Commercial Real Estate

Analysis of a Triple Net (NNN) Deal: Is This KFC Building a Good Investment?

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Do you ever think something sounds like a great investment deal? Is it possible it’s really not? Aside from more complicated factors like market fundamentals or rent sustainability, is it ever possible the numbers themselves can trick you?

Yes!

I've recently been exploring commercial investment deals. For anyone who knows me, you know I'm not usually into commercial. But I've been consulting with someone to find something in the $1.5M-$2M range, and the journey has been very eye-opening. We first met with a commercial agent to explore the options. We discussed restaurant buildings, retail buildings, multifamily residences (5+ units), and we even threw out high-dollar residential buildings.

It was very quickly obvious that a $2M residential property in Venice Beach would not cash flow. There was no question there, as the cap rate wouldn't even pretend to be positive. So we started ruling out the entire notion of the residential property idea.

The most exciting option seemed to be a NNN commercial building. This would be buying a building that a commercial tenant would rent out. For example, a McDonald’s. McDonald’s themselves don’t own the buildings they are in, as most businesses don’t, and that building by itself would be something we could buy. Then the NNN (called “triple net”) part is that unlike owning a residential rental property where you (the owner) has to pay for the repairs on the building, the tenant pays for everything. So you buy the building and never have to pay expenses for the building—McDonald’s would pay it all.

There are different versions of NNN options—some mean the owner pays absolutely nothing, some mean the owner has to pay for the roof and structure but nothing else, and whatever other variant there might be.

The other factor we were encouraged to consider was buying a NNN in another state outside of California. The reason for is that the land in California is more expensive than other places, so there would be a higher return if we were paying a lower price for the property initially. Make sense?

The KFC Deal

So we began exploring NNN options. We looked at a KFC (Kentucky Fried Chicken), a Starbucks (yum!), a Verizon Wireless store, and there was even a three-tenant building that had a Chase Bank, a T-Mobile store, and a Mexican restaurant called Filberto’s. I personally liked the latter the best, but it had just sold to another investor. All of these properties were outside of California.

I’m going to give you the best deal of them all to explore in more detail—the KFC.

free-mentor

This KFC is in Nebraska and priced at $1,477,000. It was the best of all of the options presented with because the cap rate was higher than the rest (6.5%), the lease term of the tenant (KFC) was the longest (a new 20-year lease), and the tenant was responsible for everything including the roof and structure. It is also sandwiched between some major high-dollar companies like a new Walmart and many others.

The other properties all had lower cap rates, maximum 10-year leases with the option to get out early, and the owner (us) would be responsible for the roof and structure.

No contest, the KFC was the front-runner.

Very simply, here are the numbers associated with this property. And remember, this is literally the most hands-off real property you can buy. The most you could do with this property if you own it would be to walk in and order a bucket of chicken. So that alone is pretty enticing—no work! Not even if you wanted to work on it!

Purchase Price: $1,477,000

Annual Rent Collected: $96,000

Cap Rate: [(96,000/1,477,000)*100] = 6.5%

Wow, what’s not to love about this investment! Sure, 6.5% isn’t an insanely high cap rate, but it’s very solid, totally decent, and you’re literally hands-off and stress-free with this property. Some markets like Atlanta and Houston offer 6.5% cap rates on their residential rental properties, but you still have mangy tenants and/or property managers to deal with and headaches with repairs and such. Additionally, there are many commercial deals out there at a standard 7.5% cap rate, but they all require more of your participation and offer more headaches. So 6.5% with no effort? How could you beat that?

Related: BP Podcast 047: Apartment Complexes, NNN Leases, and Commercial Real Estate with Joel Owens

Is it REALLY a Good Deal?

Sounds like a killer deal, right? Actually sit back and think about it and decide whether it’s a good deal or not.

Initially, we thought this may be the perfect investment for what my client was looking for. Granted, he was semi-morally opposed to KFC just because he loathes fast food, but who cares who the tenant in a property like this is if they are solid and going to be paying? It’s not like he’d have to go in there and eat the chicken.

OK, so you’ve thought about this deal. Are you on board with it? Do you think it’s solid? Is there anything we’re missing that would be important to consider?

Obviously, there is probably something missing since I’m asking. What is it?

What if you are financing rather than paying cash?

Plenty of people do have $1.5M to drop on an investment, but a lot don’t. The particular client I’m working with doesn’t and plans to finance an investment property.

Does this matter?

It’s very tempting when you see a deal that is presented to you and everything looks good about it to just go with that and not do further investigation. The agent says it’s a killer deal, it looks and feels like a killer deal, and why wouldn’t it be? It all seems legit.

There is one piece of information that is not included in the marketing packet for this KFC building—the financing.

A Note About Cap Rates and Cash-on-Cash Returns

Before we go any further, you absolutely need to be up on the difference between cap rates and cash-on-cash (CoC) returns. If you are even remotely questioning your knowledge of these two terms, pause with this article for a second and go read “Cap Rate and Cash-on-Cash Return: A Definitive Guide.”

Be sure you are up on the details of what goes into each, but here’s a very short blip about the two. Cap rate only measures the purchase price of a property as compared to how much income it brings in. The CoC is the actual return that you are getting on the money you put into that investment.

If you pay all cash for an investment property, then the CoC will be the same as the Cap Rate. If you are financing, however, it will be different. If you are financing, the more accurate number you need to know when evaluating a potential investment property is the CoC because that tells you exactly how much bang you are getting for your buck.

When you calculate the CoC, the number will be different because instead of comparing the net income with no financing cost included with the purchase price, you will be comparing the net income with the financing cost included to how much money you actually put into the deal. So you end up with an actual percentage return on exactly how much return you are getting on the amount of money you put into the deal.

Cap rates are only helpful for buying and selling purposes—and only if you pay cash for the property. The reason it works to use it if you pay cash is because the numbers will be exactly the same for the CoC equation as they were for the cap rate equation (i.e. no financing differences).

If you are lost as to what I’m saying, go back and read the article. Or if it’s starting to make sense but you aren’t quite there yet, go to the article and refresh.

What Financing Does to the Deal

So now! Back to KFC.

We already said the cap rate on this property is 6.5%. Honestly, that’s not too bad for a NNN property! It’s pretty good actually.

But what happens if we finance it?

Here are my assumptions:

Purchase Price: $1,477,000

Down Payment (35%): $516,950

Loan Amount: $960,050

Annual Mortgage Payment (4.5%, 30-yr): $58,373.19

Net Income After Financing: [96,000-58,373.19] = $37,626.81

So now we know to expect $37,626.81 annually from the property after financing. Is that a good return on your half a million down? Let’s calculate it and find out. We already know the cap rate, so now we want the CoC with our new numbers.

CoC: [(37,626.81/516,950)*100] = 7.3%

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Well, I may be tempted to call this one a winner! A 7.3% Coc is higher than the 6.5% cap rate, so that’s encouraging, and a 7.3% return on my money seems decent. It may not be as high as some investment options, but for something I literally don’t have to stress over, it seems pretty good.

Were you thinking the CoC would turn out to be bad because of how I led you into it? I did that on purpose. I did it so that you would realize it is possible for a CoC to be lower than a cap rate! It all depends on the financing terms.

My client hasn't purchased a property yet to know for sure, but the rumor is the interest rate to expect will be about 4.5%. That seems low to me, but I trust my agent for now. But what if the interest rate was actually 8% (like I assumed it would be)? What does that do to the CoC return? Without spelling out the details of the numbers, but using a loan calculator to determine the loan payment, I come up with a 2.2% CoC. Eek! Just a change in interest rates makes a huge difference! A 2.2% CoC is horrible.

Now, here’s something else to consider and a good lesson in life—never trust anyone else’s numbers for any investment opportunity!

I initially sent all of the property options to my client and he ran the CoCs on all of them. I was driving one day when we got on the phone to discuss the properties and he let me know that all of them had minimal to no cash flow after financing. I thought, “well sheesh!” There went all of those properties out the window. It didn’t shock me they wouldn’t cash flow because oftentimes properties won’t with financing, so I didn’t think much of it. But because I was driving, I didn’t sit down and run all the numbers myself.

Related: Triple Net Lease Investing (NNN): The “No Toilet” Method to Real Estate Investing

Can you guess what happened with his numbers to make everything negative?

He was determined he wanted a 20-year loan and not a 30-year. He was quite adamant and just when I was sure I had convinced him to go with the 30-year, he slapped 20-year numbers into the CoC equations. Then, on top of that, he also thought 8% was more realistic, as did I, for interest. So what happens if suddenly you are using a 20-year loan with 8% interest? Well, without even calculating the CoC, I can tell you that it puts you at earning -$362.91 annually! So the CoC would be negative. You would be losing money on your property.

Maybe we can combine his extreme desire for a 20-year loan with the 4.5% interest rate and cash flow? Yep. It comes out to be a 4.5% CoC. Not overly high, but it is positive cash flow with a significantly shorter term, so it will be paid off sooner, and much less will be paid out in interest.

So there you have it, the results on the KFC property.

I don’t have a huge point in writing all of that other than to show you a real-life commercial property analysis. Whoa, it even feels weird to say “commercial” because I’m so used to residential rental properties!

Now, the last thing that would be more practice and may be insightful would be to run all of these scenarios on the other NNN properties we received. All of the cap rates on those were closer to 5.5% and the owner would be responsible for the roof and structure. I don’t even know what those expenses would range, but they would need to be taken into account to get accurate return projections.

What’s the verdict? Would you buy the KFC? How does it compare to other rental investment options you have explored?

Leave your comments below!

Ali Boone is a lifestyle entrepreneur, business consultant, and real estate investor. Ali left her corporate job as an Aerospace Engineer to follow her passion for being her own boss and creating t...
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    Scott S. from Tacoma, Washington
    Replied over 2 years ago
    Realty Income (O) REIT has mostly NNN leases. It is one of the most reliable REITs out there with a solid track record. Monthly 4.5% dividend with a 25 yr Compound Average Annual Total Return of 15.8% https://www.realtyincome.com/Home/default.aspx
    Abraham Bar Investor from Palo Alto, California
    Replied over 1 year ago
    Actually owning stock in a REIT is very different from owning real estate: 1. Market risk 2. You cannot deduct depreciation, you pay income tax on those dividends 3. No like kind exchange Regarding Realty Income specifically, the dividend yield is actually 3.91%, 4.5% is the average annual growth of that yield, If you want to to be totally hands off by owning a dividend yielding stock there are better, safe options, https://finviz.com/quote.ashx?t=O&ty=c&ta=0&p=m
    Vipul Patel from Sherman Oaks, California
    Replied over 1 year ago
    You can claim depreciation only if qualify as a real-estate investor. Passive investors cannot qualify to claim depreciation.
    Paul Merriwether Investor from Oakland, California
    Replied over 1 year ago
    Loved the article since I was clueless on NNN commercial in general. What struck me though was that home in Venice for $2 million. I got to wondering with a down payment of $500,000 could that work??? Here are the numbers. Sale price: $2,000,000 (Clean home that has been upgraded move in ready. ) Down Payment of $500,000. Finance: $1,500,000 Loan rate: 4.2% for 30 yr’s. Monthly payment: $7,335.26 Estimated rent / Zillow $6500 / mth for Venice Beach area. Neg cash flow $835.25 not including Taxes & Ins. Taxes at 1.5% = $30,000/yr = $2500/mth. Ins at .4%/yr = $8330 = $700/mth Total Neg: $4,000/mth or $50,000/yr. or $1,500,000 over 30 yrs. WOW!!! As crazy as that sounds could it work??? Rents would go up over 30 yr’s as well as appreciation and equity as note is paid down. So what would the home value be in 30 yr’s??? Using a future value calculator with a start rate of $2,000,000 at a yearly appreciation rate of only 6%. In 30 yr’s the value would be approx $11,487,000!!!! At 7% appreciation/yr Future Value: $15,224,510.09 HELLO!!! Future rent at 2% increase/yr starting at $6500 would be $11,773.85/mth IN 30 YR’S. On a side note that $500,000 down payment earning 6% in a passive investment over 30 yr’s with periodic investments of $50,000 would grow to a Future Value: $6,824,654.90 If I could afford it, I would buy that CA home!!! Plus you can pull money out over the years!!!
    Paul Merriwether Investor from Oakland, California
    Replied over 1 year ago
    Wait a minute … at 7% appreciation the home value has grown to $3,000,000. You can do a 70% refi on a rental and pull out approx $1,000,000!!!!! Pulling out that money will NOT affect the value of the home. It’ll still grow in value at 7% the next year on that $3,000,000 value or approx $210,000!!!!
    Paul Merriwether Investor from Oakland, California
    Replied over 1 year ago
    I left out that growth to $3 million was after ONLY 6 yr’s!!! In the next 4 yr’s that value grows to approx $4,000,000. Do another refi at 50% of value pulling out $2,000,000. You now have a new 30 yr loan with a balance of approx $2,000,000. Yet you’ve pulled out $3,000,000 in the last 10 yr’s!!! As rents have increased lowering your monthly neg.
    David Feazell Real Estate Investor from Fallston, Maryland
    Replied over 1 year ago
    Hey guys. I frequently work with clients looking to buy nnn commercial properties, often involved in a 1031 exchange. Keep in mind that the location, demographics, traffic counts, tenant’s history at the site, and tenant’ rent to sales ratio are all extremely important to review when considering this type of property. Additional consideration goes into the strength of tenant as well as whether tenant is a franchisee or the corporate entity. Many factors need to be weighed in on this type of acquisition beyond the cap rate and purchase price in order for the client to be protected long term.
    Paul Merriwether Investor from Oakland, California
    Replied over 1 year ago
    Ben Leybovich wrote this great article on BiggerPockets >> Cash Flow vs. Appreciation: What Experienced Investors Know About the Debate That You Don’t<< https://www.biggerpockets.com/users/JustAskBenWhy