How can investors avoid buying a property that will be on the chopping block when the retailer’s lease-renewal option comes up?
Prior to the Fed’s June 15 rate hike—the largest since 1994—inexperienced investors were already bailing on the stock market and flocking to triple-net-lease properties with tenants like Dollar Tree, CVS Health or Sonic Drive-In. Now the trend is on overdrive as investors scour online listings to find single-tenant assets up for sale.
Understandably, a high-net-worth individual aiming to divert $2 million from the stock market may be drawn to the promise of a largely tax-sheltered, 5.5 or 6 percent return on a triple-net investment. The risks also seem low since these tenants boast investment-grade credit.
But as they race to lock up these locations, newbie investors may be running greater risks than they appreciate. All too often, they are buying properties based on prominent selling points in those online listings—price, credit, cap rate, rental levels and length of lease term—and failing to properly weigh critically important locational characteristics.
Below are some tips for investors who want to evaluate triple-net properties like the pros.
Be wary of tenant vacancies
Smart retail chains shutter anywhere from 5 to 10 percent of their least-productive stores every year and can make even-more-aggressive cutbacks as part of adaptive real estate strategies.
So how can investors avoid buying a property that will be on the chopping block when the retailer’s lease-renewal option comes up? Undesirable locational characteristics—difficult ingress and egress, poor visibility, sluggish vehicular traffic and the like—are major clues.
Losing a tenant is serious business. Take a scenario in which a dollar store vacates an inexperienced investor’s triple-net property on a stretch of highway in rural Wisconsin. Unbeknownst to the investor, the retailer was unhappy with several locational characteristics—including the condition of surrounding buildings and homes, and declining population and traffic in the trade area.
The investor asks a broker based 150 miles away to pound the pavement for replacement tenants, but the effort fizzles. “You should subdivide that 10,000-square-foot space into smaller storefronts for mom-and-pop operators,” the broker suggests.
The investor is caught in a bind. The revenue stream has dried up, and since shuttered stores suffer more roof leaks, frozen pipes and vandalism, the vacancy triggers additional obligations buried in the lender agreement. Meanwhile, the investor has to carry out a substantial construction project and find and do deals with multiple replacement tenants.
There are many other scenarios in which tenant loss can be consequential. For example, certain high-traffic, high-volume operators are known for paying eye-popping rents for freestanding or, in the case of multi-tenant sites, endcap locations with drive-thru lanes. What’s not to like, right? The problem is that many of these same chains continually tinker with their real estate strategies. When they walk away, investors often find it impossible to replace those above-market rents.
Along the same lines, a 10,000-square-foot dollar store may be able to get by with a small parking lot of about 30 spaces. But if the investor subdivides that now-vacant space, the relative lack of parking may spook mom-and-pop restaurants and other prospective replacements. Once again, the investor is stuck.
Just a couple of years ago in busy retail corridors around the Northeast, dollar stores with investment-grade credit and 15 full years of remaining lease term were marketed at a 5 percent cap rate. Today, some dollar stores with half that amount of time left on the lease are selling for the same amount—a clear expression of intense investor demand. Local retail brokers are also seeing inexperienced investors snap up triple-net properties with just five years or less of remaining term.
Assuming that a tenant with a looming lease-renewal date will stay forever is a rookie mistake.
Focus on access
When local brokers go on site visits on behalf of retailers or investors, immediate access tends to be at the top of their site-evaluation checklist.
If a single-tenant, triple-net-leased asset is on a corner at a traffic light, and customers can make a right in and a left out on both streets, it rates 10 out of 10. (I own five of these assets; every one of them meets these criteria.)
That rating goes down to seven if the property is on a corner at a traffic light, but people can only make a right in and out on both sides.
A rating of five or six would be assigned to a mid-block site with a dangerous turning lane in the middle of the roadway. Shoppers—especially parents with kids in the car—tend to be reluctant to sit in that middle lane trying to make a left into the property. Ditto on taking a harrowing left out of the property. When access carries this kind of “fear factor,” the property will suffer from lower traffic and sales.
The worst-case scenario? Single-tenant assets on divided highways that require a shopper to drive past the building and make a U-turn to gain access. Here the rating could range from zero to four based on how far people have to drive before they can whip the car around.
Regional access is another important consideration. Look for properties that are near the intersection of at least two major interstates, ideally with additional highway access as well. It is no coincidence that one the busiest retail areas in the United States—Paramus, New Jersey—is served by Interstates 80 and 287, State Routes 4 and 17, and the Garden State Parkway.
But even within a busy hub like Paramus, some triple-net assets will be harder to reach than others. Look for assets that boast easy access to complementary businesses in that commercial hub.
Real estate ‘Rosetta Stone’
Locational characteristics don’t just help you evaluate a particular property—they can also serve as a kind of Rosetta Stone for understanding everything around it, including potential sources of competition and cannibalization.
Earlier this year, a triple-net investor was looking to buy a new dollar store in a busy retail corridor in Florida. When the investor learned that a dollar store of the same brand was just a quarter of a mile away, he started to change his mind. “I don’t want to go here when you’ve got another one right down the block,” he said.
But the older dollar store was buried in the back of a sleepy strip center, and the new one boasted “10 out of 10” corner access as described above. While having two stores located practically on top of each other might seem like a sign of problematic cannibalization, the locational characteristics told another story—with its poor visibility, traffic and access, that older store was headed for the chopping block.
It all highlights the value of having the proverbial “10,000 hours” of experience in retail real estate investing. For the inexperienced, sinking money into single-tenant, triple-net investments can seem like an easy, low-risk route to ROI. After all, listing services put thousands of assets right at their fingertips, and Google maps, drone footage and digital pics create the appearance of a working substitute for visiting the site with an expert on the local market.
But local retail property brokers are wary of Internet-only transactions. They understand how the dominant tenants in this space are performing at a macro level, and their networks, personal experience and digital databases give them the inside scoop on factors such as nearby competition, trade area growth, daytime population, traffic counts, cannibalization and proposed competition. Local brokers also live and breathe the prevailing site-selection criteria of the most active and profitable operators in the triple-net space. They can warn newbie investors if a property (because it fails to comply with that retailer’s latest criteria) is at risk of going dark.
In addition to the locational criteria, every investor needs to consider the reputation of the tenant with regard to the tenant’s promise in the NNN lease to “maintain the property in good repair and condition.” As a property owner, I’ve had situations where a particular chain was, in multiple locations, not promptly attending to issues with potholes, oil stains and striping in the parking lot. Why should an investor factor this in? Apart from the potential risk to those visiting the site, lenders require that such maintenance work be performed in a timely manner on properties which they hold as collateral. If not, there may be adverse financial consequences to the property owner in the loan agreement.
None of the observations above are meant to discourage high-net-worth individuals from diving into triple-net-lease investing. These deals are popular for a reason: When rooted in a solid understanding of real estate risks and fundamentals, they yield healthy returns—even as bubbles in other parts of the economy are bursting all around them.
Written by: Richard J. Brunelli