8 Key Factors to Consider When Buying a Single Tenant Property - Michael McVinney
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8 Key Factors to Consider When Buying a Single Tenant Property

This post originally appeared on tBL member  Progressive REP Blog and is republished with permission. Find out how to syndicate your content with theBrokerList.

8 Factors to Consider When Buying a Single Tenant PropertyThe single tenant retail market is still exceptionally strong as maturing investors continue to sell more labor intensive properties and search for simplicity while deferring substantial capital gains. At Progressive Real Estate Partners, we have had a lot of success both selling some of these more intensive properties and helping our clients exchange into single tenant properties, as well as listing single tenant properties and selling them to 1031 exchange buyers.

Ideally, a sophisticated investor is able to find some level of imperfection in the market and thus achieve a higher yield compared to the risk of the specific single tenant property. There is no perfect property. There are always trade-offs. To help investors examine the risks and rewards of single tenant retail properties, I have put together this list of considerations:

  1. Who is the Tenant: If you look at three properties that are all, for example, doing business as Popeyes Louisiana Kitchen, this does not mean you are getting the same financial security. An investor needs to determine whether the site is corporately owned, a franchisee with many locations or a franchisee with only one or two stores. Some corporate tenants even set up separate entities from state to state so the California entity may be different than the Florida entity. It is critical to dig as deep as possible to understand the financial security that the tenant signature provides. This is why sites that are owned by publicly traded companies (with financials posted online) that have strong financials trade for the lowest cap rates. The transparency is very valuable.
  2. Lease Term: The only security that a buyer has is the length of the existing lease. Generally the longer the lease the better because the investor will hopefully not have to deal with the potential re-tenanting of the property. Although I hate to say this, the reality is that I have seen many investors in their 70’s have the attitude that if they buy a 15 year lease either they may not be alive by the end of the lease to deal with the potential problem OR if they have to deal with re-tenanting at lease expiration they are less likely to care. I see this psychology all the time between a lease that has 9 years left vs. 14 years. That extra 5 years matters a lot to many investors.
  3. Location: Busy intersection? Growing community? Good access? Good visibility? Good co-tenancy in the immediate trade area? These are just some of the factors when evaluating a location. The objective is to determine whether the location will support the tenant’s business and, if for some reason, you get the building back, will the location be suitable for replacement tenants. I very much believe that every single tenant investor should personally see the real estate they are buying. If you are fortunate, the site will look just as you suspected when you viewed it on Google Maps.  If not, you may find for example that the property sits on a hill and isn’t visible from the street or the grocery store anchor that the property fronts is actually closed. Unless you have so much money and so much real estate that making a mistake just does not matter that much to you, make sure you visit the real estate during due diligence.
  4. Current Rent vs. Market Rent: Most single tenant retail buildings that are on the market are paying above market rent. But how could this be, especially if the property was just built. Wouldn’t the rent the tenant is paying have to be market? The reality is that when, for example, a Starbucks, or Panera Bread or AutoZone wants to be at a site, they will generally pay a premium so that the developer can afford to build the location. Also, substantial improvements to the building are frequently specific to the individual tenant and these improvements would not be of value to a future tenant and therefore a future tenant would not pay the same rent as the current tenant. Also, if the existing tenant fails at the site, there could easily be something wrong with the site which is why the next tenant will not pay as much. Some investors will only buy a site that has existed for many years and has a current rent that is market. But that could easily result in the investor buying an older building with a shorter lease term than if they purchased a new building. As I said above, there are constant tradeoffs. The hope for the investor buying the newer building with the above market lease rate is that the tenant will succeed and over time, the market will grow into the lease rate so if they did leave after 15 or 20 years, the rent would be replaceable.
  5. Rental Increases: Take two properties that are both selling for a 6% cap rate with an annual rent of $100,000, but one has 10% increases every 5 years and the other has 2% increases every year. After 15 years, the rent starting in year 16 would be $133,100 based upon 10% increases and $134,586 based upon 2% increases. Although they are almost identical, the 2% per year yields an extra $75,800 to the investor over this time. Change it to 3% increases and the year 16 rent is $155,796 and the additional rent received over the first 15 years is $227,588! Need I say more?
  6. Expenses:  Who covers what? Most single tenant retail lease are what we call on the West Coast triple net (NNN) leases or Absolute NNN leases. There is some different thinking in other parts of the county relative to these terms as the words “double net” and “triple net” seem to be utilized instead of triple net and absolute triple net respectively. Apart from the semantics, the key to this equation is what is and what isn’t covered by the tenant and what are the logistics for covering these items.The ideal situation from an investor’s perspective is an Absolute NNN lease. This means that the investor gets a check each month for rent and the tenant does and pays for EVERYTHING else.

    From that starting point, there are many variations of a triple net lease. Sometimes the tenant maintains the building and property, but the owner pays for the property taxes and insurance and then submits these invoices to the tenant for reimbursement. Sometimes the owner maintains everything on the exterior and common areas and the tenant reimburses for these. Sometimes a common area manager maintains the common areas (this is especially true if the property is a part of a larger shopping center), and then bills the investor who subsequently bills the tenant. All of these methods affect the investor’s management responsibilities and may affect the value of the property to potential investors.

  1. Options: Options only benefit the tenant. I have seen investors who have a 10 year lease with 4, 5 year options say to me, “I have a tenant with a 30 year lease”. There is some truth to that. The tenant has control of the property for 30 years and frequently at pre-determined rents, but the investor only has a lease for 10 years. If market rents soar in value, the owner will still only get the pre-determined rent, but if market rents fall, you can be sure the tenant will show up to renegotiate their lease.

    The length and number of options are also important as 10 year options are better than 5 year options (although 5 year options are most prevalent) because 10 year options help with future resale or financing. That being said, there are many Walgreens out there with 25 year leases and then 50, 1 year options. Talk about not being able to sleep at night if you own one of these (unless you have a very diversified portfolio or it is simply a great piece of real estate).

  1. Zoning & Future Use of the Building: What could you do with the property if the tenant fails? You might be buying a drive thru building in a community that no longer allows them and if the tenant goes out of business you may not be able to utilize the drive thru. What about a child care center located in a master planned community whereby it can only be utilized for this use? How about a single tenant retail box that may need to be divided if the existing tenant vacates? Knowing your options based upon zoning and either shopping center or community restrictions, could be very important to the future value of the investment. Also, from a practical perspective, what type of uses could occupy the building and will it cost a lot to put such uses into the building. The need to prepare for this possibility is probably the most overlooked consideration by single tenant investors. Unfortunately, our leasing team are frequently the ones that have to break the news to the investor about the challenges of re-tenanting their single tenant investment.

At Progressive Real Estate Partners we realize that our job when selling a single tenant property is to present the property in the best possible light and highlight as many of the potential positives and let the buyer and buyer’s broker assess the potential risks relative to these rewards.  On the other hand, when we represent an investor buying a single tenant property, our job is to understand the risks and help the investor assess these risks relative to the rewards so that they get the best “value” for the investment.

In my opinion, so long as our investor population continues to mature, long term interest rates stay relatively low, and the 1031 exchange laws remain unchanged, the single tenant market will continue to thrive.

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