Walter

In today’s real estate market, there is no doubt that single-tenant retail net leases are a highly sought-after investment because they offer numerous advantages in comparison to other property types. The advantages include more defined returns, increasing rents on well-located retail properties, projected sales, long-term leases and the availability of various investment sizes.

A much larger buyer pool is coming into the real estate investment world, and a large part of this group is attracted to the retail net lease acquisition option. A net lease is as close as possible to a non-business in real estate, making it an attractive investment for new money coming into the real estate market and for 1031 exchange investors looking to roll money from one real estate sale to another to avoid capital gains taxes. These types of investors are willing to accept a smaller return on investment for secure, long-term income, free of the day-to-day management responsibility.

A typical triple net lease is an arrangement in which a commercial tenant pays the real estate taxes, insurance and maintenance on a property in addition to the rent. This reduces the property management burden on landlords because they simply collect the rent and all maintenance is passed through to the tenant. For example, a single-tenant net lease buyer can purchase a Walgreens drug store and never visit the property but collect a check every month. Net leases can be looked at more specifically as cash flow investments providing a constant stream of income.

Net lease investments can be compared with alternative low maintenance investments such as CDs or bonds. Another advantage is that they do not fluctuate erratically like the stock market. Current cash-on-cash returns for net-leased property are anywhere from 5 percent to 10 percent and the current rate on a 5-year CD is 3.5 percent, making net leases profitable, secure and management-free investments. In addition, real estate offers depreciation, which provides more net cash to the investor than other investment alternatives.

Retail Net Leases Become a Favored Investment

Retail net leases flourished in 2003 and should continue to remain strong in 2004. There are several factors that make single-tenant retail properties a more desirable net lease investment than other real estate product types such as office:

1. Location. It is a key factor for retail net leases because retail is location driven. Historically, the rent on a well-located retail property will continue to rise with many potential tenants wanting the location when the existing tenant’s lease expires. Other property types do not necessarily benefit from these premier locations on busy streets in densely populated areas. The success of a retail tenant on a well-located property is going to be much greater than the success of a business that’s not necessarily predicated on location. With a drive-thru Jack in the Box, it is much easier to define the success of the tenant. First, Jack in the Box has locations across the country and has traditionally been a successful business. Secondly, the company has completed demographic research and can project sales after occupying the same location for several years. In comparison, other property types are not necessarily location driven, making it very difficult to understand whether that specific location is profitable or if an investor is solely counting on the credit of the tenant.

2. Retail properties tend to have longer-term leases than office properties. Many single-tenant properties have 20- to 30-year terms with options to extend. With other property types the leases tend to be shorter, and when the building comes up for lease again, an investor might have delays or high re-tenanting costs, which inhibit the investor’s cash flow.

3. The re-tenanting of a single-tenant retail building is much less capital-intensive than the re-tenanting of an office building.

4. Retail net leases have the availability of various retail investment sizes. The range of investment is broad. An investor can purchase a Jack in the Box in the $1 million to $2 million category, or a Best Buy, Wal-Mart, The Home Depot or Sam’s Club, depending on rents, for $20 million to $50 million.

Assessing the Value of a Retail Net Lease

Because of the increased demand for single-tenant retail net leases, numerous investors have sought to purchase a Walgreens or Sav-On Drugs anywhere in the country, regardless of the location. Investors should make smart acquisitions and dispositions by looking at the big picture. A worthwhile real estate brokerage firm builds business plans for its clients and assesses the value of single-tenant net lease property relative to five major criteria — location, density, population, demographics and the credit of the tenant.

In retail net leasing, investors should look at well-positioned properties in dense locations so they have an opportunity to double, triple or quadruple rents when the properties become available for lease renewal, versus potentially not having tenants in weaker markets. I strongly recommend investing in high-density regions such as California and other populous states. California real estate offers some of the most well-located and successful net lease opportunities. In comparison to many other alternative investments, retail net lease properties generate solid returns with minimal management and tremendous upside in rental growth. If investors decide to venture outside of California, they should find a great location with high density so that when the property comes up for lease again, it will be easier to re-tenant.

Currently, cap rates for single-tenant drug store properties on long-term leases reside in the high 5 percent to the low 7 percent range. California commands the highest pricing but the intrinsic value of real estate could be much greater when the tenant cycles out of the lease. Current cap rates in the western states average 6.5 percent. However, the more sparsely populated areas of the country have higher vacancy rates. If an investor has a net lease in a lower populated area with Kmart as the tenant, and Kmart goes vacant, the investor then potentially has a large retail box without a new tenant demanding to move in right away. In California, when a property goes vacant, there’s usually a new tenant there to snatch it up. In the case of Kmart stores in Aliso Viejo and other local areas, the buildings were sold at a much higher value than the capitalized value of Kmart, making them even more profitable for the investor due to its strong location and tenant demand.

Consider each investment with care. A property at an 8 percent cap rate outside of California doesn’t mean that it’s a better buy than a 6 percent cap rate in California. In the long run, if an investor is paying $1 million for each and the property is eventually sold, the out-of-state property may not have increased in value at the same rate as a comparable California property. Looking back 5 years at single-tenant retail buildings in California, many are worth much more today because of land value due to increased demand. Just remember that when buying the best, you often have to pay premium prices.

Overall, single-tenant retail net leases are excellent real estate investments if evaluated based on the location, density, population, demographics and the credit of the tenant. More importantly, a net lease investment must fit into an investor’s portfolio and business plan, balancing other income-producing investments, safety and a certain amount of risk.

Richard Walter is president of Faris Lee Investments, a retail investment advisory and brokerage firm in Irvine, California.


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