What a dark pharmacy box with nine years of rent left teaches about residual value.

This is a case worth studying because the failure is never in the math the buyer runs. It is in the question the buyer never asks. Take an 11,600 sf single tenant drugstore format in a secondary midwest market, bought at $2.05m on $162k of NOI, a 7.9 going in. Investment grade parent, 11.5 years remaining on a 25 year lease with no early termination right and no co-tenancy. Absolute net, tenant on the roof and structure. The buyer underwrites credit hard and spends almost no time on the box. Fourteen months in, the chain announces a store closure round and this location is on the list. The tenant keeps paying, on time, every month, and will keep paying for nine more years because the lease is a corporate obligation with no out. Technically nothing has gone wrong. What has gone wrong is that the building is dark, and a dark building with a paying tenant is a different asset from the one the buyer thought they owned. Test the market at 15 months and the best indication comes in around $1.44m, roughly an 11.3 on the contract rent. Buyers price the nine years of remaining payments and treat the real estate as close to zero, because an 11,600 sf drugstore format in that submarket has perhaps two credible second generation users and both would want it cut in half at the owner's expense. Contract rent is about $14 a foot. Local market rent for a reconfigured box there is $8 to $9. That comparison is the one that never got run before closing. Cost so far in this illustration: about $610k of paper value, plus a refinance that turns into a problem because the lender is looking at a dark building even though the payment history is clean. Holding and collecting is fine, but the exit is now a nine year clock and there is no selling into strength. What to do differently, stated plainly: before looking at the credit rating, price what a non credit local tenant would pay per square foot for that specific building in that specific submarket, and only buy when contract rent is at or near that number. Credit protects the income. It does nothing for the residual.

2 replies

priya_n21 PB2BPRO 21

This is the version of single tenant risk that most underwriting walks straight past. The cash flow arrived exactly as bought and the position still lost $610k. The question that has to sit beside will the rent arrive is what the building is worth to someone who is not this tenant, and answering that takes real local knowledge rather than a spreadsheet. One question on the number though. Is the $1.44m real if the building is never sold? At $162k a year against a $2.05m basis, the nine remaining years carry roughly $1.46m of rent. Hold to expiration with the box worth $400k as a shell and the absolute dollars come out acceptable. The damage is measured against what was expected.

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priya_n21 PB2BPRO 21

tylerbrooks9 AO1APRO 10

The cause is worth putting slightly differently. The rent to market rent gap mattered, and the format did too. An 11,600 sf drugstore box is a hard shape, corner site, drive-through, wrong depth for most users, built for one operator. A 9,000 sf flexible rectangle at the same rent spread would have re-tenanted at a discount instead of not at all. So there is a second rule to add to that one: prefer buildings whose shape works for more than one kind of business. And this was not bad advice. Everybody in these rooms says tenant credit is the defining variable, and that is true, it just answers a narrower question than people hear it answering. It tells you whether the checks clear. The checks cleared.

tylerbrooks9 AO1APRO 10

What a dark pharmacy box with nine years of rent left teaches about residual value.

2 replies