What's the exit play on a low cap rate NNN property

[Lee G.]

I've been baffled at some of the absolute NNN deals that are being sent around. For example I saw a Starbucks location listed at a 5.5 cap with a new 10 year lease. The lease has a 10% escalator at year 5. They are asking 1,073,000 for it. I'm wondering how does one exit that type of deal in a rising interest rate environment? I realize a 5.5 cap deal is an all cash deal but typically cap rates move with interest rates so if we get rates bumping up, the cap rates increase ultimately destroying your equity. Like with bonds, the building's value is a function of the return, which in this case is fixed by the lease.

Are you betting that you can renew the lease at a much higher rate at the end of the lease? Or are you just looking for some sort of capital loss/tax play in buying a building like that? @JoelOwens you sell these deals... what is the deal?

[Joel Owens]

1.2 DSC is low for restaurant types.

Restaurants go dark more than any other NNN asset. So lenders tend to like more down and higher DSC's. Parent corporate backed 25% and franchisee usually lenders want 30 to 35% down.

Typical finance for 1 million range is local banks and credit unions. Those will generally be shorter term rates that do not run the length of the primary term of the lease. The investors go after those short loans because the basis points are lower which helps them eek out some tiny cash flow while waiting for the rent increases to kick in.

The 2% a year with 5 years is a long time to wait for that 10% bump to happen. I like to see every year increase or every 3 years so the yield happens faster ESPECIALLY if you are buying at lower cap and blending the cap rate number higher over the primary term of the lease.

The lease will spell out option periods already after primary term. Usually advanced notice is required about 6 months on exercising an option or not. I have seen though some really bad leases written by attorneys for new developers or private sellers. The tenant has a sweetheart deal so will not alter any terms of the lease for the new buyer as they do not get a payoff.

Some foreign investors are only getting 1/2 a percent return where they live so 5.5 works for them. 

The value is tied to the credit tenant and length of primary lease term. The buyers have to know what their predicted loan balance is before they buy. So if the debt to make the cash flow work is a five year loan then what will be the balance at that time going for a refi if you do not want to sell??

If you buy at a 6 cap and get debt at 4 you have a 200 basis point spread. In year five take your balance owed and factor a high rate say 6 or 7 and compare what the payment would be with a lower balance but a higher interest rate on the refi.

I am not very bullish on single NNN right now as I feel it is overheated. I can't justify buying a 4 million restaurant sitting on a half an acre for a 6 cap at over 400 a sq ft. If they go out the second generational tenant will be nowhere close to that. I would rather buy a quality strip center at 150 to 200 a sq ft and diversify my tenant mix and risk and have great breakeven occupancy to service the loan. Those are also trading at a higher cap rate currently so I feel there is room for cap compression.