An 8.9% cap with seven years of term in a town of 3,400, and how to price the exit

A scenario worth working through. Freestanding discount retail box, 9,100 sf, small rural town of about 3,400 people, on the state highway across from the school. Built 2011 for the tenant. Rent $73,500, so $8.08 a foot, absolute net with a corporate guarantee from the parent. Asking $825,000, which is 8.9% and about $91 a foot. Seven years and two months left on the original 15 year term, four five year options at 10% bumps. The store looks busy on every drive by. No sales reporting. What is appealing: the landlord does nothing. Taxes, insurance, roof, lot, all on the tenant, and a careful read of the whole document twice turns up no carve back to the landlord. What is hard to solve is the exit. A local bank will lend but wants 25% down, 20 year amortization, a five year call, and its appraiser will care about the lease. So realistically the buyer sells in year four or five with two to three years of term left, into whatever cap rate exists then. A 9% going in that turns into an 11% exit with three years of term is a loss even with seven years of coupon. The alternative is to hold past expiry, and either the tenant renews at $8.88 or the owner holds a 9,100 sf box in a town of 3,400. Second generation rent out there is maybe $4 a foot with luck, and the building is worth land plus scrap sentiment. So the question worth settling is whether the coupon is enough to pay for owning a residual that is close to zero, and whether this should be underwritten as a 15 year hold through two renewals instead of a five year flip.

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brandonlee36 SP1BPRO 15

Run the exit properly and the answer usually falls out. Take the going-in basis of $825k, four years of after-debt cash flow, then a sale at year four with three years and two months of term remaining at a cap 150 to 250 basis points wider than the going-in, because that is what short remaining term does to a rural single tenant asset. If the numbers still work, fine. If they only work by exiting flat, the whole thing rests on someone else making the same bet you are unsure about. The better question is the 10% option bumps. Four options at 10% every five years is genuinely attractive if the store performs, and no sales reporting means you are guessing. Look at what can be seen from outside. Is it the only one of that format within 20 miles, and how long is the drive to the nearest larger town's competing box. A remodel in the last couple of years is worth more than any pro forma, because operators do not spend that on stores they intend to close. And price the downside honestly. At $4/sf second generation rent that is $36,400 of gross rent on a building you would then be paying taxes and insurance on yourself, in a market where you have no other assets and no relationships. That stops being a coupon and becomes a project 400 miles from your house. The going-in yield has to be high enough that the coupon returns most of the capital before expiry, and 8.9% over seven years does not get there.

brandonlee36 SP1BPRO 15

An 8.9% cap with seven years of term in a town of 3,400, and how to price the exit

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