When valuing a multi-tenant, income-producing property, a discounted cash flow analysis is the most appropriate valuation method because it accounts for an investor’s perceived risk associated with each income stream and calculates a value based on the required return to compensate for that risk. Risk factors range from macroeconomic to microeconomic issues; some of which can be mitigated or insured against while others are unpredictable and uncontrollable. By analyzing income streams independently, investors can focus on the factors most likely to affect that particular tenant/business and account for them by increasing their required return, thus lowering the present value of that income stream (reducing the amount they are willing to pay for it).
Discounted cash flow analyses are especially important when valuing multi-tenant retail properties. This is because of the importance of tenant mix within this asset class, which results in a variety of businesses/services, square footages, etc. In no other asset class will one find such a range in the terms and concessions in different tenants’ leases within the same project. To some extent, the terms offered to various tenants reflect the landlord’s risk assessment at the time of lease; however, investors purchasing these income streams must reassess the value based on current market conditions and risk factors.
For this article, I will discuss and analyze risk factors that are particularly relevant for 3 broad classifications of retail tenants: anchors, franchises, and mom-and-pops.
Anchor tenants are typically major department/chain stores in a retail center whose presence draws customers thus providing smaller tenants with increased exposure/business. Anchor tenants generally occupy large blocks of space, but due to their importance (leverage) they are able to negotiate lower rental rates than other, smaller tenants. Still, because many retail leases contain percentage rent clauses, anchor tenants contribute to the landlord’s bottom line by increasing overall gross sales in the center. Much like their footprint and role in the vitality and viability of the center, anchor tenants’ income streams deserve an oversized risk analysis.
Investors must consider the likelihood and overall impact of the anchor tenant defaulting on their lease and/or vacating the center. This would not only include lost revenue from the anchor, itself, but also the lost revenue from percentage rent due to the reduction in gross sales. The cost and time required to replace the former anchor must also be calculated. If landlords do not replace the anchor quickly other tenants may default or choose to leave; creating a positive feedback loop that is anything but “positive.”
Many of the “brand name” tenants that occupy retail centers are franchises that are locally owned and operated. Franchises make good tenants because they have proven business models and quality standards that are imposed and enforced at the corporate level. Franchises’ recognizability can contribute to a more positive perception of the center; resulting in increased patronage, gross sales, and leasing demand, which in turn can lead to higher rents. As a result, franchises are generally seen as less risky than independent businesses.
When analyzing franchise income streams investors should focus on the age, history, and current public perception of the individual franchise. There are relatively young/new franchises that are considered to be some of the most desirable tenants, i.e. Orange Theory; however, newer franchises may also be considered riskier because they do not have a track record over multiple market cycles. While the past is not necessarily an indication of the future, investors can and should look at a franchise’s performance over its history and during different economic cycles; paying special attention to the current relevance and perception of the product or service (think Blockbuster).
Another important factor to consider is the number of franchise locations, both nationally and locally (owned by the franchisee). The number of locations across the nation can provide insights into the viability, popularity, and strength of the franchise, in which case the more the better. When viewed from a local perspective, the number of locations requires a more skeptical analysis. Multiple locations owned by the same franchisee may indicate financial strength and success; however, it may also be a sign that the franchisee has spread themselves too thin and/or oversaturated the market thus making an otherwise attractive tenant a risk of default.
Perhaps the most important factor for an investor to consider is whether or not there is a corporate guaranty securing the lease. Personal guarantees are only as strong as the individual signing the guaranty and, if the business is in dire financial straits, one can expect this to extend to the guarantor. Corporate guarantees, on the other hand, are secured by the corporate franchise, which takes responsibility for the financial obligations of the lease in the case the franchisee defaults.
“Mom-and-pop” retail tenants are small, family-owned or independent businesses that present the greatest risk to investors due to competition from large retailers, e-commerce sites, and franchises which have the advantage of economies of scale, greater buying power, larger advertising budgets, etc. This is not to say that such businesses cannot be good tenants; however, they require the greatest scrutiny with particularly attention being paid to the number of years in business (in general and/or at their current location), financial strength (gross sales/net profits), and amount of local competition from similar businesses. If the tenant has been in business and profitable for many years (at the present location) with a history of on-time payments and provides a product or service that insulates them from corporate/franchise competition, they may be a relatively low risk. The upside for investors is that “mom-and-pop” tenants generally do not lease large blocks of space and thus re-leasing the premises is relatively easy and inexpensive.