Fixed debt matched to the lease, or short cheap debt and a balloon two years before expiry?

Question

I have been analyzing instead of buying for long enough that people have stopped asking me how it is going, so here is the specific thing keeping me in the spreadsheet.

A 12 year net lease on a small format retail box, national tenant, $148k NOI, priced around a 6.9 so call it $2.15m. Two financing paths quoted to me last month, both of which I would need to confirm in writing before I did anything.

Path one. Ten year fixed, 25 year amortization, 60 percent proceeds. Debt matures with two years of lease term left. That is the version where I sleep for a decade and then discover what lenders think of a net lease box with 24 months of term on it. My understanding is that most net lease lenders size on remaining term and get uncomfortable inside five years, so a refinance at that point could mean a large paydown or a forced sale into whatever the market is that year.

Path two. Seven year fixed at roughly 40 basis points cheaper, same amortization, and I refinance at year seven with five years of term left. Cheaper money, and I hit the refinance window while the lease still looks like something a lender wants. But I take rate risk three years earlier and I pay a second set of closing costs.

There is a third answer, which is to stop trying to match anything and just size the loan so it fully amortizes inside the lease term, take the lower proceeds, and never have a maturity conversation at all. Cash on cash drops meaningfully and my equity check goes up by a couple hundred thousand.

The flat argument for path one is that ten years of certainty is worth more than 40 basis points. The flat argument for path two is that refinancing while your collateral still shows well is the whole game. I keep switching.

derekj19 · Answer

The thing I would want to know before picking is what the tenant does around year eight or nine, because that is what changes the refinance conversation more than the rate does.

If they exercise a renewal option early, or you can get them to sign an extension in exchange for something small, your remaining term at maturity goes from 24 months to something a lender will actually look at. I have heard of owners going to the tenant around year seven and offering a modest tenant improvement allowance or a small rent concession in exchange for pulling forward five extra years. Whether a corporate real estate department will engage with that depends entirely on how the store is performing.

So path one plus a plan to extend the lease before the balloon might be a different animal from path one on its own. Path one with no plan is you and a clock.

mitchell_ray4 · Answer

I build the tools rather than sit on the finance side, and the fully amortizing option is the only one where the answer does not depend on somebody else's mood in a year you cannot see. You said cash on cash drops meaningfully. By how much? If it is 7.5 down to 5.8 that is a real price to pay. If it is 7.5 down to 6.9 I would take the version with no maturity in it and go do something else with my week.

Rena Guide · Answer

The mechanism behind @windlass's worry is worth stating plainly, since it catches people.

Net lease lenders generally underwrite the lease as much as the building. Remaining lease term at loan maturity is one of the things they look at, because if the loan comes due when the lease has almost run out, the lender is being asked to rely on a property that may be empty soon. Some lenders will not go past a term that leaves only a short tail. Others will lend, with lower proceeds or a required paydown. That approach differs by lender and changes with market conditions, so treat any specific threshold you hear as something to confirm in writing with the lender you are actually using, along with prepayment terms and whether the loan can be assumed by a buyer.

The reason the fully amortizing path removes the problem is that there is no balloon to refinance. You trade current cash flow for the removal of a future financing event. That is a preference, and reasonable people land in different places on it.

One detail worth pinning down on all three paths. Ask what happens under the loan documents if the tenant goes dark while continuing to pay rent, or if the lease is assigned. Some net lease loans include cash management or default triggers tied to the tenant rather than to your payment record. That clause can matter more than 40 basis points, and a real estate attorney should read it before you sign.

Fixed debt matched to the lease, or short cheap debt and a balloon two years before expiry?

3 replies