Residual Value Analysis and Determination With Lease Term Remaining
Residual value is potentially the most critical aspect to consider when purchasing a net lease asset. However, it is also the most difficult aspect to forecast, because of the unpredictable nature of the variables that affect the value of an asset.
There are three main disparate scenarios that impact residual value:
- the property has a remaining term left on the lease;
- the property is vacant, or soon to be vacant, with high potential for market rental rates similar to the previous rent paid by a credit tenant;
- the property is vacant and has limited re-tenanting possibilities without drastically reducing rent or providing significant tenant improvement allowances.
Statistical analysis of net lease properties with 10 or fewer years remaining on the lease indicates that the cap rate of a property increases on average 8-9 basis points for each decreasing lease year remaining.
For example, a CVS property with 10 years remaining on the lease may sell for a 5.25% cap rate in a great location, while that same CVS property with 5 years remaining on the lease could be purchased for a 5.65-5.70% cap rate.
The lease term remaining on the property will have a significant affect on your buyer pool and the value of the property. Net lease properties with strong tenants are significantly more valuable and attractive to net lease investors with 10+ years remaining on the lease.
Credit of Tenant
Tenant credit, or potential replacement tenant credit, is critical to projecting residual value. Properties in high density retail corridors with traffic counts above 40,000 have a strong likelihood of attracting, or retaining, national tenants. The best outcome is that a strong national tenant, like 7 Eleven, extends their lease under the original terms and maintains the high credit rating they had when the property was purchased.
A tenant with a BBB (S&P) rating has a 4.26% chance of defaulting over a 10 year period. In contrast, a S&P B Rated tenant has a 26.36% chance of default over the same period.
You should monitor your tenant’s, and its competitors, financial position throughout the lease term to get ahead of any potential downgrades and vacancies, and understand their position in the industry.
Shameless plug! That’s precisely what Confidant Asset Management does.
Macroeconomic Market Conditions
Interest rates and market confidence are directly correlated to the cap rate of net lease properties due to their ability to slow down, or speed up, real estate transaction volume. Consistent interest rate hikes (all else being equal) will lead to an increase in cap rates for net lease properties as investors look to place their money in alternative investments.
This can inhibit your ability as a net lease property owner to liquidate your asset. This effect is especially pronounced in tertiary markets.
Predicting the actions of the Federal Reserve is impossible, as the last 12 months have shown us, but investors should pay close attention to the long-term benchmarks set by investment banks and the Federal Reserve for interest rates on the 1, 5, and 10-Year Treasury Bonds. The typical spread between capitalization rates for retail, office, and industrial properties and the 10-Year treasury floats between 380 to 450 basis points. A correction is likely when the spread compresses to less than 200 basis points as it did in 2006 and 2007.
The constant monitoring of your tenant and overall market conditions is critical to effectively exiting your investment at the point of highest value.
Things to consider when you expect to own vacant building in the near future will be discussed in a following article.