out there. Once you finally selected the type of retail, office or industrial tenant you want, you now have to analyze it to see if it actually a good deal or not. Just because they are a name brand corporate name doesn’t necessarily mean the deal makes sense. In this chapter we will cover ways to evaluate triple net leases and proper NNN property due diligence in a few easy steps. This is important whether you are buying the deal by yourself or your getting assistance from a broker. Understanding how to evaluate deals will save you a lot of time and aggravation.
Part of the mail box money strategy is buying into deals with financially strong, credit worthy tenants to start with. Signing a lease with anything less then reputable could cause a lot of sleepless nights and headaches. This can easily be avoided by working with tenants who have been evaluated by credit rating agencies such as Standard and Poors, Moody’s, Fitch and NAIC. Ideally it would be even better to work with a publicly traded company although there are very good tenants that are private national companies. To read about select tenant, refer to the tenant profile chapter of this book along with any publicly available information you can obtain. I also included a list of tenant credit ratings in the resource section at the end of this article.
TENANTS TO AVOID
The more you start looking at different leases during your due diligence process the more you will notice the different types of guarantees such as corporate guaranteed leases and franchise or private guaranteed leases. Now you want to be very keen to look for the differences. This is something that you would want to see for yourself as some brokers sometimes miss this sometimes. With corporate guaranteed leases your rent is guaranteed during the life of the lease term by the corporation, let me give you an example. When you deal with McDonald’s, there is the McDonald’s corporate restaurants you sign on as a tenant, which is a public company and their is the McDonald’s franchise which is privately owned. In this scenario, McDonald’s Corporate has an “A” credit rating compared to McDonald’s Franchise which may not have the credit rating as corporate. Keep this in mind while you are scanning through available opportunities. Some investors tend to go with private franchises or companies because of the opportunity for higher yields but this is something
that I particularly do not recommend to my clients. You want to focus on tenants that will give you the highest chance of success. Not to say that going with a lower credit rating and private company will result in the location failing and going dark but going that route creates that possibility.
UNDERSTANDING CAP RATES
I mentioned CAP rate and yield a few times in the previous section, so I will briefly discuss this as that is another important aspect to look for during the due diligence process. If you are not familiar with CAP rate or Capitalization rate it is the ratio between the net operating income produced by an asset and its capital cost (the original price paid to buy the asset) or alternatively its current market value. This is essentially one of the main calculations you will be seeing as you look at different net lease opportunities. To get to the cap rate on a deal you will need the annual net operating income, the rent and the cost of the deal.
Cap Rate = Annual Net Operating Income (Tenant Rent)
/ Cost (Asking Price)
Let’s do an easy example. Say you have your eyes on a CVS net lease deal and you find out the annual net operating income is $180,000 a year and they are asking $3,000,000. The cap rate will be 6 percent, which is $180,000 divided by $3,000,000
$180,000 / $3,000,000 = .06 = 6%
Now this isn’t the only calculation you should be looking at because depending on the your objectives and situation other factors may be important. In some situations I work with investors looking to buy a deal all cash, which cap rates will be the primary figure they would be looking at. For other situations an investor may want to use some cash and get financing for the rest, which in this case the investor would be concerned about their cash on cash return and net return. Cash on cash return can be defined as the calculation determines the cash income on the cash invested.
Annual Net Cash Flow / Net Investment = Cash on Cash Return
For example, if you receive $120,000 from a net lease property and you invested $450,000 into the deal then the cash on cash return would be 26 percent. This of course is an example because other factors including rent increases and appreciation which can positively effect the cash return but evaluating this way is typically used on a long term basis outlook. Some investors choose to purchase net lease deals with financing which is a
good idea in some situations. The idea of putting down a smaller amount of cash to get a larger sized deal makes a lot of sense but will require a harder look at the deal. I will touch on financing more in a later chapter.
Another option for an investor is a loan assumption, which their are many of these types of these deals out there. This allows a qualified buyer to assume the loan of a seller and own a asset without having to get a brand new loan. Typically with net lease financing they are structured with long terms and some with hefty prepayment penalties
Continue to part 2 of NNN property due diligence
Dwaine Clarke is a published author and founder of Clarke & Tinker Net Leased Property Group, a commercial real estate sales and advisory firm located in Connecticut. Connect with Dwaine on Twitter and Linkedin