Do you buy the credit or the box? Two net lease deals, 160 basis points apart

Run both past a lender before you decide, because the appraisal will tell you something you are paying a broker not to say. On a net lease the appraiser usually gives you a leased fee value and a dark value, and the gap on your Deal A is going to be enormous with rent at $27.50 against $15 market. Some lenders size the loan off the leased fee. Plenty size off something closer to the dark number, or they haircut proceeds when remaining term runs past their loan term. On Deal B the two values are much closer together, so the debt behaves more predictably and you are less exposed to a credit committee changing its mind.

That is not an argument for B. It is an argument that your equity check may not be the number you think it is on A, and you should confirm sizing and any lease-term covenants with the lender in writing before you get attached to either one.

For anyone reading this who is newer, a few of the terms above are doing a lot of work.

Leased fee value is what the property is worth with the current lease attached, so it reflects the rent the tenant actually pays. Dark value is what the same building is worth empty, priced off what a new tenant would pay for that space in that market. When contract rent sits well above market rent, those two numbers separate, and the gap is the part of the price that depends on the tenant staying.

Above-market rent is common in net lease, particularly on sale-leasebacks, where a company sells the building it occupies and signs a long lease back. The seller can set a higher rent, which raises the price they receive. The lease is still real and the rent is still owed. The building just carries a rent number the open market would not support on its own.

A corporate guaranty means a company stands behind the lease payments. Whether that company is the rated parent or a smaller subsidiary matters, because you can only collect from the entity that signed. Read the guaranty page, not the marketing sheet.

Rent to sales is annual rent divided by that location's annual sales. Lower generally means the store can afford the rent more comfortably, though the useful range differs a lot by retail category.

None of that settles @tally's question. It does tell you which numbers the disagreement is actually about.

The question I would want answered before voting is what happens at the end of the lease in Deal A, not the middle. Fifteen years of certain rent is great, and then you own an empty purpose built box with a drive-thru and a basis that assumed $27.50. Is anyone underwriting that day, or does everyone just plan to sell in year eight to someone who is also not underwriting it?

@wren that is the part that stops me too. Every model I have seen on these assumes a sale at a cap rate that is roughly today's cap rate, on a lease that is seven years shorter. That is the whole trick. Term shortens, cap rates widen, and the exit price does the work nobody wanted to show.

@tally, have you priced Deal A at, say, a 7.4 exit with eight years of term left? If it still clears your hurdle I would find the flat rent much less frightening.

I would take A and I am not embarrassed about it. I want the money to arrive without me thinking about it, and an investment grade parent on a fifteen year lease is the closest thing to that in this asset class. The re-tenanting problem in B is a real job that I do not want, at a cap rate that is only 160 wide.

@marlow, the flat rent is what bothers me about A more than the credit does. Fifteen years with no bumps means your real income shrinks the whole time, and at the end you hand back a building priced off a rent nobody else pays. B's 1.5 percent is not much, but it is not zero, and the rent is below market so a renewal conversation is not a crisis.

I want the boring outcome. I am no longer sure A is the boring one.

What I learned in small multifamily does not carry over well here, but here it is anyway. Every vacancy I have had cost me two months of rent and a few thousand in turn work, and the unit re-leased at market immediately. That is a small, repeatable problem.

What @tally is describing on Deal A is a single vacancy that could last eighteen months and cost a year of rent in landlord work before anyone signs. I have never had to think about a turn that large. Owning one tenant means owning one turn, and that turn is the entire investment.

Let me make sure I have this straight. The dark value is not something someone shaves off to be careful, it is genuinely what the building is worth if the tenant leaves, and on Deal A that could be roughly half the purchase price? If that is right then the 6.4 cap is buying a lease with a building attached rather than the other way around.

@juniper yes, roughly, though the ratio depends entirely on the land value underneath and how generic the shell is.

@tally, two things I would want before I could vote. First, is the 6 percent rent to sales on Deal B from audited store reports or from the operator's own spreadsheet, and does the lease actually require them to keep sending you sales figures? A reporting covenant you can enforce is worth a lot more than a number the broker read out once. Second, on the 60 unit guarantor, have you seen financial statements for the guarantor entity itself, or just a consolidated summary for a parent that did not sign anything? I have watched a strong sounding guaranty turn out to cover a holding company with almost nothing in it.

I take a long time on this stuff and I have never regretted the time. I have regretted the deals where I let the marketing package define the questions.

Nobody has put a number on the dirt yet and that is where I would start on both.

On a purpose built pharmacy format box you usually have a hard corner, signalized, an acre and a half, sometimes two. In a lot of markets that land carries real value on its own, and the highest and best use after the tenant leaves may be to take the building down. Demolition on a single story retail shell is not catastrophic. If the land supports a quick-service pad and an inline strip, your dark value assumption is too pessimistic.

On the generic 9,500 sf box, check whether it is a pad on someone else's parcel or its own legal lot, and get the zoning in writing from the municipality rather than from the offering memo. Uses that were permitted when it was built are not always permitted now, and that varies by jurisdiction. I have seen a re-tenanting plan die on a parking ratio.

Buy the corner, and the credit question gets less frightening.

@parcel is right about the dirt and I will put costs on the building side.

Converting a purpose built pharmacy shell for a second generation user is not a paint job. You are usually looking at demising walls if you split it, new storefront glazing, HVAC that was zoned for one occupant, a drive-thru lane that is either an amenity or an obstruction depending on the taker, and ADA upgrades that get triggered the moment you pull a permit for real work. Where I build, that package on a 13,000 sf box has landed anywhere from $45 to $90 a foot depending on how much of the mechanical you keep. Call it $600k on the light end.

So @tally, when you model the vacancy on A, it is not just lost rent. It is lost rent plus a capital number that is a meaningful fraction of a year's NOI times several. Deal B's shell is generic, which means the same event costs a fraction of that.

I have lived the B version of this once and it was fine, which is a weaker endorsement than it sounds. Regional operator, generic box, went dark with four years left. They kept paying because the guaranty was real and their lender would not let them default on an obligation that visible. I re-let at close to the old rent nine months after they finally handed it back, with about $180k of my money into the shell.

Nine months of no income while paying taxes and insurance out of pocket is a different experience from reading about nine months of no income. If you cannot write that check without selling something, the credit question is answered for you.

Slow question. If the lease is the asset in Deal A, is there any sense in which I am really a lender to that pharmacy company rather than a property owner? Or does the fact that I can foreclose on nothing, because I already own the building, break that analogy entirely.

@vellum you are a lender with a bad recovery position and no covenants, which is a fair way to think about it.

Here is what is wrong with everyone's framing, mine included. The 160 basis point spread is not the compensation. Price both deals against the same vacancy scenario and see what survives.

Take @tally's Deal A at a 6.4. Say 13,000 sf at $27.50, NOI $357,500, price about $5.58m. Assume the tenant goes away at year 10 renewal. From there you carry twelve months at maybe $90k of taxes and insurance, spend @girder's $600k, and re-let at $15 for $195k. Your income falls 45 percent permanently and you have put in almost seven hundred thousand. Value at an 8 on the new rent is about $2.44m. Against $5.58m paid.

Deal B at an 8.0. 9,500 sf at $11.25, NOI $106,875, price about $1.34m. Same event, re-let at $13.50 for $128k, cost you maybe $150k and nine months. You come out ahead of where you started.

The spread that would actually equalize those outcomes is not 160 basis points. It is a lot wider. That does not make B the better deal, because B's probability of the event is higher and harder to estimate. It does mean A is being priced on a rent that only one company in the world pays.

@ledger's numbers are the first thing in this thread that made the choice feel like arithmetic instead of temperament.

160 wide is what the market pays for a rating, and the market is often wrong on exactly this. I would not buy either at those prices. I would take Deal B at an 8.75 or Deal A at a 7.1 and I would tell both brokers exactly that, in writing, with the math. One of them calls back in six weeks.

@tally, the third answer to your poll is that neither deal is priced for the risk it carries and you keep looking. That is where I have ended up on most net lease I have underwritten this year.

One practical thing on comparing the two. If you are in one of the roughly dozen states that do not make sale prices public, you cannot verify what either seller paid or what similar boxes traded at without paying for data or leaning on a broker who has a reason to be optimistic. Check what your state actually discloses before you assume the comps in the offering memo are checkable.

Also, brokers push the credit deal because it is easier to sell to more buyers, so it moves faster. That is a fact about the brokerage business rather than a fact about the asset.

I have been building a list for a year and my filter has collapsed down to one line. Contract rent divided by market rent. If it is over about 1.25 I need a reason that is better than the tenant's rating. Deal A is at 1.8. That is not a lease, that is a bond with a garage attached.

Something I never quite understood. Why would a tenant ever agree to pay $27.50 when the space next door goes for $15? Is it just that they got a big check up front in a sale-leaseback and the rent is really the interest on it?

@compass that is most of it. In a sale-leaseback the seller controls both the price and the rent, and those two numbers are linked. Higher rent, higher proceeds, and the company is financing itself at whatever implied rate the buyer accepts. It is a financing decision made by a CFO, and the rent number tells you more about their cost of capital than about the local retail market.

Which is why the funds I have been reading about underwrite the rent against market before they underwrite the credit. The credit tells you whether you get paid for the next eleven years. The rent to market ratio tells you what you own afterward.

Worth checking what the lease actually leaves you on the physical side, because triple net gets used loosely. I have run service work on plenty of so-called NNN boxes where roof and structure stayed with the owner, or where the tenant's maintenance obligation had a dollar cap per year with the overage bouncing back to the landlord. On a 20 year old shell that is a real number. Get your roof inspected and dated on both deals regardless of what the lease says, because the tenant's incentive to spend on a roof in the last three years of a lease is zero.

Three clauses decide this more than the cap rate does, and I would read them side by side.

Go-dark. Can the tenant stop operating while continuing to pay? Most national leases allow it. That matters because a dark box in a center kills your co-tenancy standing and your resale, even with rent current.

Assignment and release. Can the tenant assign the lease to a weaker entity and walk away from the obligation? If the original guarantor is released on assignment, the rating you paid for has an expiry date nobody put on the flyer.

Renewal options. Options at fixed rent are options against you. On Deal A, if the renewals are at that same $27.50 flat, they will never be exercised, and the fifteen years is really fifteen years. On Deal B at below market with 1.5 percent bumps, the renewals are worth something to you.

Get a real estate attorney in the relevant state to read the guaranty and the assignment language, since how those provisions are enforced varies. But you can read them yourself first and know what you are asking about.

@warrant the release-on-assignment point is the one I had never thought about. Paying a premium for a rating that can be handed off is a strange thing to do.

I will second @girder and raise him. Every second generation retail conversion I have run came in over the number, and the overage came from the same places. You open the ceiling and find the sprinkler layout matches a floor plan that no longer exists. The new tenant wants their own storefront and your permit set becomes a design job. The municipality decides the parking lot needs restriping and two more accessible spaces while they have your file open.

@ledger used $600k. On a purpose built box with a drive-thru I would carry $750k and a fourteen month timeline before I felt honest. Which mostly argues that the vacancy on Deal A is not an event you plan for. It is an event you avoid, or you buy the other one.