By Mary Ellen Kuesel, CFP®
Mary Ellen Kuesel, CFP®, is an Accredited Asset Manager Specialist and a real estate broker in Mequon, Wisconsin.
Walgreens, CVS, 7-11, Dollar General, BP gas station, McDonalds and even the U.S. Postal Service offices all have one thing in common: they are situated in prime locations selected on the direction of their underlying corporation. The developers that construct these properties many times offer them for sale with a long-term tenant lease to an investor who collects the rent and owns the real property. Many investors, and perhaps financial planners, do not have sufficient knowledge of investment real estate to include it in a diversified investment portfolio. However, real estate in its various forms has become part of an investor's overall portfolio for those seeking higher risk-adjusted returns.
Commercial investment real estate discussed in this article focuses on net leased properties that may be appropriate for various investors' portfolios. Investment real estate can provide current income as well as have the potential for appreciation. If leveraged, investment real estate provides future appreciation, as the rent from the lessee will pay for the debt service on the property. Real estate enhances the return of a diversified portfolio of stock, bonds and cash due to its low correlation with stocks and bonds.
Generally, its analysis and review is outsourced to a competent and experienced real estate attorney to determine the suitability for the client, a review of the lease terms, an evaluation of the tenant's creditworthiness, business expertise, financial strength and the inclusion of a guaranteed income stream. Selecting corporate tenants having a defensive outlook, such as drug stores, grocery stores, or staple goods, will benefit consumers in down times, and they will be in a better position to withstand the cyclical nature of the economy.
The last six or eight years have made investors skeptical of reaching historical rates of returns on their stock and bond portfolios. The volatility in the real estate markets gave rise to investment in the real estate bubble. The residential real estate market has fallen greatly in these past months. However, investors might want to explore fixed income alternatives and turn their attention to investment in income-producing real estate-in particular, net leased property.
Net leased property is the deeded ownership of real property and its improvements (buildings) whose tenants are under contract to lease the property for a specified period time at specified rent terms. In a net leased property, the tenant takes responsibility for maintenance, repairs, property tax, and insurance on the property. The benefits of net leased property take into account that the investor receives predictable monthly rental income from the tenant without the responsibility for property maintenance, operating expenses, property tax, and insurance. An investment-grade tenant affords the investor hands-off property management combined with a minimum of risk due its guaranteed escalating lease payments by the investment-grade corporation. An added advantage to ownership is that it is probable the investors in real estate can monitor the financial condition of the publicly traded corporation leasing the property. Corporations who elect not to own property are not encumbered with real estate debt service.
For the purpose of this article, the focus is only on net leased property. In a double net lease (NN), the tenant is responsible for taxes and insurance and for most operating expenses other than the roof and structure. In an absolute or triple net lease (NNN), the tenant is responsible for all operating expenses including insurance, property tax, and interior and exterior maintenance.
Reasons for Investing in Net Leased Real Estate
Long-term leases offset many of the factors negatively affecting real estate value, mainly due to its guaranteed production of fixed income and its potential for long-term capital appreciation. Real estate offers diversification in an investment portfolio due to its low correlation to stocks and bonds, which is especially important in a volatile stock and bond market. Therefore, real estate acts as a hedge against inflation. For retirees, investment real estate adds a measure of predictable income certainty in a climate of uncertainty of Social Security benefits in the future and the lack of defined retirement benefits.
Factors Affecting Real Estate Values
Real estate value may be negatively affected by economic, regulatory and tax changes as seen in the current devaluing of residential real estate. Vacancies in retail stores due to the current recession reduce marketability of releasing or selling the property and threaten the viability of the commercial real estate market. It is therefore essential to purchase property with stable cash flows, strong tenant creditworthiness, and a guarantee for its payment of rent.
If cash is needed in the short term, real estate's lack of liquidity will be a detriment because of its long holding period-between 10 and 25 years. There are no annual investment fees for holding real estate, however there are higher acquisition costs for attorney review of the property and the lease contracts attached to it.
Obtaining credit to purchase net leased property today is more difficult, however the best opportunity for credit emanates from smaller-cost net leased properties that can be secured from a banker with whom the buyer has an established relationship or from a local banker if the property is located outside the buyer's home locale. Generally speaking, however, non-recourse financing may not be available. Credit for larger net leased properties is usually secured through a commercial mortgage banking company with a broad capital base with access to various lenders such as insurance companies, private equity, or pension fund advisers. The creditworthiness of the underlying tenant corporation is a determinative factor if obtaining credit. For instance, a Walgreen's net leased property with a credit rating of AAA may qualify for non-recourse financing.
Benefits of Owning Net Leased Real Estate
Tangible deeded real property is relatively easy to understand and the investment-grade tenant's choice of location eliminates the buyer's need to search for excellent property locations, taking into consideration demographics and lifestyle characteristics. Furthermore, net leases remove the need for property management while the investment-grade corporations guarantee the income generated. The average historical annual yield of net leased properties is between 6 percent and 10 percent with leverage increasing the cash-on-cash return.
Sample of Actual Purchase: Points to Examine
Tenant: national corporate tenant with an S&P investment-grade rating of BBB.
Address: rural America
Location and description: Single tenant, freestanding building located 15 miles from a state university on a corner lot on a U.S. highway. Within a quarter mile radius of the property is the county seat high school, middle school, an all brick senior citizen center, an auto park, a regional office for an electric company, a new office park, and a new locally owned grocery store under construction.
Building size: 8,125 square foot, pro-engineered Nucor building that is under warranty.
Base lease term: Corporate guaranteed lease commenced May 1, 2004 with an initial term of 10 years and three to five year options to renew.
Net Operating Income (NOI)*: $45,000
Capitalization Rate**: 8 percent
Price: $562,400; price per S/F: $69.22; rent per S/F: $5.54
Years Rent CAP FMV @ 8% CAP***
Base term Years 1-3 $45,000 8% $562,400
Years 4-6 $48,000 8.5% $600,000
Years 7-10 $54,000 9.6% $675,000
1st Option Years 11-15 $59,400 10.6% $742,580
2nd Option Years 16-20 $65,340 11.7% $816,750
3rd Option Years 21-25 $71,880 12.8% $898,500
Percentage Rent: 2 percent over breakpoint of sales over $1.5 million
* Net Operating Income (NOI) is rental income less operating
expenses excluding mortgage payment and income tax.
** Capitalization Rate (Cap Rate) is the ratio of the purchase price to the NOI; i.e. NOI/purchase price.
*** Property value is computed by dividing the NOI by the current market Cap Rate (8%); i.e. NOI/cap rate.
Please note: Total retail sales in 2008 were 11.2% higher than 2007.
Tax advantages motivate many real estate investors. Tax advantages for NNN properties include interest deduction for debt service, depreciation, 1031 deferral of capital gains, and the stepped-up basis at death. The tax code provides for cost recovery (depreciation) of real property, which is the presumed annual decline in value for obsolescence. This non-cash deduction shelters some of the taxable rental income, making real estate ownership a form of tax shelter. The 1031 exchange allows for the deferral of capital gains tax on appreciating real estate when the owner reinvests the entire sale proceeds of investment property in replacement investment property. The stepped-up cost basis at death affords heirs a possible tax-free transfer of property at the owner's death.
NNN Acts Like a Corporate Bond
A NNN property acts like an investment-grade 10-year corporate bond with some exceptions. The bond coupon rate is fixed for the period, its value fluctuates in price according to interest rate changes, and its principal is returned at maturity. The financial stability and business reliability of the corporation must all be analyzed prior to purchase.
The NNN property has stated periodic increases in rent throughout the period, potentially appreciates in value at end of period, and has the added advantage of tax benefits. There is the possibility that the tenant will exercise its options to continue leasing for 25 years with rent escalations along the way. The rent escalations, which should be included in the terms of the lease contract, increase yield and fair market value.
At the end of the lease period, the property, which is owned by the investor, can then be sold or leased to a new tenant at presumably higher rents. The stability of the retail operation (as noted above), the size of the building, the cost per foot, the rent per foot, the location, and the demographics of the property all need to be analyzed to secure the viability of re-leasing or selling the property in the future.
Both real estate and bonds are dependent on the creditworthiness of the underlying corporation that guarantees its rent and interest. The risks involved in bond ownership are that the bonds can be called early with resultant reinvestment risk, in addition to default of the corporation or bankruptcy. The risks involved with the real estate include illiquidity, lack of a single central marketplace, long holding period, and bankruptcy of the underlying corporation. However, with a default of the tenant, the investor retains ownership of the property with all its rights. Just as some bonds are insured against loss, the NNN property is guaranteed by the underlying corporation, a bond, or a third person guarantor.
As always, the right location and demographics of the property chosen are critically important for renewal of leases or sale of the property. Due to increasing rents throughout the lease term, the value of the property increases by dividing the net operating income from a reasonable comparable capitalization rate. Both long-term bonds as well as real estate can be negatively affected by tax regulation and economic downturns.
Considerations for Purchase of Real Estate
Leverage on real estate increases the cash-on-cash return-the rent from the tenant services, the debt, and future appreciation. For investors, particularly young investors who are not in need of income, the purchase of leveraged net leased property may offer the opportunity to invest for the future. It is also possible to include real estate investments in a self-directed retirement account, which offers investors the option to invest in traditional investments, such as stocks, bonds, and cash, as well as non-traditional investments, such as real estate and businesses. A tax counselor must be consulted.
Real estate has a low or negative correlation with stocks and bonds and is an appropriate diversifier, as it tends to offset systematic risk in a stock and bond portfolio. Conversely, real estate has a strong correlation with inflation and can act as a hedge against a rising inflation environment. The usual allocation of real estate as an alternative asset is between 5 percent and 15 percent percent of the investment portfolio. However it may be difficult to obtain appropriate diversification in the real estate asset class if individually owned property is held due to its cost.
Comparison of NNN property to Bonds
|Laddered Portfolio of Bonds||Bond Mutual Funds||Investment Real Estate (NNN)|
|Requires investment management||Professionally managed||No property management|
|Provides fixed semi-annual payments||Payments fluctuate||Provides predictable escalating monthly payments|
|Value fluctuates with interest rates||Value fluctuates with interest rates||Value appreciates with increasing|
|Call risk/Reinvestment risk||Call risk/Reinvestment risk||Cannot be called|
|Principal returned at maturity||Principal returned at current sale price||Market value at end of lease is based on current rent rates|
|Difficult to sell in open market||Sold readily at open market||Not readily sold at secondary market|
|No annual fee, unless managed||Annual investment management fee||No annual fees|
|No option to renew|
The higher acquisitions costs of purchasing real estate may be offset by the lack of annual investment management fees of a stock and bond portfolio. To mitigate systematic risk in an investment portfolio, real estate and its asset allocation should be carefully considered for diversification. A financial adviser should include the present value of a guaranteed income stream, such as Social Security benefits or guaranteed rental income, in the asset allocation of a balanced portfolio. The value of the income stream would be attributable to the fixed income asset allocation and would allow for more quantifiable allocation to equities for diversification. (Source: Individual Investor August/September 2008 Published by AAII, the American Association of Individual Investors.)
Institutional investors, foundations and pension funds all include real estate as an asset class when determining their asset allocations. Allocating part of investment portfolio to fixed income for stability reduces risk for investors needing to generate current income.
Financial planners might want to offer clients the option to invest directly in individually owned real estate to enhance their risk-adjusted returns. While net leased property may not be appropriate for everyone, it may be an appropriate asset for investors considering building a real estate portfolio. The critical points to examine include its long-term financial stability, its defensive outlook, its reasonable size, an attainable rent per square foot, the inclusion of escalating rents and the lease payment guarantee. The advantages and disadvantages of comparable appreciating income-producing assets should all be included in a discussion of the investor's goals and objectives. As with all investments, the merits of the real estate investment must be monitored at least annually.