Negotiating lease terms for NNN commercial build-to-suit

8 Replies

As an investor I am currently negotiating a buil-to-suit NNN lease that I am building from the ground up and will have a lesser known national fast food franchise as the tenant. I will be getting a 20 year lease but I would like some opinions on determining what the base rent, possible percent rent, rent escalators, etc could be? I will be negotiating with the franchisee and not the franchise itself.

Regarding the base rent, if the project (land and construction) is valued $1.5M should I use the CAP=NOI/value to determine the rent? Let's say we agree on a 10 cap rate and the NOI is basically what the rent would be since there would be very little to no expenses (except for attorney/accounting fees) then that would make the annual rent $150,000. Or do I just calculate the rent according to the square footage for this type service in the area? Any other options?

As for a percent lease,  what different formulas have been used regarding what percent over a certain breakpoint on gross vs. net income of the business?

Rent escalators? For commercial properties, what are some are the norms for rent increases, 1% a year, 3% every two years, 5% increase after 5 years?

Please feel free to add any comments regarding your experience with negotiating lease terms. 

I would think it was best to have a commercial broker that is up to date with current market conditions to negotiate a lease that will encumber your property for 20+ years.

Updated almost 4 years ago

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I wouldn't limit yourself to a cap rate based on the land and construction costs. Many properties with NNN leases sell for significantly higher than the land-inclusive replacement cost. As an investor, you should try to attain the highest possible rents that you can negotiate, with regular increases (preferably yearly increases but at a minimum 10% increases every five years). You took the risk of acquiring/owning the property when it was vacant and you should try to attain the maximum amount the market will pay for the property you can provide. As Bob said, the services of an experienced broker could be well worth it in helping you achieve the most you can get.

I would check on Loopnet for similar properties for lease and check out the asking rents for similar build-to-suit offerings. Or you can search similar properties for sale on Loopnet to determine the amount of rent other tenants are paying for recently signed built-to-suit NNN leases. Don't leave money on the table.

Good luck!

Scott you need a broker who knows NNN.

I eat,live, and breathe this stuff.

You should already have a forward commitment from the tenant to get the construction loan from the  bank.

If you already own the land then you would not be doing a leasehold type arrangement for the lease.

Your other options then is a ground lease where they construct the building and if they do not renew the option period you tend to get the building by default.

You could also get the NNN (no landlord responsibility) or NN ( landlord responsible for roof,structure,parking lot ) depending on what you negotiate. You own the land and building on those.

Is your goal to hold for the long term or sell off? Usually when you develop NNN most are all in for land and building for a 9 cap or so and sell at a 6 cap for a newly minted lease. A lot of the value depends on the size of the lot, inter-connectivity to other anchors without going back out on the road. If there is just a median turn in, a stop sign, a stop light. sight lines, daily traffic counts, what the concept is etc.

Sometimes even if the franchisee you can get the corporate to back the lease. Franchisees are generally worth less than corporate guarantee. 

When you sell a franchisee better have a higher starting cap rate and more increases. I do not like rental increases every five years UNLESS it is a corporate guarantee. If I have a franchisee that goes up 10% every 5 years and they go out in year 4 I had ZERO increases in rent to offset inflation and diminished returns the last 4 years.

Writing a bad lease can make you lose money on this deal. You need a marketable lease so that an end buyer finds it attractive and the lease can get good loan terms for purchase of the property.  

One developer called me that built out a bank. What they agreed to in the lease with an attorney representing them was horrible and severely impacted the value of the property going forward. I read it and couldn't believe it.

If you want to talk on the phone I am happy to talk for nothing in return. Just do not go blindly into this and make a bunch of mistakes.   

    

Originally posted by @Joel Owens :

Scott you need a broker who knows NNN.

I eat,live, and breathe this stuff.

You should already have a forward commitment from the tenant to get the construction loan from the  bank.

If you already own the land then you would not be doing a leasehold type arrangement for the lease.

Your other options then is a ground lease where they construct the building and if they do not renew the option period you tend to get the building by default.

You could also get the NNN (no landlord responsibility) or NN ( landlord responsible for roof,structure,parking lot ) depending on what you negotiate. You own the land and building on those.

Is your goal to hold for the long term or sell off? Usually when you develop NNN most are all in for land and building for a 9 cap or so and sell at a 6 cap for a newly minted lease. A lot of the value depends on the size of the lot, inter-connectivity to other anchors without going back out on the road. If there is just a median turn in, a stop sign, a stop light. sight lines, daily traffic counts, what the concept is etc.

Sometimes even if the franchisee you can get the corporate to back the lease. Franchisees are generally worth less than corporate guarantee. 

When you sell a franchisee better have a higher starting cap rate and more increases. I do not like rental increases every five years UNLESS it is a corporate guarantee. If I have a franchisee that goes up 10% every 5 years and they go out in year 4 I had ZERO increases in rent to offset inflation and diminished returns the last 4 years.

Writing a bad lease can make you lose money on this deal. You need a marketable lease so that an end buyer finds it attractive and the lease can get good loan terms for purchase of the property.  

One developer called me that built out a bank. What they agreed to in the lease with an attorney representing them was horrible and severely impacted the value of the property going forward. I read it and couldn't believe it.

If you want to talk on the phone I am happy to talk for nothing in return. Just do not go blindly into this and make a bunch of mistakes.   

    

 I agree with everything Joel said in his above post. Regarding rental rates my experience would be a premium rate above market due to being BTS and new construction. A local broker would be able to help you with the going market rental rate is.

Also, just my opinion, make sure that if you are agreeing to have this built out by a certain date that you give yourself plenty of breathing room on that date or leave it open to a range of time (less specificity) as this can cause leases to terminate, a tenant to back out, a tenant to file a motion to reject a lease based on LL not providing on set date. Not pretty at that point.

As mentioned above, all of these things vary greatly. Since you are dealing with a QSR tenant, they pay the highest rents. They typically have a max all-in rent/sales ratio of 8-10%, so if a store does $1,000,000 a year in sales they will not pay more than $100,000 a year for rent+all other NNN expenses (cam, insurance, taxes). You can ask the franchisee for some financials to examine store sales and see what this ratio would work out in your scenario.

As far as rent escalators, can be anything. I've seen 2% annually, 10% every 5 years, a percentage tied to CPI (ie. the lessor of CPI OR 6% ever three years), flat for the entire term. I would ask for 2% every year. 

For percentage rent, you can negotiate an artificial breakpoint- you and tenant decide on a number for the breakpoint and the percentage of net sales above that number (ie 3% of sales above 1.5million) or a natural breakpoint (if the rent is $100,000 a year and the percentage rent is 3%, then the natural breakpoint is 100,000/.03=3,333,333- so the tenant would pay 3% of net sales above 3,333,333). The logic behind the natural breakpoint is that a tenant should only pay the percentage rent on sales over and above what is required to pay the minimum rent.

You should take all of this into consideration but it is imperative to get in touch with a knowledgeable commercial broker who is familiar with the market and can give you some comps for the rents in the market. Also make sure you have experienced legal counsel to draft the agreement, because as stated above, if all of the terms aren't properly incorporated in the lease it will have an impact on the value of the investment. Try to negotiate as absolute-NNN as possible (tenant responsible for all expenses). Since you are dealing with a franchisee, make sure to carefully examine their financials, and try to get as many people as possible on the hook for the Guaranty for the entire 20 year term (all operators, and even spouses) so you have as much recourse as possible in case of default.

Oh, and don't forget to negotiate option terms- shoot for four, 5 year options with same or better terms that are in primary lease. If all goes well, you could have an asset with the potential of 40 years of predictable, steady, passive income!

Originally posted by @Dmitriy Shnitman :

Oh, and don't forget to negotiate option terms- shoot for four, 5 year options with same or better terms that are in primary lease. If all goes well, you could have an asset with the potential of 40 years of predictable, steady, passive income!

I think the lease options benefit the tenant more than the landlord.  The tenant can always walk off at end of firm term.  From a lending perspective, the options mean very little.

Mark

Originally posted by @Mark Creason :
Originally posted by @Dmitriy Shnitman:

Oh, and don't forget to negotiate option terms- shoot for four, 5 year options with same or better terms that are in primary lease. If all goes well, you could have an asset with the potential of 40 years of predictable, steady, passive income!

I think the lease options benefit the tenant more than the landlord.  The tenant can always walk off at end of firm term.  From a lending perspective, the options mean very little.

Mark

 Yes they do benefit the tenant more than landlord and tenant will probably request options to extend. However, it does save the landlord a headache and expenses down the line to renegotiate or find a new tenant for the space, especially if tenant has fulfilled obligations of lease for 20 years. If you do agree on options to extend, make sure that in lease that tenant must notify in advance and in writing (12 months for example) of their intent on exercising option.

I was thinking more from perspective that @Scott Morris intended to sell investment upon lease up, which I'm not sure is his intent. Options can add value, and help market the investment, as buyers like to see as much predictable cash flows as far in the future as possible. 

Also be careful with assignment and subletting language within the lease. If you allow assignment or sublease, make sure that they will require Landlord consent and original tenant and Guarantors are not relieved of any obligations of Lease and Guaranty. 

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