FEATURE ARTICLE, JULY 2005

NET LEASE PROPERTY: OFFSETTING REAL ESTATE RISK
A primer on net lease properties’ attributes that can make real estate a lower-risk alternative.
Chris Campbell

When Dennis Yeskey, national director of Real Estate Capital Markets of Deloite Consulting LLP addressed an audience of certified public accountants from around the country about real estate investment, he asserted that real estate has traditionally been considered a part of the “alternative investments” class of assets, after bonds and stocks, because of its volatile, unpredictable nature. But today, he suggested, real estate should be considered a third necessary asset class for investors with risk/reward levels falling between those of bonds and stocks. Indeed, since September 11, 2001, and the subsequent stock market decline, unprecedented capital has flowed into the real estate market.

But risks associated with real estate have warded off the most conservative investors. Rising interest rates, demographic shifts, volatile market cycles, public works projects, rezoning legislation — even changing pigeon migration patterns — all exemplify risks particularly associated with real estate investment that have made real estate seem to investors to be the riskier asset to invest in.

 Among real estate types, net lease property is uniquely insulated from the risks typically faced by property owners. Net lease property is property leased to a single corporate tenant on a long-term, “triple-net” lease. The tenant’s corporation guarantees rent payments with its full corporate credit, so that even in the event of the local tenant’s failure, the rent still gets paid. As a result, lenders are willing to provide high leveraged financing up to more than 90 percent loan to value. Typical real estate may be financed up to 70 percent loan to value.

The triple net lease confers to the tenant property management responsibilities usually associated with real estate ownership. Pigeon migration patterns may shift, but the property owner is no longer the one raking up the droppings. Likewise, repairing the roof, repaving the driveway, and insuring for the visitor who slips and falls on the slippery walk. The owner just collects the rent and takes the depreciation expense for tax purposes.

But how does the investment perform? Typical real estate valuation is subject to a host of unpredictable influences that lie beyond the owner’s control, such as neighborhood decline, demographic shifts or fluctuating real estate values. By contrast, net lease property is valued based on the predictable income stream from the single corporate tenant, independent of local market volatility. The long-term lease assures stable income from the property, eliminating concern about sudden vacancy interrupting the rent stream and about the unexpected hassle of re-tenanting.

A common concern is: What if that single corporate tenant goes bankrupt? Witness Kmart’s demise in January of 2002. Owners of Kmart properties around the country relied on the guarantee of that corporation to pay its rent and felt assured they had the real property equivalent of a corporate bond — until Kmart filed Chapter 11 and the rent payments stopped. Even big corporations go bust. And even net lease property is not a sure thing.

Since 1998, creditors, wary of credit risk, have refused to offer high leveraged financing to tenants with credit below investment grade (credit deemed by an agency such as Standard and Poors to be of high caliber), even with a triple net lease in place. “Credit tenant property” is the premium sub-class in the net lease arena that minimizes the credit risk of net lease property ownership. The high caliber of the tenant’s credit provides assurance about rent payment reliability. Because of the secure nature of bondable credit tenant property, pricing for these assets tends to be more stable. Additionally, the “bond” lease used for these properties places an even fuller list of real estate responsibility on the tenant, including responsibility for casualty, condemnation and structural repair.

In the unlikely event of the bankruptcy of the tenant corporation, the underlying property is still of value and these properties, with their long term leases in place and full due diligence performed, are easily repositioned for retenanting. In the event of Kmart’s bankruptcy, one client of Net Lease Capital had purchased a Kmart property as part of a tax strategy. As Kmart prepared to file Chapter 11, the client was able to fill the space with a Wal-Mart, without interruption of the rent cash flow.

A Net Lease Capital strategy tailored for risk management incorporates sub-investment grade, retail property to keep costs down while still managing risk for a price-sensitive, risk-averse client.

After September 11 and the collapse of Enron Corporation, investors, fearful of further real estate volatility, are fleeing to quality. In the credit tenant niche, they increasingly demand higher credit tenants, often preferring office and industrial properties to retail, which may seem less stable. Some investors prefer tenancy-in-common structures for their instant diversification, as a way of mitigating the risk of over-allocating investment dollars to properties with failing tenants.

Net Lease Capital Advisors uses credit tenant property in a variety of structures. The firm likes credit tenant property for larger investors, since they can achieve whole fee ownership interests with exceptional liquidity. A fluid market makes for efficient transactions. Unique attributes of this property class afford strategic alternatives not available with other real estate.

A recent transaction exemplifies the strategic application of credit tenant property in a tailored tax solution. The transaction defied conventional logic, incorporating sub-investment grade, retail, credit tenant property, which had sat on the market for 3 years, in a structure designed to balance risk and price sensitivities.

An accountant who had worked previously with Net Lease Capital brought in a client that had a $17 million sale of property that had been depreciated to $2 million. The capital gains tax would be substantial, amounting to approximately $5 million. To defer the tax payment, the client sought to perform a 1031 exchange, but expressed reluctance due to soaring prices in a market where cap rates were falling to unprecedented lows. Could the potential tax savings be worth the risk of an exchange and extended property ownership?

Net Lease Capital proposed deferring the tax through an exchange for $17 million of credit tenant property, which would enable a post exchange refinancing that returns to the client $5 million of cash. The client agreed, but was concerned about credit risk in light of recently revealed corporate scandals. Financial failure by the single tenant corporation would jeopardize rent payments needed to pay down the debt. Concerned about this credit risk, the client demanded office property tenanted by a corporation of high investment grade credit. But price would be an issue.

Considering the client’s inflexible price sensitivity, Net Lease Capital suggested a transaction wherein sub-investment grade credit retail property would be purchased at low pricing. They calculated a savings of $850,000 in equity investment that would have been required to purchase the investment grade property originally desired.

But the risk of a lower credit tenant in the retail sector still was unacceptable. As the client backed away and considered paying the tax, a Net Lease Capital strategist argued for a structure that would manage the risk. They would take advantage of the relatively small size of retail properties to assemble a diversified pool of property for the exchange, rather than using a single larger property. Credit risk from any one tenant’s failure would not have overwhelming impact on the owner’s ability to cover the debt.

In this “basket” structure, a well chosen, smaller retail property would be more easily repositioned than a large office building in the unlikely event of a tenant’s default. The properties would be analyzed for geographic and demographic characteristics assuring the quality of the underlying real estate itself, as well as a promising future for the properties, irrespective of their tenants’ performance.

 Among those selected, one property was chosen that had two public corporations guaranteeing its lease, the result of a subleasing that followed the property’s initial sale-leaseback. Since the probability of default for an S&P, “B” rated corporate bond is 20 percent over a 20-year period, the strategist calculated the cumulative probability of default for both lessees to be 4 percent — less than the 5 percent default rate of S&P “A” rated corporate bonds over the same period; so even in the event of one default, the lease would still perform. Risk managed.

Finally, by investing the $850,000 in equity savings achieved through using this lower investment grade property, the strategist determined the client would be able to make back the entire amount of its cash investment within 5 years of reinvestment of the cash. The non-recourse debt assured that if the tenants did fail, in 5 years, the client would have the same amount of equity as he started with and be able to repeat the transaction without loss.

The exchange took place and the cash-sensitive client was ultimately able to defer a $5 million capital gains tax payment for less than $2 million of cost, while achieving comfort with the risk levels of the strategy, even with retail and sub-investment grade property in the equation.

Chris Campbell is with Net Lease Capital Advisors, a boutique investment and advisory firm based out of Boston, New York and San Diego, that offers sophisticated tax solutions in real estate.

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