Bought a 6.8 cap with six years of term, sold at year three well down

Can I ask the dumb version of this? When you say the lease got shorter and the value dropped, is that just because the next buyer is closer to having an empty building? I always pictured a lease as either good or not good, not as something with a value that runs down like a battery. Reading your numbers, three years of term cost you about $500k of price on a building that produced identical rent the whole time. That's the part I need to sit with.

@compass yes, basically. A fifteen year corporate lease trades like a bond with a building attached. A three year lease on the same box trades like a piece of real estate with three years of income attached, and the buyer prices the leasing risk, the downtime, and the tenant improvement money it'll take to fill it if the tenant leaves. Two completely different buyer pools with different return requirements. @rigging bought into the first pool and sold into the second.

We've done work in a few of those auto parts boxes when they turn over. They re-tenant fine in a decent location, but the second generation user almost never pays the same rent, and somebody has to pay for demo and a new storefront. That gap is what your 8.6 cap buyer was pricing. Not a comment on you, it's just what the number means.

Your exit cap moved for two separate reasons and it's worth splitting them, because only one is something you controlled.

Remaining term is the first. Single tenant pricing is heavily driven by how long the income is contractually good for. Once term gets short, buyers underwrite re-tenanting cost and vacancy months, and the cap rate they need rises accordingly. That decline runs continuously while you hold, whether or not you look at it.

Rate levels are the second. Net-lease cap rates track the cost of debt closely, so a move in rates between your purchase and your sale shows up in your price even though the lease was unchanged. You can estimate the split. Find what a fresh long-term lease on a comparable box traded at on your sale date. The distance from your 6.8 to that number is roughly the rate move. The rest is term.

On your underwriting: 6.8 was treated as a yield you would simply collect for six years. It was a yield on an asset losing value every month you held it, and flat rent gave you nothing growing to offset that. A bump schedule doesn't stop term decay, it slows the erosion in dollar terms.

The loan maturity point is real even though you weren't forced. Lenders on single tenant assets generally want the debt repaid or heavily amortized by lease expiration, and quotes get sharply worse as remaining term shortens. Confirm in writing with your lender what they will require at that point before you sign anything, since this varies by lender and changes with the market.

The discipline going forward is to price the residual first. What is the box worth with no tenant in it, and what does a second generation user in that submarket actually pay per square foot? If those two answers hold up, the going-in cap is a much smaller decision.

Did the lease have renewal options, and if so at what rent? I ask because people count options as term and they aren't. An option at a fixed flat rent is a decision the tenant makes for their own benefit. If the market rent is above the option rent they renew and you're stuck at below market. If it's below, they leave or renegotiate. An appraiser will give you some credit for options on a strong credit, and a buyer will give you less than you think.

The rent never changed and the value fell 22 percent. That sentence is going in my notes.

@cobalt is right about the re-tenant cost and I'd add that everyone underestimates it. Those boxes have one bathroom, a mezzanine office, and racking anchored into the slab. Getting one ready for a generic retail user means slab patching, a new front elevation, HVAC that has usually been run to death, and code work you don't find until you open a wall. I've never scoped one of those conversions and come in at the first number. @rigging, your buyer wasn't being greedy at 8.6.

What did your closing costs actually run on the buy side? I'm building out the true all-in cost for a first purchase and net lease keeps looking cheap on paper because there's no unit turn budget. You said $860k equity on a $2.3M price with $1.5M of debt, so roughly $60k of costs on top of the down payment. Was that mostly the loan or the diligence?

Curious about the sale side. Did the broker tell you up front that three years of term would price at 8.5 plus, or did that come out after you listed? I've been poking around at how net lease brokerage works and I can't tell how much of the pricing conversation happens before the listing agreement.

Who was responsible for the roof and the parking lot in your lease? You mentioned a retrade over the lot. In the boxes I've worked on, the tenant handles the interior and the routine stuff and the roof and structure sit with the owner about half the time, depending on how the lease was written.

@rigging what residual value did you put in your model when you bought? I suspect the answer is that there wasn't a model with a residual in it, which is exactly what I did on the two deals I almost bought last year. I've since started running every hold at three exit assumptions and the spread between them is embarrassing. On a short-term net lease the exit assumption is most of the return, and the going-in cap is almost decoration.

I walked from something shaped like this eight months ago. 7.0 cap, five years left, flat, small town pharmacy box. The thing that stopped me was calling two brokers and asking what a two year remaining lease on the same building sells for. One said nine and a half, one said "depends if it's dark." That was enough. I don't say that to be smug, I only got the question right because someone here made the same mistake first.

The part that gets sold as passive is genuinely passive right up until it isn't, and then it's a full leasing assignment with a construction project inside it. Nobody prices their own time for that. @rigging never had to do it, which is worth saying out loud, he sold before it became work.

I'd push back a bit on where everyone is putting the blame. Term decay is real and it's arithmetic. But @rigging held for three years and sold into whatever the market was on that day, for reasons that had nothing to do with the asset. If he'd held to year five with a lender-required leasing reserve and a renewal in hand, this thread would read completely differently. The failure I see is buying a six year income stream with an unknown hold period. The lease told you when the money stopped. Nothing told you when you'd need it back.

Short lease, flat rent, one tenant, needed the cash. Any one of those is survivable. Four at once is the whole story.

Pull your loan documents and look for a cash management or sweep trigger tied to remaining lease term. On a lot of single tenant debt there's a clause that starts trapping cash flow some months before the lease expires, or on notice of non-renewal, and it's frequently twelve to eighteen months out. If yours had one, your usable cash flow in year four was going to be a lot smaller than the $36k you were counting. Terms vary by lender and by loan, so read your own docs and confirm anything you're unsure about with your lender in writing. It's the least read section in the whole file and it decides whether you have money in the year you most need it.

The other side of this is that the tenants signing those leases know exactly what they're doing. My business has signed three leases in five years and every time we pushed for the shortest term that got us the deal, because term is what we're paying for. Somebody's flexibility is somebody else's cap rate.

The rough shape I use is that every year of remaining term below about ten is worth somewhere between 20 and 40 basis points of cap rate, wider on weaker credit and weaker locations, tighter on a corporate guarantee in a strong retail node. @rigging went from a bit over six years to a bit over three and paid 180 basis points. That's inside the range, and some of it was the rate environment. So the deal wasn't mispriced going in by that much. It was underwritten as a 6.8 forever instead of a declining asset with a residual you have to estimate. @canton, I'd say the hold period point and the term point are the same point. Buying short term means committing to a specific hold, and if you can't commit to it, you should be buying longer term.

@sextant fair, that lands. I'd still keep them separate in a checklist, because "how long is the lease" and "how long can I actually hold" are two different questions and people answer the first one and skip the second. Your basis point range is a useful anchor though, I've never had a number for it.

This is the thread I needed and also the one I didn't want. I've been looking at net lease specifically because I don't want a second job. Does this mean the whole idea is broken, or does it mean buy long term and plan to hold it to the end? Because if the answer is that the income is real and the exit is the risk, I can live with that as long as I'm honest about not selling early.

@marlow that's how I'm reading it too. I added two lines to my checklist after this: remaining term at the end of my intended hold, and the value of the building with no tenant in it. If those two don't work I don't care what the going-in cap is. Thank you @rigging, genuinely, this is the most useful $470k I never spent.

What was the dirt worth? An acre with its own curb cut on a retail corridor has a floor under it that's independent of the lease. I've bought land in a couple of markets where the pad value alone was most of what a dark building would have traded for, and knowing that number would have told you how far the price could actually fall. Sounds like you found the answer the hard way at $1.79M.

I run small multifamily and the trade is visible right here. My buildings need me constantly and the income wobbles, but no single tenant leaving moves my value 22 percent. @rigging did nothing for three years, which is worth something real, and then took the whole risk in one event at the end. Different shape of the same total work.

One tenant is one point of failure and everyone repeats that as if it only means default. It also means one lease expiration, one renewal negotiation, and one price on one day. I own eleven doors and I've never had all of my value depend on a single date on a single document. That's the thing about this asset class I still can't get comfortable with, even though I like the passivity.

I came into this room thinking net lease was the easy one and I'd figure out the hard strategies later. What I'm taking from this is that the work all sits at the front, in the tenant credit and the term and what the box is worth empty, and after that there really is nothing to do. That's a different kind of hard, and I'm not sure yet whether it suits me. Appreciate you writing it up plainly @rigging.