Did We Make the Right Decision? - Posted by Todd

Real Estate Investing Retail
1

Posted by Todd on September 15, 2011 at 13:55:59:

Hi,

My wife and I are new to CRE investment but it’s been something that we’ve been interested in and watching for the last couple of years.
Recently, we signed an LOI on a property in a small, but rapidly growing town of OK. The property is a single tenant, NNN regional restaurant
chain located on a pad site of a national department store. Here are the numbers:

Price: $580,000
Cap: 8.69 %
Remaining Lease Term: 9.5 Years
Lease Type: NNN
No Corporate Guarantee
10% Rent Increase after 5 Years
Rent: $22/SF

After a little research, we discovered that this business has had some difficulty being profitable and last year, the current owner and tenant re-
worked the lease to reduce the lease rate and extend the lease term. Initially, we viewed this as a positive because it told us that the tenant had
been hurt by the economy (who hasn’t?) and that they were willing to work through it with the owner instead of taking off in the middle of night.

We picked a weekend and went to visit the property. The existing owner was also nice enough to setup a meeting so that we could meet the tenant. When we got there we noticed that it was surrounded by great neighborhoods, near the corner of a busy intersection and clean.
However, the tenant told us that it was still an underperforming store and we noticed that there was some maintenance that needed to be
performed (pothole in parking lot and leak in roof, landscaping had been neglected). Just before we were supposed to leave, the tenant told us
that he is trying to sell the business. Once we got home we did some searches on Loopnet and found similar or better retail space for $16/SF.

We decided to pass on this deal because we felt that this business wasn’t a priority for the tenant any longer and the reduced rent that they were
paying was still higher than was was currently available in the area.

My question to the board is, do you think we made the right call? Also, is there anything that we could have done to alleviate our concern about
the tenant? If you agree that turning this down is the right decision, what would have been an appropriate counter offer in order for this to
make sense?

Thank you in advance for your help. This will be helpful for next time. Thank you,

Todd

2

Re: Did We Make the Right Decision? - Posted by Todd

Posted by Todd on September 19, 2011 at 21:17:48:

Thanks everyone for your help. It is much appreciated.

3

Re: Did We Make the Right Decision? - Posted by brandon

Posted by brandon on September 17, 2011 at 09:23:52:

Id say passing was a good move.

If you find yourself in that spot again ask yourself what the building is worth if it were vacant and base your offer off of that.

4

Re: Did We Make the Right Decision? - Posted by ray@lcorn

Posted by ray@lcorn on September 15, 2011 at 15:17:26:

Todd,

Yes, you definitely made the right decision.

Given that you are just getting into the business you do not need to start with a problem tenant in a special use building. Restaurants are notoriously volatile, and the building can be expensive to renovate for other uses. Even experienced investors (like me) shy away from that scenario.

Second, given the weak tenant demand for retail space you could easily be looking at a year or more to fill the space if the current tenant doesn’t make it, or worse, be tied up in a bankruptcy. That potentially adds additional capital requirements that kill the return.

So I don’t think there is really any appropriate counter offer for a first investment. For reference, I would consider it a a high-risk deal at perhaps a 12% (or higher) cap rate. I recently took a run at a NNN national restaurant with corporate ownership that just came out of Ch. 11. I valued it at a 15% cap and didn’t get the deal. Someone else was willing to pay more, but that did not affect my valuation based on my personal assessment of the risk.

And I always check the cap rate valuation against the depreciated replacement cost. You have to allow enough room in the per square foot (PSF) cost for improvement costs of refitting for a new tenant. (You didn’t give the square footage so I don’t know the asking price PSF, and that could significantly affect the guess-timate cap rate noted above.

For example, we are currently buying existing office buildings at $50-$60 PSF. New construction would cost $100-$125 PSF plus land cost. Therefore we can spend the $50-$60 PSF it takes to renovate the building to new tenant specs and still be under market on a cost basis, lowers the break-even lease rate, and provide a margin of safety for cost overruns.

Bottom line, this is a buyers market. Use it to your advantage, there are plenty of deals out there and you can be picky. Set your criteria and stick to it.

Hope that helps,

ray

5

Re: Did We Make the Right Decision? - Posted by KC

Posted by KC on September 15, 2011 at 15:07:43:

You need to find out what the market rent is. You could also ask the tenant at what rent he will make a profit. You could have asked to see the tenant’s sales and financials during the study with the thought that sales will likely be under-reported. It’s also possible that this tenant or business was not a right fit.