NNN lease too long for 1% annual escalations?

[Spencer R.]

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]

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.