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Greater Interest in Alternative Investments

Net-leased real estate getting closer looks.

December 18, 2008
by Robert Mathers, CPA, PFS and Edward Coyle

As more and more investors become frustrated with seeing their stock and bond portfolio values plummet and suffer the daily angst of triple digit swings on Wall Street, there is a renewed interest in conservative Alternative Investments. Alternative investments, generally speaking, are investments that are considered outside of the traditional asset classes of stocks, bonds and cash. Examples of alternative investments include real estate, commodities, options and financial derivatives. Alternative investments are often used by hedge funds. One of the old tried-and-true alternatives is bricks and mortar, i.e. real estate. Of the entire spectrum of real estate investments available for purchase there is a property type that has been overlooked by most high-net-worth (HNW) individuals — Net Leased properties.

Net-Leased Real Estate

What is net-leased real estate? These are individual properties that are leased, for the most part, by credit tenants on long-term leases of 10 years to 25 years. The term "net leased" means that the tenant is responsible for all operating expenses — real estate taxes, building insurance, utilities and building and ground maintenance. In other words, the investor has little, if any, management responsibilities, always problematic for an individual without the time or inclination to deal with tenants or maintenance issues.

For whom is leased rental real estate suitable? Many alternative investment classes are suitable for ordinary investors. However, due to illiquidity, high risk or other factors many alternative investments are reserved only for "Qualified Purchasers", or those with at least $5M to invest. Other investments may be reserved only for "Accredited Investors," or those with $1M net-worth or income greater than $200,000.

Net leased real estate may be a sensible way of diversifying an investment portfolio and can not only minimize exposure to risk but is also a strategy to generate constant, stable and predictable monthly/annual income with added tax benefits potentially derived from depreciation and interest expense deductions. Note that the investors must contact his/her tax advisor for the determination of whether the passive activity loss rules may apply.

Types of Net Leases

Not all net leases are the same so here is a quick tutorial. Absolute and Triple Net are terms that refer to the tenant paying all costs of the lease including the building structure, roof and parking lot replacement. This is in addition to taxes, insurance and common area maintenance (CAM). Double Net has the owner/landlord ultimately responsible for the roof, structure and parking lot replacement. The term net lease can have varying meanings and a close reading of the lease will determine who is responsible for what.

Investment real estate values are expressed in terms of Capitalization Rates commonly referred to as "Cap Rates". By definition, a Capitalization Rate is "any divisor (usually expressed as a percentage) used to convert anticipated economic benefits of a single period into value." Many times, this divisor is computed by accumulating differentials of risk associated with the stream of economic benefits being analyzed. Generally speaking, with respect to the economic benefit stream of a real estate investment, a pretax cap rate is the Net Operating Income (NOI, net income less all expenses before debt service), divided by the purchase price. Or conversely, the NOI divided by the cap rate will be the purchase or selling price. Cap rates, associated with a real estate investment are a measure of several determining factors:

  1. the credit rating of the tenant;
  2. terms of the lease such as triple-, double- or single-net, length of the lease tenure, increases in rent during initial term;
  3. cost of financing;
  4. location;
  5. age of property;
  6. condition of property upon purchase; and
  7. long-term viability of location and building.

A property with strong measures of the above will trade (sell) for a low relative cap rate reflecting the strength of the overall investment, the higher the cap rate the greater the risk.

The good news for anyone looking to purchase a net lease property at this time is that cap rates are rising making it more affordable for those looking to make a purchase in the near future. Re-pricing is happening across the board as lenders tighten equity requirements (30% is not unusual) meaning there are fewer qualified buyers for properties thus more properties available. For example, a brand new Walgreen’s location that was selling for a six-percent cap nine months to 12 months ago can now be bought for a 6.85 percent to 7.15 percent cap. The higher the cap rate, the lower the valuation.

Conclusion

There are dozens of net-leased properties available at any one time and most are brand new construction with fresh long-term leases. They are available all over the U.S. A qualified, seasoned commercial real estate professional who will represent a buyer’s interest should be consulted when searching for a property that meets an investor’s goals and needs. There have been many millionaires made in real estate. If suitable for the investor, the asset class can add stability and income in a volatile market.

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Robert Mathers, JD, CPA, PFS, ABV, is President & CEO, Clifton Gunderson Wealth Management providing comprehensive wealth management integrating a RIA, broker dealer, general insurance agency with a CPA firm for tax and assurance services. Ned Coyle is an Investment Specialist with CB Richard Ellis Group with a concentrated emphasis of net leased property brokerage of assets and is a contributing writer of WMI. Coyle is an Investment Specialist with concentrated emphasis in the practice of single tenant, net leased property brokerage of assets located throughout the U.S. He has three decades of commercial real estate experience. He also has extensive understanding of valuation analysis and enhancement and has worked in REO sales on behalf of a former Toledo savings bank (absorbed by the RTC); Trustcorp Bank (now Key Bank) and Bank One, Columbus. Ned has successfully completed assignments for local, regional and national corporations, high net worth individuals and REITís. Ned joined the Toledo affiliate office of CB Richard Ellis Group, Inc. in 2007 when Michael Realty Company was acquired by CB Richard Ellis