10 Questions You Should Ask: Net Lease
Net leased properties can be very safe, stable investments. Sponsors often portray them as “no-brainer” investments that don’t require much thought. What could be simpler than a building that is leased to a single tenant who is responsible for paying all of the expenses?
It turns out that as in all investments, there are risks. What happens if the tenant does not renew their lease? Will Taco Bell be as popular in ten years as it is today? Will anyone want to buy this building when there are only two years left on the lease? Here are the ten questions you should ask to understand these risks.
- How strong is the tenant? Since a net leased property typically derives all of its income from a single tenant, the credit quality of the tenant is critical. Many public companies have corporate credit ratings, which provide an easy way to assess credit quality. It is important to understand exactly which business line or subsidiary is responsible for the lease payments. Unless the parent company has guaranteed the lease, the landlord can only look to this subsidiary for lease payments, and its resources may be more limited than the parent’s. If the tenant does not have a credit rating, its financial strength may be more difficult to assess. In this case an analysis of the tenant’s financial statements and historical performance will be necessary.
- How long is the lease? A lease with a long remaining term provides a predictable income stream and minimizes the risk of having to find a new tenant. Therefore a longer lease term is generally considered to be more desirable. However, there are situations where a short lease is advantageous. For example, if the rent is below current market rents and the property is well positioned in a strong market, a maturing lease can provide opportunities to increase the rental income.
- Is the lease triple net, double net, or bondable? A net lease generally requires the tenant to pay all of the building’s property taxes and operating expenses. However there are variations in the extent of this obligation. For example, the landlord is responsible for roof repairs and other maintenance obligations in a double net lease. A bondable lease is the strongest but least common form of net lease. In a bondable lease, the tenant is responsible for absolutely all expenses and obligations. A strong lease that passes on most or all obligations to the tenant minimizes the risk of unexpected expenses that can reduce income.
- Is the property well located? A strong location with good access to transportation means that the property is likely to maintain or increase its value over the term of the lease. It also reduces the risk of finding a new tenant at a similar or higher rent if the current tenant does not renew at the end of its lease.
- What is the property type? Net lease investments are typically backed by industrial, office, or retail properties. Each of these property types has different tenant types, design requirements, and location preferences.
- Is the property’s design suitable for other tenants? Buildings that have highly specialized designs may have limited appeal to new tenants who do not have the same specialized needs. This can apply to buildings that have a specific manufacturing use, for example. It can also be a concern for retail buildings such as fast food franchises that have very specific design requirements. If McDonald’s is leasing a competitor’s former location, they will need to replace or substantially renovate the building in order to comply with their branding and design standards.
- How will the building’s age affect its ability to compete with newer buildings? As they age, buildings can become less desirable because they do not offer the latest technology and design. For example, warehouse and distribution facilities used to have standard ceiling heights of 24 ft. Today, many tenants require a ceiling height of 40 ft. While demand still exists for a building with 24 ft ceiling heights, that building will command lower rents than its newer competition that offers 40 ft ceilings.
- How essential is the building to the tenant’s operations? If the property is critical to the tenant’s business, the tenant is more likely to renew when the lease expires. For example, a retailer is not likely to give up a modern distribution facility that is located in a key market. On the other hand, a facility that is used by a struggling business line is more likely to be vacated when the lease matures.
- Are the rents higher or lower than market rents? If the rent paid by the tenant is lower than the rent that can be achieved in the market, a maturing lease or weak tenant becomes less of a concern. Conversely, if the rent is above market, the risk of a decline in cash flow and/or property value when the lease matures is much greater.
- How does the lease maturity compare to the investor’s time horizon? Ideally, a net lease property should have a lease that extends well beyond the investor’s time horizon. If an investor buys a property with a 15 year lease and sells it after 5 years, the lease will still have 10 years remaining and the property will be appealing to potential buyers. If the investor instead sells the property after 12 years, when there are only three years left on the lease, buyers may perceive the property to be much riskier, and may offer a lower price. Of course, it is not always possible to find investments with long remaining lease terms, and this concern may be offset by other positive factors.
It is very unlikely that any individual net lease investment will offer the ideal answer to all of the above questions. In practice, tradeoffs are made between these characteristics, and the overall risk must be evaluated relative to the expected returns and to the investor’s position in the capital structure. The following case study illustrates how these tradeoffs can be analyzed and evaluated:
At first glance, Property A may seem less risky due to the longer lease term and stronger tenant credit. However, consider the position that the investor will be in when each property is sold in 5 years. Property A will have only 2 years left on the lease, and the rents are above market, in a location where demand is limited. Any prospective buyer for the property will take these risks into account when valuing the property, so the residual value is likely to be relatively low.
Property B appears risky because the lease matures in 4 years, before the property is sold. However, the location is desirable and the rents are below market, so there is a high likelihood that if the lease is not renewed, a new tenant can be found at a higher rent. The new lease with higher rent would increase the value of the property upon resale.
The bottom line is that both properties have risks, and determining which one makes the better investment will require a careful evaluation of its characteristics. The simplistic conclusion that a property with a strong tenant is less risky does not always hold true.