Re: Rotten NNN Deals - Posted by ray@lcorn
Posted by ray@lcorn on March 12, 2005 at 20:08:22:
Randy,
It’s not WhataBurger making the real estate profit. These deals are built and sold by merchant developers. They recieve a fee from the tenant as a development fee, and in return for taking the construction and market risk they also are entitled to the arbitrage between cost and market value. In the last few years the demand for these properties has outstripped supply, hence prices have increased to levels that make little sense from a real-estate-only value paradigm.
The structure for these deals has been around for forty-plus years. It is designed as a win-win for all involved. The tenant gets a great location without buggering up their balance sheet with real estate; the developer is well-compensated for his risk and effort; and the end-buyer gets a real estate investment that acts like an annuity, with tax-sheltered attributes. Stable income paired with favorable (and also stable) financing adds up to predictable performance… I heard one broker remark at a trade show this week that a buyer told him “I’m addicted to the income.”
The underlying safety (and strength) of the deal relies on three factors: the credit of the tenant; the local market outlook for the tenant’s business; and the “dark” value of the real estate. Whether they are “junk bonds” is determined by those factors, and it is my belief that you ignore any of the three at your peril. Credits rated below BBB are considered “junk” status, so your metaphor applies to NNN properties in a big way.
But the mere fact a tenant has an investment rating and is offering a triple net lease is not an assurance of creditworthiness. The ratings services attempt to establish the relative risk of default for a particular company. This is well illustrated by the following report on retail credits issued in late 2002 for the default rate of rated companies over a fifteen-year period:
Original Rating–Default Rate %*
AAA–.52%
AA–1.31%
A–2.32%
BBB–6.64%
BB–19.52%
B–35.76%
CCC–54.38%
*percentage of defaults by issuers rated by Standard and Poor’s over the past 15 years, based on rating they were initially assigned. Source: Standard and Poor’s Corp/Business Week
Note the progression of default rates almost doubles with each step downward in the bond rating. Some deals have the added confusion of being represented as credit tenants, but a franchisee rather than the corporate parent.
The dark value of the real estate almost always is directly connected to the health of the local economy and the location in regards to population centers, and may have little to do with the normal square foot cost of the building. The ground under the $800 psf, 2,000 sq. ft hamburger joint could be well worth the price even if the building is demolished. Don’t laugh… I’ve seen 1.5 acre outparcels selling for $1mm and up.
So for me the key is to find the product that makes sense as real estate first, then price the deal to match the factors of tenant credit, lease terms and available financing. That usually means looking at a lot of deals to find the pearls.
ray