The Secret to NNN Valuation: A 360° Approach
Am I getting a good value for my money? With net lease properties, the credit quality of the tenant and term of the lease can significantly influence the value and pricing of a NNN investment as much, if not more, than the typical cornerstones to real estate valuation – property and location attributes.
Am I getting a good value for my money? That is a fundamental question that every investor asks whether they are buying stock, a new car or investing in real estate. For triple net lease (NNN) properties, getting an accurate read on value is important for a myriad of reasons. It helps guide the cap rate/price an investor is willing to pay, it is essential for securing financing, and it can also impact exit strategy and the ability to hit the desired total return on investment.
Yet NNN properties are a bit of a unique animal in the commercial real estate world. They are often described as a “bond-like” investment because the real estate is occupied by a single tenant that signs a long-term lease. Effectively, that lease acts much like a fixed-rate corporate bond, delivering steady, predictable income over the term of the lease. As such, the credit quality of the tenant and term of the lease can significantly influence the value and pricing of a NNN investment as much, if not more, than the typical cornerstones to real estate valuation – property and location attributes.
But let’s not get ahead of ourselves and start at the beginning to discuss valuation. The key metric commonly used to evaluate NNN investments is the capitalization rate, or cap rate. The cap rate is the yield (rate of return) that the investor can expect to receive on a yearly basis from an investment.
Cap rate = Net operating income (NOI)
Price = Net operating income (NOI)
For example, if an owner is buying a Walgreens for a price of $5 million that generates $300,000 per year in net operating income, the cap rate is 6%. So, for a given NOI, the higher the cap rate, the lower the price, and vice versa. Thus, as an investor purchasing the property, you’d want the cap rate to be as high as possible, whereas if you are the seller, you would pocket higher proceeds with a lower cap rate on the transaction.
4 Building Blocks to NNN Valuation
Valuation serves a critical role in the assessment for any real estate deal. In NNN, cap rate is a natural benchmark or baseline for comparing like properties. The nature of NNN is that it often deals with national retailer tenants such as Walgreens, 7-Eleven and McDonald’s. For example, an investor may be comparing NNN investment opportunities for similar Walgreens in Chicago, Kansas City or Tampa. The pricing for those three deals can fall within a cap rate range of 50 basis points between 5.5% - 6%. All three locations have the same credit tenant, identical lease term and building structure. Thus, understanding where the nuances come into play requires taking a 360° approach to assess the overall merits of an investment.
There are four holistic categories that are used to determine value: Tenant, Lease Term, Property and Location/Market. Each of those categories acts a bit like a lever. Strong attributes or characteristics in a particular category can raise the valuation, while weak factors or less desirable characteristics can lower the overall valuation. Importantly, each of the key building blocks below provides the framework to obtain a holistic view of valuation with attributes that layer one on top of another to calibrate the overall value.
Tenant: The retailer or company signing the lease weighs heavily on property value. Company credit, business model and a tenant’s competitive position in its respective industry all are important factors in calculating value. Similar to how you would screen for good tenants to rent an apartment, net lease investors prefer NNN tenants that are reputable, have a proven and sustained business model and guarantee their rent payments. In particular, having a strong institutional-grade credit tenant, such as that of a Firestone or McDonald’s, is a sure way to raise the property valuation.
Lease: The length of the lease is perhaps the biggest contributor to the valuation of the property, in some cases, influencing value by a factor 40-50%. Effectively, the lease, if guaranteed by the tenant entity or its corporate parent, acts as a binding guarantee to pay that rent over the specified term. As such, the longer the term (e.g. 10+ years), the lower the short to mid-term risk and the greater the value. The shorter the lease (e.g. < 5 years), the greater the risk that a tenant may not renew the lease and leave an owner with potential lost revenue and added expenses related to re-leasing the property if the tenant vacates. The base rent and any negotiated step-ups in rent included in the rent also factor into the overall valuation.
Property: Any building appraisal will take into account the basic characteristics, such as age of the building, square footage, building materials, design features and overall condition and function of the property and key operating equipment.
Location/Market: This is a broad category, but it can be systemically broken down into narrower relevant buckets. It starts at a macro level, such as the state and city, and drills down to micro level details, such as the size of the trade area and physical position within a market and submarket. Typical attributes to investigate include population density, growth rate, household demographics, key employers, economic development initiatives and retail makeup of the area among other factors. Location also needs to account for factors such as traffic flow, visibility and accessibility. This is often the reason why freestanding parcels located at the corner of a busy intersection in a retail corridor have valuation premiums over similar properties located in the same area in the middle of the block.
Another factor to consider is the marketability of that particular property. If the existing tenant leaves the premises, how easily will it be to repurpose the building for another tenant use? Property marketability is a core reason why Walgreens is considered the ‘granddaddy’ of triple net lease. Their locations are usually located on “Main & Main” intersections at some of the best traffic corners in any city. Even though their lease can be up to 50 years or more, typically structured with a 15-20 year base lease term and up to a 10 or more 5-year renewal options, a triple net lease investor can take comfort that buying a NNN Walgreens is akin to buying a generational asset as the company guarantees its leases. And if Walgreens ever should vacate, the location is so prime that the property will likely retain its intrinsic value, making it easier to backfill with another tenant or repurpose the building to a new use.
Part Art, Part Science
From the standpoint of an investor seeking to invest in a NNN property, the key question to address is “Should I invest in this NNN deal?” There are plenty of websites that offer “free” 1031 Exchange calculators. Yet truly understanding NNN valuation is much more complex than simply plugging in a few data points. Getting a clear picture of value involves both quantitative and qualitative factors. The quantitative facts are straightforward. It’s easy to calculate the rent per square foot or quantify the credit quality of a particular tenant. What is more subjective is understanding the nuances of a location and its competitive position within a market that influence value.
Getting that holistic valuation dialed in requires deal NNN experience and market knowledge, which is why it is important for investors to work with a seasoned broker who has the technical chops so to speak to provide guidance on property valuation and transaction pricing. To learn more about whether a NNN investment property is the right fit for your financial and lifestyle goals contact Andrew Vu at 415-539-1120 for a complimentary strategy consultation.