NNN lease too long for 1% annual escalations?

Question

Hi everyone!

I am looking to transition from multiunit residential to commercial and have been looking around for a quite a while. I would like to sell a paid off property and 1031 into a leveraged high quality tenant retail NNN property. It is hard to find one that has a suitable cap rate and length of primary lease remaining. I found one that is within my price range from with a national corporate backed tenant and a cap rate near 8%. The location is great on a main thoroughfare next to big box stores and other high quality retail. Initial cashflow looks great assuming I can get 70% financed at a rate of 4.5%, amortized over 25 yrs. What gives me pause is the length of the lease and escalations. Almost 20 years remain on the primary lease and they have four 5 year options after that, with 1% escalations each year. If total annual rents start out at 200k/yr, does that only give me 300k/yr 40 years down the line? Surely inflation would be more than that. Is that why the cap rate is more favorable than other properties I've seen? Again I am still in the exploration phase and am just looking around, I am not in any rush to make the switch.

Wells Mangrum · Answer

The 8% cap rate is strong. Why are they asking such a high cap rate when much of the NNN market is in the 6-7% range? Makes me wonder if there is some more risk in the deal than is immediately apparent. Having said that, I recently closed on a NNN lease at a 8.5% cap and I'm very happy so far with the results. But I know that my investment is a higher risk than a Starbucks or cvs. The 1% annual rent escalations are mediocre and would also be a cause of concern for me. Is this a 5 year fixed loan that amortized over 25 years? If so, then this is something that I would change. First, I would think that you could get the loan at 4%. Maybe you could offer to amortize it over 20 years in return. Second, I don't like financing a 20 year fixed rate lease with a 5 year fixed rate loan. If interest rates rise significantly then you are exposed to interest rate risks. This is a risk that is over and above the tenant default risk. I do not know the solution to this problem but the following is my current opinion which I warn you is not mainstream: My current idea is to work through a large bank to obtain a swap interest rate hedge. I alluded to this in an earlier post on this site. This transaction allows the investor to get a long term fixed rate loan. I spoke with a large bank and this appears to be a viable option. I'm not sure why others don't pursue it. This option wouldn't eliminate the problem of receiving low rents in 20 years due to inflation. But at least it would help you to keep cash flowing if interest rates rise.

Joel Owens · Answer

Yep we have a starting cap rate and a blended cap rate. The blended is what the cap rate return does over the primary term of the lease. Option periods are not counted by the lender because they are not set in stone and a renewal might not happen. You have to watch for early termination rights in the leases. If you have a 10 year primary but they can cancel year 5 with 3 to 6 months notice etc. then you have a 5 year lease. If they do cancel early you want to see an early termination fee equal up to 50% of the remaining lease. This helps cover TI,LC, and lost rents until you land a new tenant for STNL.You also have the quality of the location and who is guaranteeing the lease. That affects what kind of financing you can land on a property. LTV plays a big role as well. You could have a starting cap rate of 7 with 1% increases or a starting cap of 6.5 with 2% increases. One is initially lower but over time could give more return.It's NOT just all about the cap rate. Some people buy a high cap rate with just under 5 years left on primary as a value play. If you do that you want the company to disclose sales. If you can't get sales you do not know how well they are doing at that location. If they are under performing or just doing average the chances of moving are high.Also look for sublease language in the primary term lease. You want to make sure landlord has to approve and that the original guarantor is on the lease still.Sometimes you will see a CVS at a 10 cap but see that a Dollar Store has gone in. Problem is the rent is artificially inflated. CVS of 12,000 a month is paying 5,000 of that and dollar store is paying 7,000. When CVS goes away on the primary then Dollar Store will only pay the 7,000. So you have to value on what the dollar store will pay and NOT what CVS is subsidizing for value on the sublease.People think NNN is easy but there are a lot of gotcha's with these properties you have to plan and watch out for. Anything sub 3 million with newly minted leases in good location for STNL is at about 5 to 6 cap. Lot's of foreign investors getting 1% where they live so are buying here with all cash.You go up into the higher priced properties especially for MTNL we are getting the 7's to 8's for cap rate.

Nick L. · Answer

@Wells Mangrum Great point about hedging interest rates through a swap.I looked into this a few years ago for the same reason. I found that they are only traded over the counter (OTC) which means each deal is custom, as opposed to trading like commodities on an exchange. For this reason it only makes sense to pursue a debt swap if your deal starts at a few million dollars.

Chet Mazur · Answer

I rarely see annual increase. I have seen some that have CPI based bump every couple of years.Is there psychological about 3% every 3 rather 1%/yr?That sounds like an attractive cap esp. here in CA.