COVER STORY, AUGUST 2005

NNNETTING A GOOD DEAL
Are you getting all the credit (tenants) you deserve?
Sean O’Shea

No, this is not a remembrance of the late Rodney Dangerfield or pseudo-therapeutic view of our popular culture. There’s much more at stake.

Yield curves are flattening, trade deficits are at historical highs, short-term interest rates are at unprecedented lows and there’s fear and loathing in the stock market.

We are living in interesting economic times, to say the least. What’s a savvy commercial real estate investor to do?

NNN lease deals are the rage in real estate investment circles, often competing with TIC sponsors as an appropriate alternative for 1031 exchange replacement properties. A 1031 exchange affords substantial deferral of capital gains, pursuant to all provisions of IRC 1031 for an investor/taxpayer. The due-diligence process is somewhat limited, transaction fees are modest and a very efficient transaction can be achieved.

Because of the tidal wave of investor interest, the line has been blurred in recent months between NNN lease deals and NN lease deals. There is also some blurring of the distinction between NNN lease offerings and credit-tenant deals, which are, in fact, a different investment vehicle altogether. Credit-tenant deals have at least three elements worth identifying for your acquisition criteria: the tenant must have an investment-grade credit rating, there must be remaining lease terms of a minimum of 15 years (preferably 20-25 years) and covenants in the lease documents that require the tenant, not the investor/landlord, to replace the building in the event of casualty or condemnation. Other issues may include no rent setoff or early terminations provisions. Credit-tenant deals require no management responsibilities, whatsoever. Even monthly rent payments go directly to the mortgage trustee in many situations.

The term investment-grade tenants is worth some clarification. It signifies corporate tenants with NNN lease structures that have been rated at no less than BBB by Standard & Poor’s, Baa2 by Moody’s Investor Services or NAIC 1 or 2. Often, NNN lease deals are offered in the present market by touting a well-known brand name like Starbucks. However, without a credit rating from one of those acknowledged agencies, a tenant simply cannot be considered for our purposes. Keep in mind that AAA tenant is often a marketing reference used by skillful and capable investment real estate brokers and sellers.

Recently, Moody’s Investor Services completed a 20-year rolling average study regarding the defaults on corporate bonds over many decades of investment activity. The results and their implications for real estate investors were stark and undeniable. Over a 80-year period, defaults from A-rated credit tenants were in the range of 2 to 4 percent, for BBB-rated tenants approximately 13.8 percent and for non-investment-grade tenants upwards of 43.7 percent. The 43.7-percent figure constitutes a number that rarely is factored into the residual risk/value calculation when an investor signs a lease or buys a building housing a standard NNN tenant, who may well have brand recognition in the marketplace. Predictably, it may not have an investment-grade credit rating.

These NNN credit-tenant assets, as a result, are being priced at an all-time premium with good reason. Those of us in Southern California have the dubious distinction of leading the pricing surge, seeing cap rates in the sub-6-percent range on a regular basis for NNN lease assets, and mid-to-high 6 percent cap rates for NN assets, which would have been offered with some negotiation 1 short year ago at 100 basis points higher. The ability to finance these assets at today’s rates has a lot to do with this pricing phenomenon. In order to achieve acquisition objectives closer to historical cap rates, many investors and sponsors have resorted to non-investment-grade tenant transactions marketed with little discernible difference in present pricing. But there’s a big difference if we are to acknowledge the track record implicit in the Moody’s study.

So, a savvy investor must ask, “Am I really getting all the credit I deserve in this overheated NNN Market?” Also noteworthy is the ability to acquire a NNN asset with no management responsibilities, and then finance a NNN credit-tenant property, effectively securing long-term, fixed-rate and bond-style debt. Most conventional financing in the present market will require a refinance in 5 to 10 years. Many view the interest rate risk to be a real concern.

To generate cash flow for investors, many sponsors in recent months have structured deals to afford a present-day dividend of 6.5 to 8 percent by utilizing low interest-only loans for 5-, 7- and 10-year terms. This is possibly a good strategy in the short term as a comparative investment vehicle to the stock market, but does anyone really believe interest rates will be lower in the future? The ability to ‘match fund the debt’ today with a NNN credit-tenant transaction at historically low rates substantially mitigates the very real interest-rate risk over the loan maturity period.

Due to the cyclical nature of the real estate business, seasoned practitioners with the scar tissue to show know the next cycle is out there, suggesting that chickens will come home to roost for many in the present market who are making “Faustian bargains” with the short-term orientation as their principal investment criteria.

The real estate investment market could turn on a dime if there is a credible liquidity crisis. With these credit-tenant assets, an investor is in the enviable position of disposing of owned assets with substantial capital gains, completing his or her 1031 exchange. That investor has the option to leverage equity out afterwards, pursuant to negotiated loan provisions.

In this scenario, the interest rate risk of re-financing in a more conventional debt situation has been addressed and the investor has net proceeds to redeploy if so desired. Or the investor can simply wait for a more favorable acquisition environment rather than the present overheated market where investment properties are effectively being auctioned with multiple full-price offers for every really good piece of NNN real estate in the country.

It is affirmed in this space that the NNN credit-tenant assets (BBB or better) provide additional liquidity for investor equity. This risk-averse alternative sees the credit tenant pay down the mortgage with a stable income stream from rentals, often paid directly to the trustee of the mortgagee. This option is worth further investigation for the investor’s acquisition and disposition strategies.

Sean O’Shea is a member of the senior management team at Triple Net Equities Inc., an investment advisory boutique located in Santa Monica, California.

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