Is price per square foot overrated?

Presently, we are sourcing properties for a client who wants unencumbered cash flow with no landlord responsibilities.

Ideally, our client would enjoy a hassle-free check each month — without the need to fix the roof, mow the grass, or pay the property taxes. This type of agreement is known as an absolute net lease.

Please don’t confuse an absolute net lease with a triple net lease. Sure, there are similarities but they are different – fodder for another foray. Fortunately, our client is not geo-sensitive. They will consider properties throughout the U.S.

Preferably, the new holdings will be located in a minimal or zero income-taxed southwestern state. Our alternatives are limitless! But in pouring through scores of offerings, we’ve considered several metrics. Indulge me while I review a few.

Price per square foot

Single-tenant net leased investments also known as STNLs abound. Dollar Generals, Caliber Collision, DaVita, Harbor Freight, Tractor Supply, Starbucks, Taco Bells are all available throughout the country. Most provide returns in the 4.5% to 6.5% range.

However, the resulting price per square foot of the improvements is staggering. We looked at a mini-hospital in an Austin suburb priced at over $1,000 psf! Wow! And no beach in sight.

So what’s the big deal? Only this. Assessed is your property tax basis on the price you pay. So long as there is a viable tenant springing for them – no problem. But if your tenant bolts – big problem. You must now release the building with a rent that replaces your return.

Capitalization rate

Simply: The net rent the tenant pays divided by your purchase price. Easy? Sure.

Here’s where it can get tricky. What if the rents exceed the market? Once again. If your occupant lives out the term and pays you as agreed – awesome! But if faced with the task of originating another tenant – hmmm. Best make sure you understand market rents.

Term of lease

For our client, the longer the better. He wants 10-15 years of sustainable income. However, key to consider are the increases in rent throughout the term.

Many drug stores such as Walgreens and CVS sign multi-year leases with multiple options to renew. Great! But, in some cases, the rent throughout the term remains flat. Therefore, no income growth occurs.

If you’re comfortable with the net amount each month, OK. But just remember, the future value of your investment is a formula of net rent and the return an investor will pay.

Cash flow

Our folks are paying cash. No need to originate debt for the buys. Thus, cash flow is simply the amount of net rent received by the tenant each month.

However, if your purchase includes debt plus equity, cash flow is more complicated. Borrowing money to buy real estate is known as leverage. But the interest rate in which you borrow must be considered.

Negative leverage occurs when your borrowing rate exceeds the capitalization rate. Deteriorated is the percentage return on your equity.

Strength of the income

In my opinion, this is the MOST important consideration.

We looked at a manufacturing operation in the Midwest. Price per square foot – check. It was well below all the sales in the area. Cap rate – another check. North of 7%. 15-year lease? Three checks in a row. Plus rent increased throughout the term by 3% per year.

Cash flow was amazing because our capitalization rate was great. But … the tenant was in the exhibit business and provided large displays for conventions. Hmmm. I’m guessing sales aren’t so hot in the year of the pandemic.

Generally, a premium is paid for strength. The market prices the strength by a lower return. Sound strange? Just think in terms of U.S. treasuries. With the full faith and credit of the U.S. government, you can expect a whopping .563%. Now you understand why people invest in commercial real estate.

Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at [email protected] or 714.564.7104.

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