What's the exit play on a low cap rate NNN property

18 Replies

I've been baffled at some of the absolute NNN deals that are being sent around. For example I saw a Starbucks location listed at a 5.5 cap with a new 10 year lease. The lease has a 10% escalator at year 5. They are asking 1,073,000 for it. I'm wondering how does one exit that type of deal in a rising interest rate environment? I realize a 5.5 cap deal is an all cash deal but typically cap rates move with interest rates so if we get rates bumping up, the cap rates increase ultimately destroying your equity. Like with bonds, the building's value is a function of the return, which in this case is fixed by the lease.

Are you betting that you can renew the lease at a much higher rate at the end of the lease? Or are you just looking for some sort of capital loss/tax play in buying a building like that? @JoelOwens you sell these deals... what is the deal?

Lee,  generally in a deal like this, people are buying them for a guaranteed return.  Investors with VERY LOW risk tolerance love these deals as they beat inflation, provide some kind of return and the tenants are very likely to renew in a good location.  This is wealth preservation not wealth generation. 

They are not necessarily all cash deals.  They are easy to finance in some fashion but you do have to ensure they have enough cash flow to cover the debt plus 20% or so (1.2 DSC).

Tim

1.2 DSC is low for restaurant types.

Restaurants go dark more than any other NNN asset. So lenders tend to like more down and higher DSC's. Parent corporate backed 25% and franchisee usually lenders want 30 to 35% down.

Typical finance for 1 million range is local banks and credit unions. Those will generally be shorter term rates that do not run the length of the primary term of the lease. The investors go after those short loans because the basis points are lower which helps them eek out some tiny cash flow while waiting for the rent increases to kick in.

The 2% a year with 5 years is a long time to wait for that 10% bump to happen. I like to see every year increase or every 3 years so the yield happens faster ESPECIALLY if you are buying at lower cap and blending the cap rate number higher over the primary term of the lease.

The lease will spell out option periods already after primary term. Usually advanced notice is required about 6 months on exercising an option or not. I have seen though some really bad leases written by attorneys for new developers or private sellers. The tenant has a sweetheart deal so will not alter any terms of the lease for the new buyer as they do not get a payoff.

Some foreign investors are only getting 1/2 a percent return where they live so 5.5 works for them. 

The value is tied to the credit tenant and length of primary lease term. The buyers have to know what their predicted loan balance is before they buy. So if the debt to make the cash flow work is a five year loan then what will be the balance at that time going for a refi if you do not want to sell??

If you buy at a 6 cap and get debt at 4 you have a 200 basis point spread. In year five take your balance owed and factor a high rate say 6 or 7 and compare what the payment would be with a lower balance but a higher interest rate on the refi.

I am not very bullish on single NNN right now as I feel it is overheated. I can't justify buying a 4 million restaurant sitting on a half an acre for a 6 cap at over 400 a sq ft. If they go out the second generational tenant will be nowhere close to that. I would rather buy a quality strip center at 150 to 200 a sq ft and diversify my tenant mix and risk and have great breakeven occupancy to service the loan. Those are also trading at a higher cap rate currently so I feel there is room for cap compression.

I understand that they are for very low risk folks but what happens on sale/exit? Take the Starbucks I mention above. They have it at a 5.5 cap which equates to $1,073,000 on NOI of 58-996 in years 1-5 and 64,895 in years 6-10. If cap rates bump up to a 7 cap because of higher interest rates, the property is worth $927,080.00.

You seem to mention it in that you are hoping for a renewal. Do you agree that cap rates increase with rising interest rates or is my understanding wrong? 

Thanks.



Joel, that was nice explanation of the scenario. One other concept here is the yield to maturity which accounts for the expected or possible sale a lower price. The investor is quite aware his yield to maturity might be somewhat lower than his entry cap rate. 

Originally posted by @Lee G. :

I've been baffled at some of the absolute NNN deals that are being sent around. For example I saw a Starbucks location listed at a 5.5 cap with a new 10 year lease. The lease has a 10% escalator at year 5. They are asking 1,073,000 for it. I'm wondering how does one exit that type of deal in a rising interest rate environment? I realize a 5.5 cap deal is an all cash deal but typically cap rates move with interest rates so if we get rates bumping up, the cap rates increase ultimately destroying your equity. Like with bonds, the building's value is a function of the return, which in this case is fixed by the lease.

Are you betting that you can renew the lease at a much higher rate at the end of the lease? Or are you just looking for some sort of capital loss/tax play in buying a building like that? @JoelOwens you sell these deals... what is the deal?

You are buying NOI at a 5.5% if you pay $1,073,000 for the right to that NOI. I'd want to see some 5.5% cap rate comps before I'd pay that.

You could turn around and sell THAT EXACT same NOI ($59,015) next year for $1,475,375 if the market perceived that NOI to now be valued at a 4% cap rate. Now even if interest rates go up in year 10 it probably means that rents are also going up so even at a possible higher cap rate the "value" can be higher since your NOI will be higher.

BUT, the main thing to realize is that cap rates are based on the market's perception of value of NOI and all cap rates are is a means of expressing that value.

Originally posted by @Lee G. :

Do you agree that cap rates increase with rising interest rates or is my understanding wrong? 

.



Sure, CAP rates are going to fluctuate with interest rates, they have too. At the same time, as others mention, if interest rates are going up significantly, rental rates should also be increasing and so your profits should not get crushed. I can't imagine CAPs compressing any more than they are today in most areas...

You can easily get 10 year money on a Starbucks 5.5% CAP rate deal right now from just about any bank if you have the financial strength to back it up and there is any term on their lease (even 5 years). I would imagine you would be in the 4.5% - 5% interest. As for getting loans shorter than the lease term, you can get around this pretty easily as well. We purchased two large single tenant office building recently with short term leases in place (3 years). The tenants in one is DSHS in WA and the other is GSA. We were able to place debt on them for 5 years at 4.5%. We could have put 10 year money on them for around 5% but don't necessarily plan to hold that long. It took a bit of work to find a bank that was interested in the deal, but wasn't overly difficult. This is where a good mortgage broker can really come in handy.

I think Single Tenant buildings like this are far too expensive though. They have been one of the hottest trading items since 2011-2012 in the retail market space. You are going to pay an absolute premium. I'd rather find a way to buy a stabilized shadow anchored strip center at a 6 - 6.5% CAP if I was going to do something like that (although I would not personally do that either)

@Lee G.   you've got a lot of great answers but I'm not sure someone as addressed your actual question - "what's the exit!?"

I'm with you, I've always been curious.  My only logical explanation is:

1.  Hopefully sell at same cap rate but with slightly higher rents due to rent escalations 

2.  Sell at small loss but net positive due to a 1031 exchange scenario

3.  Hope for rent extension and escalations and refinance out

4.  If the property is in a good area with credit tenant, no exit, just hold it and collect rents like an annuity

5.  Sell to foreign investor (or some one from California) at even lower cap rate

@Jason Mak   - Thanks. I see a number of those deals and have been wondering about it. Your exit scenarios make the most sense though I don't think they make an cents (pun intended).

exactly...6 months ago I was looking to purchase these deals. They weren't attractive in the conventional sense but we were desperate for an exchange and didn't want to touch anything with management. In essence we were thinking about using a NNN as a bridge for an exchange but I was asking the exact question as you.

Here's my thought process and some of my math on this Starbucks - 

Buy at 5.5 cap - 1,073,000.00 

NOI @ years 1-5- $58,996

hold until year 5 when rent escalator kicks in. Your NOI goes to is $64,895. I think you are hoping to can sell for no less than a 6 cap which would make your exit worth $1,081,593.33 but given your transaction (exit) costs, you are underwater on sale excluding your cash flows. Now if rates spike and you have cap rates following interest rates, selling at a 7 cap is a loss - 927,080 excluding transaction costs. And yes, you could juice some of your returns by levering some of the deal but that won't cover the transaction costs on exit. Hoping for a 4.5 cap sale I don't think is plausible but I know people are doing those types of deals in secondary cities like Denver, Phoenix, etc. Joel said foreign investors will accept that type of return on a national credit...

Unless you are planning on holding this until you die and praying the location is good enough that the tenant stays for a really long time, this seems like a bad deal. Am I missing something?

@Lee G.

Hi, care to share what you wound up doing ? Starbucks going for even less at  4.7 - 5.5 cap now and some with only NN terms too.

Thanks, Rich 

Hi @Richard Chang - We are primarily developers and value add investors so that Starbucks or low cap deal isn't us. My current project load includes 2 subdivisions, an apartment complex and a condo project. The value add has gotten really hard in the intermountain west, where we primarily invest. 

My question was more along the lines of who is buying these deals and why are they buying them? I've spoken to a couple buyers of these deals and it doesn't make sense to me. 

It does make sense to those investors who can secure money at rates not available to us mere mortals. REITS who might self fund but calculate cost of money in relation to stock valuations, Investment banks who can borrow below 2.5%, etc. It then becomes a matter of what the basis is between cost of money and Cap rate. If they can make 2.5-3% over cost of money they might make the deal.

If you are an all cash buyer you can keep holding for the right time to sell or refi indefinitely.

If you are using debt you want longer term debt of 7 years fixed or longer. You do not want short term debt to make it cash flow today so that later you have a problem. Some investors use 3 year loans or floating rates to make the purchase cap work and still cash flow. I think those are bad choices for most situations. You are then looking to have to refi or sell possibly at an inopportune time in the market.  

Some of my clients that are older love these types of properties. They have owned stock that goes up and down and some have also owned more intensive type assets and are simply tired of problems in exchange for higher yields.

They are simply in a mode where they want to receive a monthly check and do nothing. It is estate planning so they have a monthly income for retirement and then leave to their heirs.

I have seen some before set up a trust and own Walgreens and make distributions capped after they pass away to their kids monthly. This gives them piece of mind the kids won't blow all the money right away etc.

Some foreign investors buy these for cash as where they are overseas the returns are 1 to 2%.

So for a value add or yield driven investor it can be harder to wrap your mind around these purchases and they do not make sense for your strategy unless playing on a few years left of primary term at a high cap rate. Me being a principal commercial broker I work with various different types of investors across the country with transactions and where they are at for their life cycle so it's easier for me to understand the different choices and thought processes.

@Tim Shoultz hey Tim, I'm actually looking for a lender for a transaction with 2 1/2 years left on the lease but can't find financing. Which loan broker did you use that was able to help you with the property that had 3 years left on the lease? Please let me know if you get a chance. Would love to talk to them about my deal. 

If it's a single tenant net lease you generally can only land financing at 45 to 50% down with a few years left on the lease.

It's simple economics. The lenders do not count the option periods. GSA deals have a mid 90 percent historical renewal rate in the option period so some lenders are more flexible on those.

What lenders typically do  is get an appraisal for a value with building occupied with the lease term and then one if the tenant doesn't renew the option and the place is dark.

So if a Walgreens was 3 million with 3 years left on primary they would take into account cap rate but also how much down. If you want to put 800k down the dark value might not be worth 2.2 million. The lender looks at what will the loan balance be when the option is not renewed? They want that loan balance to be at or under the dark value. This way with legal costs foreclosing or taking the property back they break even or have minimal losses at best. 

Joel, . In some cases people are just interested in the secure cash flow (foreign investors), others are interested in the arbitrage opportunity that Joel Owens outlined. 

There are 2 major buyers in NNN leases (in my experience, i have developed 5 NNN gas stations with national credit tenants and 5 single tenant outparcels):

1- Institutions, large funds/famoffices/reits/etc, In this case they are either using leverage for an arbitrage opportunity (borrowing at 3%, buying at 5%) and/or hedging against their much more aggressive investments. Or some version of both.

2- Wealthy foreigners, These buyers tend to cash as they dont qualify for loans so they buy all cash but bear in mind many of them will recieve their money in an account out oftheir country and will not pay income taxes, so that bolsters their returns abit. Alot of foreigners also choose to open a property managment company (a shell, as a NNN lease doesnt need management) to be able to have a business here in the states to help with visa/residency.

Both these buyers have a much longer investment horizon that individuals so the appreciation is inhertient.

The reason I invest in NNN properties is for the Income that it produces. The only exit strategy would be to sell the property at the next lease renewal in say 10 years from now, when the lease is resigned at a market or a higher rate. Along the way if I find a better property to trade up to, I can. How many retirees do you know that are earning 5.5% on their savings, have built inflation protection through rental increases and can pass the property down to their heirs with a step up in basis. (Answer: none) Also, the rate of return is actually greater if you finance it as opposed to putting in all cash. These are great properties to acquire along the way while focusing on your main source of income like a job or flipping houses etc. NNN properties are a nice pension to have, because someday you won't have the energy to work for a paycheck, but because you invested along the way, you will be okay.

Join the Largest Real Estate Investing Community

Basic membership is free, forever.

By signing up, you indicate that you agree to the BiggerPockets Terms & Conditions.