Evaluating Your Next Commercial Real Estate Retail Investment

[Charles D. Smith]

Commercial real estate properties have great potential to generate significant returns for investors. However, different types of commercial real estate, or ‘real estate assets,’ have their own unique sets of risks and benefits. This article will review the retail asset class, which covers various properties, ranging from small stand-alone banks and restaurants to regional shopping malls and power centers. Regardless of the size and type of retail property, below are some considerations and tips to consider when evaluating your next retail investment.

Types of Uses Matter More than Ever

Over the last five years, the growth of e-commerce has forced the retail industry to evolve significantly. Retail investor circles often suggest investing in ‘internet and Amazon-resistant uses,’ or operations that provide in-person experiences, such as restaurants and nail salons. Due to the COVID-19 pandemic, it is recommended to invest in essential uses, delivery services, or drive-thru restaurants. While the long-term effects of the pandemic on the retail industry are uncertain, it’s critical that investors closely monitor tenant mixes and uses to develop a better understanding of potential future vulnerabilities.

TIP: If you are evaluating an investment and are concerned about the financial stability or viability of the tenants, underwriting a higher vacancy level or reserving more capital is recommended. This important step will hedge against the future costs of re-tenanting the space.

Be Aware of Significant Lease Provisions

When it comes to retail leases, the ‘devil’ can truly be in the details. Retail leases can have provisions, such as co-tenancy and exclusive use clauses that can materially impact your underwriting. Under a co-tenancy clause, a tenant may have the ability to exercise specific remedies if the property’s occupancy drops below a certain percentage or if an anchor tenant is no longer operating at the center. These remedies could include giving them the right to terminate their lease or pay a reduced rent. As an example of an exclusive use clause, a pizza restaurant within a shopping mall may have the sole right to offer pizza. The investor could then be prohibited from leasing any additional space to prospective tenants that offer pizza, even if it’s an ancillary part of their menu. This exclusive clause example could create significant issues and hinder an investor’s ability to lease vacant spaces, potentially impacting underwritten lease-up assumptions.

TIP: Always inquire about any key lease provisions, especially if they are not clearly defined in the offering materials. At the appropriate time, you should review all leases thoroughly.

Landlord vs. Tenant Obligations

One advantage of investing in retail properties is that tenants are typically responsible for their leased premises, and the landlord handles everything outside of the tenant’s walls, typically including the roof and structure. However, this can vary from property to property and even lease to lease within the same property. For example, you may be evaluating a shopping center where one tenant is responsible for all of the repairs and maintenance within their premises, including the HVAC units. You may then find that

the tenant next door has the same responsibilities except that the landlord is responsible for the HVAC units. Depending on the number of units, size, and condition, that additional landlord responsibility could result in thousands of dollars in extra repairs and maintenance expenses added to your underwriting.

TIP: Do not assume the responsibilities of the landlord and tenant. Make sure you clearly understand what each party is responsible for and underwrite accordingly.

Pay attention to Reimbursements

Most retail leases follow what is called a Triple-Net (or NNN) lease structure. In this structure, the tenant pays a base rent amount and their pro-rata share of the property's real estate taxes, insurance, and common area maintenance, commonly referred to as "Additional Rent." Sometimes prospective purchasers are led to believe the tenants are all under NNN lease structures, and they reimburse for all expenses only to discover later that some tenants have reimbursement exclusions, limitations, and caps specified in their lease. For example, a prospective tenant who occupies 20% of a shopping center has lease language stating that they will reimburse for all expenses, excluding property management. If the annual property management fee is $50,000, that could result in $10,000 of expense reimbursements the landlord will not recover. If you are unaware of this and do not underwrite accordingly, this could have a meaningful impact on your cash flow assumptions.

TIP: In the Seller’s offering materials, the type of lease structure is usually provided. It is vital to ask about any expense exclusions, limitations, or caps. You may also want to ask the Seller for any recent tenant invoices, with backup, showing their additional rent. This will allow you to verify that reimbursements are being billed following the lease and offering materials.