The world is a dangerous place, fraught with risk. Life is all about assessing, analyzing, and mitigating those risks. Decisions are weighed and made based on an individual’s/company’s risk tolerance and expected return. The risk-return tradeoff states that the potential return rises with an increase in risk. In other words, investors are willing to accept a lower return for less risk. Prime examples are Treasury bonds in the capital markets and long-term, triple net leases with a credit-tenant, i.e. CVS, in commercial real estate. There are many risk factors to consider when making an investment decision, and these vary in applicability and importance based on the market, asset class (office, retail, flex, industrial, and land), etc. Before discussing various types of risk it’s important to understand the valuation method for income-producing properties, particularly cap rates, and the difference between market value and investment value.
As covered in my article, What’s a Cap Rate?, cap rates are a measure of value, expressed as a percent, that represent the all-cash return an investor is willing to accept based on a property’s net operating income. Cap rates are a simple, albeit incomplete, valuation method that provide a useful starting point from which to analyze an investment (for more information, check out my article, “4 Things Cap Rates Aren’t Telling You”). Market cap rates are determined by and based on recent sales comps for a particular asset class. For example, the current average/market cap rate for industrial properties in the Route 28 South submarket is 6.1%. This metric was derived from the sale of 35 properties in the submarket over the past 12 months. While related, the average sale price ($143/SF) is a less important indicator of value because it applies more to owner-user acquisitions. The average vacancy at the time of sale (11.6%), on the other hand, is a relevant data point because it relates directly to the risk that investors in that submarket/asset class are willing to incur for each dollar of net income. This means, that on average, investors in the Route 28 South industrial submarket are willing to accept a 6.1% return on an all-cash purchase despite an asset being 11.6% vacant with the associated lease-up costs.
The market cap rate and associated vacancy at the time of sale reflect the market value of a particular property type within that (sub)market; market value being the probable sales price in a competitive and open market under fair sale conditions. It is from this baseline that an income-producing property is analyzed and assessed based on its specific characteristics in relation to its competitors and market sales comps. For example, if the average property age in a particular submarket is 15 years and the subject property is 25 years old an investor may require a slightly higher return to compensate for the associated risks, i.e. deferred maintenance, repairs/replacements, etc. Alternately, if a property is fully leased and the average vacancy at the time of sale is 11.6%, as in the Route 28 South submarket, investors might be willing to accept a slightly lower return. This all contributes to a property’s investment value, which is a subjective measure, unique to each investor and heavily influenced by their risk profile.
As mentioned previously, there are a variety of macroeconomic and microeconomic factors to consider when analyzing an investment. To illustrate the practical application of these concepts, I will perform an analysis a real-life income-producing, triple net investment property in Chantilly, VA. The subject property is a 32,000 SF industrial building, built in 1986. The property is fully leased to 8 tenants with staggered lease expiration dates over the next 5 years. All leases are triple net with 3% annual base rent escalations and several have contract rents that are significantly below market. None of the building’s tenants have renewal rights and many have improved their spaces at their own cost and expense. With a net operating income of just over $255,000 per year and an asking price of $4,160,000, the property is being sold at a 6.13% cap rate. Below, I will identify and explain various, pertinent factors that have the power to increase or decrease a property’s value based on the risk premium, expressed as a percent, that is applied to the market cap rate.
Building Age/Year Built
A property’s age can impact its risk premium for a variety of reasons. As logic would imply, the older the building the higher the risk due to natural deterioration, deferred maintenance, repairs, and replacements, etc. That being said, they also built things to last “back then.” The subject property is 34 years old and the average age of industrial buildings that sold in the Route 28 South submarket in the past 12 months is 32 year old. As a result, there is little to no case for an increase in the cap rate (reduction in value) based on its age.
What’s important to know is whether there are any big-ticket items that must be addressed in the near future that are the responsibility of the landlord. In triple net leases, tenants are generally responsible for maintenance, repairs, and replacements of systems servicing their space. Also, landlords are able to “pass through” the costs of any capital improvements in the triple net charges; however, they must be amortized over their useful life. If the property is only partially leased, landlords must cover the proportionate share of the costs for the vacant space. The subject property is fully leased and the roof was replaced in 2017, further justifying no adjustment to the market cap rate.
Don’t put all your eggs in one basket. Diversification refers to the risk management strategy of investing in a variety of assets to reduce exposure to one particular asset and the conditions/circumstances that might adversely impact it or its value. The concept also applies to individual properties, which can be “single-tenant” or “multi-tenant.” As the name suggests, a single-tenant building has a higher risk profile because if the tenant defaults and/or vacates, the entire income stream is lost. Multi-tenant buildings are less risky, in general, but within this category there is a risk spectrum based on the size and proportion of the individual tenants’ spaces. For example (in theory), a multi-tenant building with 2 tenants is riskier (4x more) than a building with 8 tenants. Assuming the tenants’ proportionate share and base rent were the same for all of the tenants, if one of the two tenants in the 1st building were to default/vacate, it would result in a 50% reduction in the property’s net operating income; however, in the case of the 2nd building, the loss of one tenant would only result in a 12.5% decrease in NOI.
The subject property has 8 tenants, which occupy either 2,600 SF or 5,200 SF. Therefore, the loss of one tenant would only result in an 8.125% reduction in NOI, on the low end, and 16.25%, worst-case scenario. Risk is compartmentalized and minimized by the number of tenants, thereby creating built-in diversification. This validates the subject property’s cap rate as it relates to the average market cap rate and might even justify a slight reduction.
Length & Strength of Leases
When purchasing an investment property, one is essentially buying the leases and associated income streams, and the longer and stronger the leases, the better. Length and strength are interconnected. A lease that is “long” but not “strong,” meaning the lease language is vague, tenant-sided, etc. or the tenant is financially weak, is less valuable because the income stream is less reliable. Leases that are “strong” but not “long” are also less valuable because investors must factor in the possibility of vacancy losses when the lease terms expire along with the costs associated with securing another tenant, i.e. brokerage commissions, tenant improvement allowances, etc.
One exception to this rule is a situation in which the contract rents in the existing leases are below current market rents. The same concept applies, in that long-term leases with financially sound tenants maximize value from a risk mitigation standpoint; however, cap rates are applied to a property’s current net operating income, which is the sum of the various contract rents at that moment in time. In this case, a shorter lease term would be preferable because it would sooner provide the landlord with the opportunity to increase the base rent to the then market rate either by renewing the existing tenant or finding a new tenant. Application of the same cap rate to the larger net operating income would lead to a significant increase in value; however, a case could also be made to apply a lower cap rate depending on the length and strength of the new lease, resulting in an even greater increase in value.
I will use the subject property to demonstrate this principle. The property is currently valued at $4,160,000 based on a net operating income of ~$255,000 and a cap rate of 6.13%. At present, approximately 13,000 SF is leased at well-below market rents. After applying current market rates, the net operating income would increase by over $33,000 per year. Using the same cap rate would result in an increase in value of nearly $540,000 ($33,000 ÷ 6.13%). If the new leases are “long and strong,” a reduction in the cap rate might be justified; leading to even greater appreciation. For example, if 6% were used instead of 6.13% (a relatively minor change), the value would increase by an additional $10,000. For the subject property, the risk associated with some of the shorter lease terms is mitigated by the opportunity to increase the property’s NOI, and the potential losses/costs are offset by the resulting appreciation in value.
To be continued…
For more information on the subject property discussed in this article, please contact me at 703-943-7079 or Ryan@RealMarkets.com.