Passed on eleven net-lease deals and bought the twelfth, on one number

Let me check whether I have the ratio right. Contract rent is what the current tenant actually pays under the lease. Market rent is what you guess a different, ordinary tenant would pay for the same square footage if the current one left. So a ratio of 2.2 means the tenant is paying more than double what the space is worth to anyone else, and you're really buying nine or eleven years of that company's promise. Is that it?

@juniper that's how I read it too. What I don't know is where the market rent number comes from. @bramble, you said "my estimate of market rent." How did you get $11.50 for that submarket, and how confident are you in it? Because if the whole screen hangs on one estimate, the screen is only as good as that estimate, and I'd want to know the error bars before I passed on eleven deals.

@anchor is pointing at the weak joint in the method. The rent ratio is a sound way to think about residual risk and it is what net-lease underwriters mean when they talk about rent being at, above, or below market. The number in the denominator is an estimate with a real range, and how you build it decides whether the screen works.

The usual sources are asking rents on comparable non-credit space in the same submarket, signed lease comps from a broker who actually works that market, and replacement economics, meaning what rent a developer would need to justify building similar space at today's construction cost. Those three rarely agree. If asking rents say $12 and signed comps say $10, you have a range, and a ratio computed off the midpoint is a range too. @bramble's 1.16 might be 1.05 or 1.30 depending on the input, which does not change the conclusion much. A 2.2 stays above any reasonable threshold no matter which input you pick, and that is where the screen does its work. It separates clearly bad from clearly acceptable and leaves the middle ambiguous.

Two things the ratio does not capture. Building shape and site constrain who can use the space at any rent, so a low ratio on a purpose-built format in a thin market can still re-tenant badly. And the ratio says nothing about interest-rate sensitivity, which moves net-lease cap rates and therefore your exit value independent of anything about your tenant.

On the estoppel point @bramble made, that is standard practice for a reason. Verifying with each tenant in writing what they believe the lease says catches side agreements the seller may not remember or may not disclose. Whether a verbal side arrangement is enforceable varies by state and by the terms of the written lease, so that is a question for a real estate attorney in the state where the property sits.

The zoning side of the ratio is the piece I'd add. Market rent assumes a permitted use. I've had two situations on land where the obvious second-generation user for a building couldn't get there because the use wasn't permitted by right and the variance path was a year and a public hearing. So @bramble's $11.50 is really $11.50 for uses that are allowed on that parcel today. Worth pulling the zoning district and the permitted use table before you trust your own denominator, and that table differs by municipality.

9,600 sf hard corner with two tenants is a different animal than the single-tenant stuff everyone in this room talks about and I think that's most of why the deal works. You've got two rent streams and a demising wall already in place. From the construction side, the cost of splitting a single-tenant box after the fact is where these deals eat you. New demising wall, separate utilities, separate entrances, sometimes a new storefront, sometimes fire separation upgrades that trigger other code work. On a 9,600 sf box I've seen that run $60 to $110 a foot on the affected area depending on what the existing systems look like. @bramble already owns the split. That's real money he didn't have to spend.

The estoppel story is the part I'd want more of. Three weeks outstanding and the seller kept asking you to extend, so somebody was hoping you'd get tired. I've had that on two deals in progress right now and the answer is always the same, whatever they're slow-walking is the thing you need. Did the trash enclosure show up in the estoppel itself or did you find it talking to the tenant?

I mostly buy notes, and I'm honestly stuck on this one, so here's a basic question. If I bought a note secured by one of those 2.2-ratio pharmacy boxes instead of buying the building, am I in a better spot or a worse one? I'd have a lien and the borrower would eat the residual risk, but if the borrower hands it back I own the same bad box with less basis. I don't know how to think about which end of that I'd rather be on.

Ran @bramble's deal in my model and the number I keep landing on is the service tenant. 2,400 sf on a 5-year term inside a 9-year auto parts lease. Say the service tenant is $32k of the $128k, so 25% of NOI rolls in year five. At a 7.15 going-in, if that space sits vacant twelve months and costs $40k in TI to re-let, you're down roughly $72k, which is more than half a year of total NOI. Doesn't break the deal, it does mean the effective yield over a ten-year hold is closer to a 6.5 than a 7.15 in the case where the roll goes badly.

@bramble did you reserve for that or are you treating it as it comes? Not a criticism of the buy. I just think the headline 7.15 is a 7.15 only in the year you bought it, and the two-tenant structure @girder likes is also two roll dates instead of one.

Reading this thread mostly to figure out where someone like me fits, and the answer seems to be that somebody has to produce the market rent number in the denominator. That's a leasing broker who actually works one submarket, and everything else in this thread depends on them being right.

@ledger's point is the one I'd act on. I'm a few deals in on active stuff and the ceiling I keep hitting is exactly this, deals that look like one yield and turn out to be a schedule of roll dates with capital attached to each. @bramble, the version of your screen I'd steal is the rent ratio plus a second column for weighted average lease term and a third for dollars of TI I'd have to fund at each roll. Eleven passes with the ratio alone might have been ten passes with all three, or twelve.

Also the 7.9 pharmacy at a 2.2 you didn't buy. Somebody bought it. The pricing exists because the market splits on whether that risk is real.

@plumb is right that it comes back to somebody knowing one submarket cold, and that's the part I'm working toward on the license side. The thing I didn't expect from this thread is how much of net-lease diligence is just documents. Estoppels, the use table, the lease itself. Nobody in here mentioned walking the building once.