COVER STORY, FEBRUARY 2005

THE POINT OF DIMINISHING RETURNS
High market prices are changing net-lease investments.
Robert Miller

Miller

During the last 3 years, single-tenant, retail, net-lease real estate (STNLR) has changed from the low maintenance, passive real estate investments of the past into properties that investors should approach with more caution and cognizance. While the average real estate investor may see what looks like a plethora of bank, drug, auto, fast food and dollar store properties available, one must investigate deeper to uncover the supply of available credit tenanted real estate in today’s marketplace.

The aggressive nature in which purchasers have been acquiring property during the last 3 years, combined with: (1) tenants such as Walgreens and CVS/pharmacy exercising rights of first refusal to purchase and hire developers for a fee; and (2) a variety of other tenants demanding to own, as opposed to lease, their real estate (such as Wendy’s and Steak N’ Shake), have depleted the supply of STNLR. The low interest rate environment has resulted in unprecedented sales volumes, valuations at record levels and a bevy of eager, capital-rich investors who cannot find a home for their money in the real estate marketplace.

This uneven supply and demand ratio has driven real estate returns beneath the basement and created a frenzy of investors overpaying for real estate — purchasing at valuations they may not be able to duplicate for generations.

For example, an “A” credit drug store (such as CVS or Walgreens) trades in today’s marketplace between a 6.25 percent and 6.5 percent capitalization rate. Long term 10-year fixed money costs approximately 135 basis points above the 10-year treasury (4.22 percent as of 1/14/05) leaving the investor who puts down 35 percent on a $5.6 million investment a 5.1 percent pre-tax cash-on-cash return for investment years 1 through 10.

If the interest rates or rent does not decrease (both which are not likely), the value of these real estate assets based on an income approach to value will never equal or exceed today’s current values for a very long time. The average investor does not realize that the value of the respective real estate asset being acquired is based on the current income stream the property produces less the annual principal and interest payments it is able to service. Interest rates will eventually increase during the next 5 to 20 years, as will the cost to service this mortgage. In contrast, during that same time period, neither the rent nor the value of the real estate will increase or even stay the same. Instead, they will most likely decrease. The investor may not realize this devaluation until 3 to 4 years into the investment.

Even under these detrimental market conditions, demand continues to increase and the supply of STNLR continues to decrease. Buyers and brokers are facing a scarcity of good product. For example, an experienced, Chicago-based real estate broker hopes to deliver two Chicago area Walgreens properties and three bank properties during the first 6 months of the year. During the last 6 months, the broker would be pleased to identify an additional 6 STNLR for sale in the Chicagoland market. A few years ago, a broker would have been able to identify two to three times more properties for investors. The Chicago market as a microcosm is indicative of the scarce availability of STNLR around the country.

So what are purchasers to do? They are faced with sacrificing credit, lease term, location or return when completing deals. However, none of these sacrifices should justify a purchase price based upon a capitalization rate below 8 percent. Three years ago a 7.75 percent to 8 percent capitalization rate was considered the ceiling of the market (meaning the most aggressive return the marketplace would pay) for “A” credit STNLR. Now, the marketplace has seen an increasing amount of available “non-credit” STNLR purchased for lower capitalization than what was once considered the top of the market. These properties consist of: (1) fast food or casual themed restaurants such as Burger King, Arby’s or Applebee’s; (2) dollar stores such as Family Dollar, Dollar Tree or Dollar General; (3) auto stores such as Advance Auto, Murray’s Discount Auto and Auto Zone; and (4) a variety of other retailers that are able to take advantage of today’s aggressive STNLR investor.

For example, Chicago-based Millco Investments Company recently sold 32 franchise guaranteed restaurant properties and 35 convenience store properties (each with average credit) at an average capitalization rate of 7.6 percent. That is more than 60 deals to more than 60 different purchasers, purchasing at sub 8 percent capitalization rates, with full recourse debt, while earning an approximate pre-tax return of no better than 8 percent. The credit of the tenants guaranteeing these leases should not justify the low returns for which they are trading. If a sub-par Walgreens’ location — which is guaranteed by a NYSE publicly traded, S&P “A” rated tenant with a new lease — trades for a 6.5 percent capitalization rate, a non-credit private restaurant franchisee — whose financial statement is un-audited — should not trade for a mere 100 basis points difference. But due to the lack of availability of STNLR, investors have disregarded these risks in an effort to avoid paying capital gain taxes. Perhaps investors should consider paying the taxes as opposed to taking a risk on a non-credit tenant. Three years ago, these non-credit tenants traded for 9.25 percent to 10 percent capitalization rates while the “A” rated publicly traded tenants traded for 7.75 percent to 8.5 percent capitalization rates, which is an almost 200 basis point difference. Today that margin has narrowed to barely 100 basis points.

Here are some guidelines for today’s real estate investor who is deciding whether to sacrifice credit, lease term, location or return during a purchase:

1. If sacrificing credit of tenant and lease term for a better return, purchase a well-located piece of real estate in which the revenue stream can be duplicated or increased in the event the existing tenant does not exercise the lease renewal options. The good location and replaceable revenue stream is the best insurance policy an investor can have.

2. If sacrificing return, purchase a well-located piece of real estate with a very good credit tenant and long-term lease. Odds are that the length of the lease term will offset any valuation questions the investor may have at the time of acquisition. The initial lease term of this asset may be for 25 years with no rent increases, but the investor can count on 25 years of relatively maintenance-free rent. Upon expiration of the initial lease term, the residual value of the real estate will most likely be equal to the income approach to value of this real estate asset. Additionally, 25 years of inflation will most likely make the current market rents 25 years from now above what the tenant’s renewal option rent may be.

3. If sacrificing location for return — don’t do it. Investors cannot gamble on a poor real estate location to ever have the ability to attract a rent that will be higher during the time from the initial lease term. Of course, there are instances in which poor geographical areas have experienced gentrification. However, it is not wise to bet on this scenario with no gentrification presently evident.

Finally, for all those investors who are acquiring STNLR as part of a tax-deferred exchange, if all else fails, pay the capital gain tax – it is merely 15 percent to 17.5 percent of the gain. There is no reason for investors to overpay, unless they intend to own the property at their death and permit their decendents to realize the benefits of a step-up in basis.

Robert Miller is president of Chicago-based Millco Investments Company, a national commercial real estate brokerage and investment firm specializing in the sale of commercial investment real estate with a focus on single-tenant, free-standing, net-lease properties.



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