4 Essential Questions to Ask Yourself
Many investors mistake net lease assets to be zero-maintenance investments. Compared to other asset types, net lease investments are at the low end of the scale in terms of building maintenance, but they still require attention. While investors’ landlord responsibilities for the actual property are minimal compared to a multifamily building, it is still important to oversee the investment itself. Similar to how a stock investor proactively monitors the companies and industries they own shares in, a commercial real estate investor should periodically check in on their investment too. Monitoring investments allows landlords to spot red flags early, providing them with the time needed to divulge and possibly implement a back-up plan before any major damage occurs.
The first step in monitoring a net lease investment is getting to know the property inside and out, and that means understanding who the tenant is and how they operate. To minimize the risks involved with net lease investments and to better prepare for the future, here are crucial questions every investor should know the answers to and why.
Who Guarantees the Lease on Your Property?
There are two types of operators that could be on the lease of a net lease investment: corporate or franchisee. The easiest way to find out if an operation is owned by a corporate or a franchise operator is to look at who signed the lease. Both guarantees have positive and negative aspects to them, and it is important to understand the difference to better assess your tenant’s strengths and weaknesses.
Investing in a property that has the name of a large corporation behind the tenant would appear to be a no-brainer: the investment is secured by the corporation’s assets. With a corporate backed lease, the landlord has the benefit of being able to access the tenant company’s 10k, assess how that company is doing, determine the amount of assets guaranteeing the tenant’s lease, and see into the performance of the company. Without this information, or the tenant’s revenue, the health of the tenant is purely speculation.
Unfortunately, for many net lease retail landlords, the safety net of having a corporate backed operator as a tenant may just be an illusion. Jiffy Lube, Carl’s Jr., Hardee’s, Applebee’s, and Burger King are examples of corporations that operate less than six percent of their sites. A number of corporations have a 100 percent franchise model, although they may guarantee the lease for some locations. This means that while lease payments may be issued from a corporate parent account, the actual tenant is a much smaller company. As such, the security of rental income depends entirely on the tenant’s ability to generate enough revenue to make the monthly payment and the landlord will have no insight into how the operator is performing. This is why it is important to thoroughly read the lease and truly understand who is responsible for payment.
While smaller operators may have fewer assets to back their leases, they are more likely to report direct store-level sales to their landlord. With this information, a landlord may keep running tabs on the business’s financial health, and remain confident that the operation will continue to make its monthly rental payment. The issue of receiving monthly sales volume reports is sometimes a tug-of-war occurs, as tenants seek to keep store sales tallies private, perhaps as leverage in seeking rent concessions. However, the landlord needs to prevail or they risk jeopardizing the security of his or her investment in the property.
What is the Financial Strength of Your Tenant?
For an investor, a tenant with a substantial amount of assets provides a safety net for any defaulted lease payments. Verifying that the tenant has the assets available to cover defaulted payments guarantees that in the event the tenant misses any payment(s), the property landlord will be able to sue the company for any rent owed. On the flip side, it is highly unlikely a landlord will receive compensation from a tenant with insufficient assets to ensure payment, and they will probably be left with just a vacant building.
It is common for small operators to sign a one to three-unit guarantee on their lease and then sell off their company-owned real estate. This practice leaves the retail operation itself as the only guarantor of the lease, with no assets to back it. Without a personal guarantee tied to the lease, an operator can walk away from their operation, free of any penalties. In this case, the landlord’s only remedy is to seek the value of the tenant’s defaulted payments through liquidation of the operation’s business assets.
Is Your Tenant Engaged in Strategies That Affect Your Property’s Value?
No matter who the guarantor is on a lease, it is important to pay attention to any movement in the tenant’s business. Landlords frequently fall into a false sense of security with their tenant because the rent payments are being made every month. They often forget about the possibility of their tenant leaving the site.
For both franchisee and corporately-operated stores, landlords need to keep track of the financial moves of their tenant and their tenant’s competitors. This includes expansions, consolidations, renovating, re-locating, acquisitions, sales, store closings and in particular, the selling of operations. With this information, a landlord has a greater understanding of the tenant’s operating environment and can better predict future financial performance of their specific site.
It is not uncommon for a company to sell their operations to other, sometimes smaller, operators. In such instances, the guarantee of the lease changes. This could affect the value of that guarantee positively if backed by a larger operator, or negatively, if the size of the guarantee is reduced.
Sometimes a tenant will only want to sell off the operations in a certain region. In doing so, a tenant will usually package a mix of desirable and undesirable operations together as a portfolio. To attain the desirable locations, the operator who buys the portfolio is coerced into purchasing the undesirable locations. After the sale, the operator will typically try to shed the less desirable sites if they are not advantageous to hold any longer. This puts landlords of those sites in a precarious position. Thus, if a tenant is actively involved in acquisitions or dispositions, the security of your investment is much less certain than with a stable tenant.
Often, if not written into the lease, landlords may not even be notified if an operator sells their business. The language written into the lease will outline whether the tenant is required to notify the landlord if they decide to sell their operations. If the lease was written by a good lawyer, the language may allow the tenant to sublease with consent of the landlord but there are many clauses that do allow tenants to sublease without landlord consent or notification.
Is Your Property Re-Tenantable?
With the pace of change in the retail landscape, a property owner must have a strategy in place for replacing an existing retail operator beyond simply believing that they’ll find a tenant to backfill their location when that time comes. Without a plan to re-tenant, even owning a property with a tenant that has favorable terms can still be risky for landlords.
Over the last five years, Goodyear surprised more than 500 landlords with store closures. Investors who had kept up with industry news were aware of their tenant company’s strategy and were able to arrange back-up tenants to minimize the financial impact. On the other hand, vulnerable landlords were presented with the challenge of trying to re-tenant vacant auto service properties while they were still responsible for property taxes and other costs. The vulnerable landlords ended up having to sell the building vacant for a fraction of what they could have sold it for when it had a lease.
Up-sizing and building a “relocation store” in the same market is another retail store trend. If a tenant is over-performing in a smaller retail operation, they may move down the street to reopen with a larger footprint. In their smaller markets, where land is inexpensive, Family Dollar has found success with this practice. Often times, Family Dollar will have a developer build them a new store nearby with an additional 2,000 square feet of retail space on a lot with 50 percent more parking, and the only cost will be a slight increase in rent. Up-sizing leaves a landlord in a precarious situation: losing the tenant wipes out rental income and reduces the assessed value of the property. Finding a replacement tenant is challenging when the dominant operator has just opened a larger store in the immediate market area.
As with any investment, an owner of net lease properties needs to stay highly informed of current tenant trends and have a strategy in place to replace a tenant – no matter how good the lease may be.
While answering these questions will give you a clearer picture into the health of your tenant and the level of risk your investment holds, there are always other factors to consider. Make sure to periodically check in and monitor your investment for any indications of trouble. Where there’s smoke, there’s usually fire, so if you start to see red flags pop up, spring into action and implement a plan to help minimize future loss.
Matthews™ is actively engaged with both corporate and franchisee operators across the country, staying up to date with the latest data, trends and news of store closures, mergers and more. In the case that you were not able to answer the questions above, or have other questions regarding your investment, our specialized agents are equipped to help find you the answers and solutions you need.
For more information regarding your net lease investment, please reach out to: Dalton Barnes