Net Leased Properties

Net leased properties are an investor's dream. You sign up Walgreen's to a 30-year lease. You go someplace warm, set up your beach chair, and collect the rent. The tenant is responsible for the new facade and the build-out of the interior. No one calls about the light bulb that went out in the hallway. No one calls about the dripping faucet. All of that is the tenant's concern. Your main job is to see that you wear enough sunscreen - and, once a month, to go and deposit the rent check.

Net leased properties are typically single-tenant properties in the retail sector. They are called "net leased" because the tenant is responsible for paying all operating costs, including real estate taxes, insurance, utilities, and maintenance. Drug store chains and fast food operators make up a high proportion of tenants. These are not interested in committing their capital to real estate ownership, so they enter into long-term leases. Frequently, these leases are at rates above the local market. A chain may have determined that it can do a certain volume of business at a given location and that it is economical to pay some proportion of that volume as base rent. That rent, on a per-square-foot basis, may be substantially more than the average rent on that street. Some tenants enter into "percentage rent" leases (leases where rent is calculated as a percent of the actual volume of business) and pay the greater of base rent or percentage rent. In that case, the net lease landlord has the comfort of knowing that a high-quality franchise is unlikely to mis-represent its volume of business, and so the percentage rent is secure.

An entire brokerage industry is devoted to matching buyers and sellers in the net leased market. On the Internet, brokers post the capitalization rates for long lists of net leased properties that are being marketed. An investor can compare the rate of return from a McDonald's in Newark to that of a Taco Bell in San Antonio, a Wendy's in Tuscaloosa, or a CVS in Chicago.

As much as do investors, appraisers appreciate net leased properties. Their valuation is relatively simple. Long-term rent is fixed in the lease, unless a percentage rent clause or CPI escalators are involved. A vacancy allowance is required to reflect the possibility that the tenant may fail, but in the case of strong tenants, the possibility is marginal. Management is an expense that may not be borne by the tenant, but, for the landlord, management may consist of little more than an occasional view of the property. With small deductions for these items, net income (the income to which the capitalization rate is applied) may be only slightly less than the tenant's contract rent.

The key variable in the valuation of net leased properties is the credit-worthiness of the tenant. It is one thing to have FedEx on a lease and quite another to have Joe's Deli, the one and only deli operated by Joe. The capitalization rate for the McDonald's may be 6%, whereas the rate for Joe's Deli may be anywhere from 7% to 8.5% (producing a difference in value of up to 30%). It all depends on Joe. If Joe is wealthy and is a personal signatory on the lease, the cap rate is low and the value, therefore, high. If Joe is financially shaky, then the net lease may produce no special premium, and the value of the property is whatever it would be if there were no net lease. The most important job for the appraiser is to research the financial status of the tenant.

The goal of the retail property owner is to make his or her leases as "net" as possible. Net leases shield the landlord from unexpected cost increases. The owner's goal is also long-term security. Both goals are achieved in net leased properties with strong-credit tenants. Landlords with those net leases can relax. Where to find those landlords is on the beach.

Eric T. Reenstierna, MAI