Why a Net Lease Property for Your First Commercial Deal?

Question

There are numerous ways and strategies to invest in commercial real estate since there are many asset types (office, industrial, multifamily, retail, etc.) in the sector. Investing in commercial real estate is a complex process and for a novice investor there may be hurdles to consider. For example, purchasing a commercial building requires a significant amount of cash either for a downpayment or to pay in full. In addition, investing in commercial real estate carries different risks associated with the specific asset that each investor needs to know, understand, and properly mitigate.

However, I believe the best way to start investing in commercial real estate is by acquiring net lease properties. Investing in net lease properties involves significantly less risk when an appropriate due diligence process is applied, and a tenant background has been thoroughly checked. The details of this process are outside of the scope of this article, so I will not elaborate on it. However, I would recommend reading this article, Triple Net Lease Investing (NNN): The “No Toilet” Method to Real Estate Investing, that explains the mechanics of net leases properties.

Why net lease properties? Net lease properties are easy to manage and require little or no time to maintain. Typically, net lease properties are occupied requiring no marketing effort to attract new tenants. Additionally, they tend to be more stable and less risky since net lease properties are income producing assets. Many investors compare investing in net leases property to purchasing bonds as they both have predictable yields and stable cash flows. On the flip side, they also offer moderate returns and minimal upside. Lastly, they require little or no rehab work. This article highlights the analysis of a retail net lease property and showcases its benefits, Analysis of a Triple Net (NNN) Deal: Is This KFC Building a Good Investment?.

Furthermore, rehabbing, marketing, and managing properties are essential strategies for value-added deals. These strategies add a degree of risk to any transaction and may create distractions for new investors who are trying to get in the game. My advice for new investors is to stay laser focused on developing a strong track record. New investors need to be knowledgeable about a specific property type to have a better chance to be successful. They must also develop credibility and trust to attract capital to fund future deals, as well as, educate and nature others about their product offerings. These skills need to be mastered prior to investing in any deal that requires rehabbing, marketing, or managing. Most likely, it will take one to three deals to establish a solid track record.

Once again, novice investors need to be very intentional about getting the first foot in the door. Essentially, new investors need to shorten the investment cycle by pursuing properties with zero or little rehabbing, marketing, or managing effort. The goal here is to stay focused on the analysis, acquisition, and execution of the deal. In order to accomplish this, new investors need to understand how to generate leads, raise capital, secure financing, conduct due diligence, and negotiate contracts. The key to establishing a solid track record is repetition. Doing as many reps with the learning categories, they will master the investment cycle.

In conclusion, new investors should consider acquiring net lease properties for the first deal because they have less risks than other commercial real estate properties. Also, net lease properties shorten the investment cycle allowing the new investor to repeat the transaction faster. Ultimately, investing in net lease properties will allow new investors to get into the game, gain knowledge, and develop credibility to inspire potential investors to future deals. In other words, new investors will develop a faster track record by focusing on investing in net lease properties first.

Joel Owens · Answer

Evan there are a ton of variables.

In high growth warm belt states there is only so much land. So as population and incomes increase you have to add onto existing buildings or tear down and build with more density and higher to be able to handle and absorb the increase in population.

You could have a 10 million Walgreens in urban core. Fast forward 25 years and now super high rise buildings all around it. Someone could pay 20 million for your land and do a 200 million project with street retail at the bottom and multifamily at the top. The location with dirt over time tends to be paramount number one to everything else. Some business models go out and or adapt to change over the decades but doesn't change quality dirt. Now some areas could shift in growth from new town to old town over the decades. You have to look at the economic department and what current and future land use plans are. Most of my clients do not hold full term. They sell and then trade up to larger properties over time. Some budgets they have to start out in small suburban areas, then 1031 into strong suburban, and eventually in urban core. The more you go in the rents per ft tend to rise. Labor, legal, construction materials will cost more as the years and decades go by with inflation so new builds have higher rents per ft on average by a large margin over existing locations. That lift tends to outpace whatever rental increases on existing properties and keep a property owner with not above market rents UNLESS they way overpaid in the beginning with a new lease. Some developers in exchange for extra TI to tenant get way above market rents from tenant when they sell off (example extra 200k in TI for extra 750k in sale price with inflated rent).

Many commercial brokers/agents just sell whatever crap is on the market to a buyer who will purchase it because the broker/agent lives by the deal to survive. When brokers/agents are investors themselves and in the business along time they tend to be wealthy already and do not live by the deal. They can say (hey this is a piece of crap don't buy it) without a hesitation or care in the world. That is if they represent the buyer. The listing brokers job is to sell whatever it is the sellers give them whether great, mediocre, or a bad property.

Alot of NNN buildings are simply block boxes with gingerbread (exterior application) on the outside. Most of them are easily changeable for not much cost. There are some unusual tenant type build outs that are hard to repurpose and we generally stay away from those unless the dirt is so amazing and the rent is so low we still make money scraping the building if the tenant ever vacates and build new.

You can make lots of money in NNN you just have to know what you are doing or know someone who does!

Jason Hirko · Answer

@Ronald Rohde is exactly right - no one is going out and buying a NNN Starbucks in Austin and financing it at their local bank either. You'd be lucky to buy one for a 4 cap, and your financing cost is going to be higher than that. Those are assets for people to park money. But I see multi tenant second generation space in secondary markets returning 8-10%. It's not a sexy, and the credit of the tenant isn't as strong, but a lot of the same key principles apply.

Ronald Rohde · Answer

I would add a bit more nuance. There is a huge world beyond just free standing, single tenant net retail.

You can buy a small bay warehouse on net leases for less than $2m. Its more work, but still no toilet issues.

Guillermo Matias · Answer

I want to go back and capture some learning concepts from experienced investors that replied to my original post. It is worth noting that my original post was intended for novice investors. I want to break down these concepts further, so new investors can digest, understand, and put them into practice.

The first learning concept is “headache rentals” or “headache real estate.” Headache rentals tend to be value-added deals that require additional work. These deals required active management from investors and sometimes involved toilet repairs or other issues. In addition to rehabbing, these deals required marketing for new tenants as they tend to have some level of vacancy since these properties were not fully stabilized.

However, headache rentals provide better yield than net lease (NNN) properties discussed in my original post. There seems to be a significant difference in yield between going passive or dealing with the headaches. Some investors choose to deal with issues to achieve more desirable yields and higher equity multiples.

Here are some of the NNN nuances that were not included in my original post. Acquiring NNN properties is considered passive investing. Some value-add investors get a little bored investing in NNN because of the little or no work required to maintain these properties. As a recap, NNN properties tend to have high credit tenants (Walgreens, Starbucks, and KFC) located in good locations with longer terms (5 year or more). More than often, these assets are used for people to park money (more on passive investment strategy later). On the flip side, NNN properties tend to provide lower returns than headache rentals. Additionally, NNN properties require a large chunk of cash to secure the loan when financing is used.

High network individuals tend to invest in real estate passively. They seem to be very successful at what they do leaving zero or no time to be active real estate investors. Despite that, they want to diversify their portfolios and have exposure to the sector. NNN offers them big incentives where they can grow and protect their money from inflation while taking advantage of tax deductions. High network individuals care less about yield but more on growing their equity position and asset valuation over time. Essentially, they have no problem going alone in a deal and putting down a big down payment to secure a NNN property. Coming with such a large down payment is one of the most difficult parts of the deal, then their work is done. Once the property is secure, all they do is collect a check every month.

For the average investor, the situation is a little different. They tend to have liquidity constraints impeding them to secure the loan due to the large down payment. Value-added or headache real estate deals are more appealing to the average investor since their focus is to achieve the best possible returns instead of protecting their money from inflation. Additionally, they tend to bring other investors to their deals to secure financing. The average investor tends to invest in short terms (3 year or less), return the invested capital, split the cash flows, and exit the investment faster.

Below are some value-added and NNN investments strategies that I extrapolated from previous replies.

Strategy #1: A more affordable way to invest in NNN retails is by searching for condo franchisee tenants suggested by John Mckee. You can acquire ten (10) small rental condos for the same price of a Walgreens with the power of leverage.

Strategy #2: Invest in a value-added deal, rehab it, and turn it into a NNN lease property suggested by John Mckee.

Strategy #3: Not all NNNs are created equal. There is a long spectrum of NNN properties from retail to industrial. While it is nice to own a 12-year NNN Walgreens, a small bay warehouse requires more work; however, it is more affordable and provides the same or better yield suggested by Ronald Rohde.

Strategy #4: Invest in second generation multi-tenant space in secondary markets. These investments are more affordable since they deal with low credit tenants. However, they have the potential for higher yield than a Walgreens located in Main and Main suggested by Jason Hirko.

Strategy #5: Invest with Joel Ownes in his value-added deals where he buys underutilized buildings and re-tenant them within a year. The holding period is typically three year with a potential of 2 times equity multiple.

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Joel Owens · Answer

Bigger projects like problematic older malls in good locations are being transformed into medical type buildings close to universities. Old golf courses also for giant warehouses and shipping. The younger generation is not playing much golf as it is expensive and time consuming neither of which the young crowd has much patience for.

With single tenant I have been in the space almost 2 decades now and have reviewed tons of properties for clients and myself.

I have talked with thousands of investors over the years. Many make a few million with headache real estate and then say I want to own passive NNN 3 million and below in price. They are then shocked to see the returns for going passive. Some still buy and others begrudgingly stick to what they were currently doing and deal with the headache for yield.

Most of my NNN clients buying stabilized and credit grade make lots of money. Not 100k or 200k a year but 500k and often into the millions of income per year. When people make that kind of money you barely have time to breathe because you are so successful at what you do. So investing becomes more about money to keep up with inflation or close to it and have in a safe place tax advantaged where the investor does nothing but get a check deposited each month into their account.

If say someone is worth 25 million it's nothing to them to put down 1 million on a 3 million property and collect 5% cash on cash and with mortgage paydown hit 8 to 11% annual returns plus in many cases large tax incentives.

When people are already multi-millionaires you still have to plan and grow that money to pay the least taxes possible. It becomes less about yield and more about equity growth and dirt value over time.

Now those accredited investors that want more yield they might buy one stabilized property with a larger chunk of their liquid cash and then invest with me passively in my value add sponsor deals which are typically up to 1 year to stabilize and 3 years to exit. I buy dark buildings for cash and re-tenant them and goal at a minimum is 2 times equity multiple upon stabilization in 1 year. I don't want to invest in syndications that have 7 to 10 year holds to hopefully double the money. I look at taking accredited investors minimum 100k invested at a time.

Guillermo Matias · Answer

Thank you for the note, John.

I’m one of those average investors struggling to buy a $2 million dollar NNN lease property. Multiple commercial banks have quoted me 20% to 25% LTV loan meaning that I have to bring +/- $500K to secure the loan. I don't have this type of cash lying around. My goal is to raise this money from family & friends and split the cash flows with them.

However, it is not as easy as it sounds. I have been spending a fair amount of time calling people, having lunches, and sending emails to get some level of commitment from this group. I spend most of my time educating and explaining the deal, so they feel comfortable investing. Raising capital from family and friends required a lot of leg work including, educating and nurturing others. Once you have a couple of deals under your belt, raising capital becomes easier and less taxing.

Also, I believe we have a similar investment strategy by looking for value-add deals and bringing tenants with good credit income.

John M. · Answer

Evan, @evan polanski

Restaurants trade at a low cap rate for 3 main reasons. Location, Long Lease, name brand/corporate guarantees. Any deviation from those and you will see higher cap rates. What happens in 25 years is anybody's guess, but if you have the right dirt/location it won't matter if the tenant leaves as you will most likely be able to rent it out again quickly and at a higher rate. I had a corporate guarantee well known tenant leave me after 10 years and it was easy for me to rent it out because I chose the location carefully. Since it was a class A location I did not have any re-tenant costs either. Hope that helps

Evan Polaski · Answer

@Joel Owens, I am curious what you are seeing in terms of overall returns upon sale.

I have never invested in single tenant NNN deals, but my concern is two fold: credit quality (fairly easy to assess going in) and renewal risk. Since many NNN deals are fairly specialty built properties, if the tenant doesn't renew, the NNN investor is stuck with land value or major re-tenant costs.

Have any of your clients run into this issue? My thought is if I buy a new Walgreens on a 25 yr term for 10mm. I get matching loan, and make my cashflow. But if in 25 yrs, they don't renew, I am stuck with land. Let's assume with appreciation, my land value is $5mm, and I was averaging 7% CoC on my $3mm down at acquisition. So I invested $3mm equity, received 5.25 in cash flow over 25 yrs, and have a free and clear parcel worth $5mm. Is my scenario even close? Is this why restaurants seem to trade (last I looked a long time ago) at lower cap rates, because of the re-tenant risk?

Christine Bellish · Answer

Hey Guillermo - this is a great thread! You explain the basic fundamentals and benefits of investing in net lease real estate well. I think people are the most familiar with multifamily rentals, so a lot of investors don't consider these types of properties when they're getting started, but they definitely should especially because net lease properties don't require as much management (less turnover, less expenses, quality tenants), which should make for an easier experience for newer investors than a value-add multifamily project that involves managing construction projects on top of everything else.

A few mentioned that these properties have a higher barrier to entry because they are more expensive to purchase - like any other asset class, it really depends where, but another way to get involved in this type of acquisition without the large upfront cost is to invest in a syndication that's acquiring net lease assets - most minimum investments are $50K that I've seen, but that's definitely more doable than $500K, especially when you're just getting started. Being a passive investor is a great way to learn - see how the deals are underwritten, the markets are chosen, the deal is presented to investors, etc, and it helps get you experience without having to take on all the burden. And if you ultimately want to go out and raise money to acquire a net lease asset personally, it'll probably be that much easier after gaining this experience because you can speak to that experience to help boost your potential investors' confidence. Getting the first one under your belt is always the hardest, but the good news is there is only one first one!

Thanks for getting this conversation started about net lease!

Guillermo Matias · Answer

Great point, Ronald. Thanks for the insight!

Why a Net Lease Property for Your First Commercial Deal?

Why a Net Lease Property for Your First Commercial Deal?

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