Chad Kurz Discusses How to Optimize Net Lease With GlobeSt

Look Beyond the Cap Rate

Two different deals with equal cap rates may appear the same, but they rarely carry the same risk or upside potential.

Take two restaurant properties offered for sale; they are in a similar market, with a similar purchase price ($3MM), and a similar cap rate being offered (5.50%).The first property is a small drive-thru only building that can be purchased above replacement cost. It is paying substantially higher rent than market, and operates at a much lower EBITDAR coverage ratio. The second property is paying below market rent; and operating at a much higher EBITDAR coverage ratio. The downside of the first property is substantially higher, and the upside of that property is also substantially lower. It makes no sense that both assets will trade at the same price and the same cap rate, yet they do. As investors analyze deals, it is important to look beyond the cap rate and purchase price, explains Kurz.

Learn from Past Mistakes

Many investors focus on the quality and prestige of the tenant rather than the real estate fundamentals, but the physical asset is more important than the tenant alone.

Buyers today, individual investors, family offices, DSTs, and large institutional investors, are making the same mistakes they have made in past decades. They purchase property based on the credit of the tenant and the length of the lease with little regard to the actual underlying real estate. As the lease term burns down, the credit of the tenant downgrades, or the tenant reduces rent or vacates, they lose a substantial amount of their initial equity. “If anything, the mistakes buyers are making today are worse than in the past,” says Kurz. “Twenty years ago, a premier credit tenant was at least located on a great corner, even if it was a challenging box to re-use. Today, some of the premier credit tenants are in challenging boxes to re-use, and they’re also located in undesirable locations.”

Consider Shorter Lease Structures

One of the other concepts buyers don’t understand is that higher interest rates and post-Covid inflation have had a major impact on new construction assets. Chad Kurz explains, “higher interest rates mean that developers are building at higher cap rates, and inflation means it’s more expensive to build. This has caused rent for new construction properties to be significantly higher than where they were just 5 years ago.”

Understanding the nuances of net lease provides owners and brokers great opportunities in today’s market to manage their portfolio.