NNN Lease Appraisal - What do you put in your NOI?

Question

Hi everyone,

I am working on my first commercial property. I plan on buying it with equity I have in other properties (Heloc) and later refinance to get the my capital out. I am trying to estimate what the property will appraise for when I refinance using the income method as it has 6 years left in a NNN lease.

I have the Cap rate for the area. Can anyone tell me what appraisers take into consideration in calculating the NOI of the property? The lease states the tenant is responsible for virtually everything besides structural maintenance. Since the developed part of the property is basically a "Barn" with un-insulated walls and a roof I am assuming this portion should be minimal (The property is a tire shop with a small drive in portion non heated). Anything else I should consider in calculating NOI in this property?

Main concern is making sure my expected appraisal will not be too far off.

Thanks in advanced!

Josh Ridpath · Answer

Your NOI is a function of two parts: Income and expenses. In the case of a NNN lease, the tenant will reimburse you for certain expenses like real estate taxes, insurance, management fees, and any non structural maintenance. The arrangement you have with this tenant seems pretty simple on the surface. My advice is to read your lease carefully and determine the manner in which your tenant reimburses for different expenses.

For sake of this explanation, lets say these expenses total $20,000 per year and your rental income totals $50,000 per year. Let's also assume that your vacancy rate in the market is 5% since you haven't provided any data. Don't assume 5% in your numbers. Do research to see what the market vacancy rate actually is. Since it sounds like you have a single tenant property, utilities should be paid by the tenant directly. Your NOI calculation should look something like this:

+ $50,000 - Rental Income (PGI)

+ $20,000 - Reimbursement Income

-   $3,500 - 5% V/C (Vacancy is applied to both Rental Income and Reimbursement Income.)

= $66,500 - Effective Gross Income

- $20,000 - The expenses listed above (OPEX)

- A capital reserve that is determined based on the overall condition of the building and market data

= NOI

According to a recent market participant survey that I subscribe to, reserves for industrial property range from $0.25/SF to $0.65/SF.

I think that biggest hurdle you are going to face is estimating a cap rate for something like this. My guess is that there are very few leased fee sales of barns in your market. Even though this property is being used as an auto garage, don't be tempted to estimate a cap rate based on sales of other NNN auto garage properties that have a national brand attached like Midas or Monroe or something like that. Cap rates in sales like those are a function of the credit worthiness of those tenants be they franchisees or corporate owned operations. For a property like yours, and appraiser would most likely rely on the mortgage equity method and investor surveys to estimate a cap rate. The mortgage equity method is a ratio of a market derived cash-on-cash return for a property like this and an estimated cost of financing based on an anticipated LTV ratio. If you have any friends who are commercial brokers or if you know any appraisers in your market, pick their brains and see what they think.

Joel Owens · Answer

What I am saying is STNL lenders have their own underwriting criteria and regardless of stated NOI they will underwrite the asset in a way that makes them feel comfortable.

So even though my clients are buying STNL and MTNL and the stated OM is accurate under due diligence the lenders apply their own metrics for their comfort level and still see if they would like to proceed at the LTV stated and what the borrower wants.

I have had the same investment grade tenant and my capital markets mortgage broker comes back with 3 different loan options from different lenders based on how they like to underwrite that tenant and deal size with location etc.

I have seen as much of a difference as 50 basis points cheaper on the rate, locked for 10 years versus 5, a 30 year amort. versus 25, a partial recourse versus full, a full pre-pay penalty versus a limited step down pre-pay penalty, etc.

Justin Lau · Answer

Hello Joel, thank you for these insights. I can see the strategy behind these. I wonder why bother with these NNN that have 5 years left? What upside is it to anyone wanting to pay 1.6 million in cash for a risk of a dark property. Would strong location near a major city, long term tenant history, corporate Guarantee, no competition be exceptions? What would you say about NNN, higher cap properties that are in small gateway cities, Near suburbs. Density is high land value high but smaller parcels and cost to build are high. Could look at that as a disadvantage or advantage if the area is having development opportunities…

Joel Owens · Answer

Justin can't give legal advice.

5 years remaining on primary lenders typically will not touch or give a loan for that. That is usually bought all cash. 1.5 million property is like a 150k house in residential. Due to land costs with building in most strong suburban areas for quality you are looking newly minted leases 2.5 million and up.

This is why clients I like to take on are buying 2 million and above price point. Most lenders want to see 8 years more or remaining primary term. Investment grade credit with lots of years left is typically 5.0 to 5.5 cap rate.

There might be some mom and pop tenant at 6 cap in small price point with years left but theoretical money as likely to go dark. In that cases only time I look at it is say for that building size of say 2,000 sq ft they are paying12 a foot and market rent is 25. That way if they go dark after some lease up costs I can still have upside with new tenant. If rent is 1 to 5 bucks a foot under market and weak tenant then  it's a no go for me. Best case I would be breaking even to losing money after releasing. An exception would be if it came with extra land to de-parcel and develop.

In your situation you might find investing with a sponsor on retail value add turn around deals might give you more opportunity upside. Once you grow that money over time then look at NNN ownership on your own.

Justin Lau · Answer

Igor, how did you make out on your NNN?

Justin Lau · Answer

Hello Joel. Would a NNN STNL be a good investment for someone with a net worth 2 million. Is relying on one 1.6 million STNL 6% cap, 5 years left on lease with 2 more 5 year options be too risky? Also supplementing with 2, 1 bdrm condos. Seems like too much in one basket. If the STNL goes dark how does that get sold or traded up later? Seems like valuations of NNN are different than with MF Buildings or SFR. It would seem that it’s reliant on the tenant to renew their next 5 year extensions. How does one trade up or buy up in these situations. Especially seeing that interest rates may rise soon reducing values of NNN Properties. I’ve seen leases finish a term lease of 10 years and then the rent is reduced significantly for shorter 5 year options. Is this typical strategy of the renter? I guess knowing the renters strategy is helpful as well to make these investments worthy.

Joel Owens · Answer

Hi Hai,

Your question:

(Aren't NNN investors usually institutional cash buyers? )

There are some institutional buyers, REIT's, insurance companies, funds, etc. but a bigger majority are individual investor buyers.

For instance I have some individual clients with net worth over 100 million. They do not need a lot of money. They want long term equity growth, cash flow to keep up with inflation dollars, and tax benefits. What they do not want is a headache for more active yield.

It's a different conversation when an investor is say worth 1 million and has a 50k job and the net worth was made through the last upcycle in investments. In that situation the investor usually still wants the yield to be high and willing to take on more headache type assets like SFR, multifamily for higher cash flow.

In another example if a doctor is worth 7 million and makes 1 million a year doing surgery they typically have no time for anything but to see patients so getting a 7 to 8% return sounds great to them and be passive and just collect a check.

Igor Messano · Answer

NNN is a lease type which depending on the area and asset it can be 10MM++ or 500k. Not necessarily.

Hai Loc · Answer

Aren't NNN investors usually institutional cash buyers?

Igor Messano · Answer

Our main concern is how lender will be valuing the property. We have the opportunity to acquire the asset without lending at a cheaper price and then refinance but we need to understand what the lender will likely lend on prior so we can estimate our final cash investment.

The actual value of the property we are comfortable with as the current lease rent is significantly below market but the real value is in the lot. We can work with the shop to relocate eventually as the lot size and zoning would allow for the development of 2 commercial retail and 7 apartments in the future.

If the property can be appraised by land value by the bank rather than the NNN lease value, but the DSCR is low, would a lender consider lending above the required DSCR if we could show significant ability to cover the payments through income? We are talking about maybe $500 per month where the NOI would be short of a 1.25 DSCR so not a huge amount of money.

NNN Lease Appraisal - What do you put in your NOI?

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