Short Lease in Good Location vs. Long Lease in Bad Location?

Question

Hi all,

I've been searching for NNN deals and having hard time to analyze which one is a better deal.  Most of the times, it comes down to 2 types of properties like below.

Property A:

- Low cap in the range of 4% - 5%

- Short term lease remaining:  3 or 5 years left with minimal renewal options.  Guaranteed by strong operator.

- Good location in a mid-size city with 200k+ in population

Property B:

- A bit higher cap in the range of 5% - 6%

- Long term lease remaining:  15 - 20 years left.  Guaranteed by strong operator.

- Small town location with population between 15k - 20k.

If the prices of the 2 properties above are the same, let's just say $1M or $2M, doesn't matter because assuming they have the same price point.  Also assuming the business model is the same (restaurant for example), and they're both somewhat healthy. Which one is a better deal to buy?  I plan to take on a loan so the long term lease is more favorable. But I also plan to re-sell for upgrade/exchange in a few years, so small town property is going to be hard to sell...

What are your thoughts?

Thanks.

Taylor Hazard · Answer

Your last sentence is telling: "I plan to resell for upgrade/exchange in a few years". From that standpoint alone I choose property A 10/10 times for a variety of reasons but the two most important factors are:

• You have a better chance of achieving significant appreciation vs. Property B. Without any more info on location I would guess that property B would experience little to no appreciation in "a few years".
• Leasing: If property A is in a desirable location for that will attract a larger tenant pool you will either A: have a far easier time releasing the property at increased or "market" rates or B: be able to sell to a user (who pay higher prices) when the building becomes vacant.

If you were not planning on selling and this was a long term buy and hold I would probably go Property B, if the lease truly has 20 years of term left secured by strong credit (strong credit being large regional operator at a minimum) thats hard to walk away from and my strategy would probably be to get the highest possible cap rate on property B and then collect those checks for the next 20 years.

Ronald Rohde · Answer

Since we're old friends now, I can nitpick on this. Sometimes you don't want too asymmetrical balance of power. If its a F500 tenant and a small time landlord, the cost of breach can be cheaper than settling in cash.

If you have resources and comfort with attorneys, then you can start to punch back confidently. Perhaps the ideal tenant is slightly larger, more profitable, but not so big that they can have in-house lawyers drag you along forever.

Ronald Rohde · Answer

a 5% cap in a town of 15,000 is pretty crazy. What is the 15 mile population? You're not comparing to say, santa monica as a "different" city than LA, right?

Taylor Hazard · Answer

You presented a scenario in which Property A is seemingly in a "strong" RE market/environment and given the cap rate of 4% I can only assume its a coastal port city or CBD of a major market. 4% is a crazy low cap rate. For example: the Seattle area is arguably the hottest industrial real estate market in the country right now and in the midst of the hottest market in the cities history, cap rates for class A industrial product with AA credit tenants hovers just above 4%. Same can be said the Inland Empire and a few other places.

Following the assumption you must be in a major market, if I was buying something worthy of a 4 cap in Seattle with only 3 - 5 years left on the lease I know as an almost certainty that I can re-lease it at what are almost surely going to be vastly increased rental rates or a user will come and pay more for the empty building. If you saying the subject property A is worth less vacant than occupied its overpriced, you should ALWAYS be able to sell a vacant building to an owner/user for more than the investment value if leased at market rates. Users are able to attribute more value to the building given its facilitating their business operations.

You should also pay close attention to the lease rates for both properties, if your telling us they are not worth the same vacant my gut says they are leased at above market rates. Are you and your agent tuned into the lease rates for each property? Do you have lease comps?

As a general rule when buying investment properties you never want to pay more than what the building is worth if vacant. What happens if the tenant goes dark in the night? Your stuck with an asset that you cant sell or re-lease at the same rates because they were likely above market.

To @Ronald Rohde's point a 4% cap for property A is high but a 5% for property B is seems way overpriced unless there are extenuating circumstances your not highlighting (for example: is the tenant fortune 500?).

Vincent Dang · Answer

Taylor:  Thanks for your input.  What I'm still not clear is that property A with very short term lease remaining and no/minimal renewal options, wouldn't that prevent it from being re-sold easily in a few years?  Also appreciation in NNN deals mostly come from rental increase.  Given the low cap and short term lease, there's not much room there so I'm not clear why A is still an optimal choice.  Also, selling a vacant property sounds risky to me.  I don't think I can sell it at the price that I bought it with tenant in it....

Ronald:  5% -6% cap in a small population because of strong tenant and good traffic areas like freeway rest area.  Usually convenient stores or big name restaurants near high way have these kinds of cap rate.

Short Lease in Good Location vs. Long Lease in Bad Location?

Most Popular Reply