CorporateInsight December 2003

Net-Leased Investments Help Drive 1031 Exchange Market

The real estate investment industry fared well in 2003, including the net lease market. All indications are that 2004 will be just as active, provided that we don't have a spike in interest rates.

In fact, the biggest threat the investment sector faces is lack of product, not lack of demand. Retail has been one of the biggest players in the net-lease market (investors like the comfort of driving up and down Main Street to view their investments), but the office and industrial sectors are gaining ground.

While the stock market is showing improvement, it may cause some investors to reassess its investment value. But with bonds, CDs and money markets still yielding low returns, the net-lease market continues to look like a strong alternative. The security of bricks and sticks is a positive alternative since stock-market investments can be wiped out, leaving investors with nothing.

Single-tenant investments and triple-net-leased investment are gaining widespread appeal among 1031 and 1033 investors and others because they are not management-intensive. Both large and small investors are discovering that single-tenant net leases deliver a predictable income stream over the term of the lease. Purchase prices for these investments range anywhere from $500,000 to $100 million depending on whether you are looking for a single asset or a portfolio. Single-tenant properties are suitable for ownership by pension funds, REITs and individual investors.

Although net-lease investments can be attractive to a wide range of investors, like any financial decision, comprehensive due diligence can make the difference between a successful or money-losing venture. So consider these factors before investing:

1) The building's zoning, which differs from city to city, should always be considered prior to a purchase. For example, daycare tenants often secure a special-exception permit to operate on a residentially zoned property. But if that tenant goes bankrupt and moves from that location, the building is limited concerning the potential tenants that can operate their businesses from that property. As the building owner, your income stream could be negatively impacted.

2) Investment risk can be minimized if the space can be used by another company in its current use or retrofitted at a reasonable cost. This issue is generally more of a concern for the investors purchasing highly specialized properties, such as movie theaters or gas stations. The advantage of retail space in conversions from one concept to another is that the incoming tenant will usually bear the upfront cost for the conversion, lessening the risk to the investor.

3) Location, location, location are still the three most important words in real estate. That couldn't be truer for net-lease investors. Investment property should be located in and among other similar properties in that market. The market should also provide a strong assurance that other identifiable users would have an interest in the property. The most important factor is that the property be positioned in the path of growth for the local market.

4) If you are purchasing an existing location with a tenant that has had an operating business, always look at the sales history of that location compared with other units in the chain or the industry it operates within. As expected, high sales volume is a strong indicator that, if that tenant vacates, some other tenant would want to be at that location.

5) Consideration also needs to be given to the property's lease, which should allow the investor to pass through to the tenant all expenses for the property's operation and maintenance. This would include the tenant paying the following: taxes, insurance, utilities, common-area maintenance and repairs. This provides the investor a predictable income stream that is free from uncertainties.

6) While investors are fortunate to be buying a property that is leased, it is critical to ensure that the sale price reflects the tenant's ability to meet the terms of the lease. It is important that the cap rate be reflective of the risk that the buyer is willing to assume because of the direct relationship between net income and purchase price.

The higher the risk is that the tenant will not be able to meet the lease terms, the higher the acquisition cap rate must be. Although tenant credit risk is always an issue when investing in commercial real estate, an investor's active underwriting can help to minimize the credit risk.

Your investment advisor should be taking all of these factors into account as you search for investment properties. If, after taking all of these factors into account, you still believe you have a good investment property, the next step should be to submit a letter of intent and begin the purchase process.

  Jonathan Hipp is a senior vice president at Grubb & Ellis Co., specializing in net-lease investments. References to market data included in this article are obtained from Grubb & Ellis' research analysts who routinely track local and national trends in the industrial market. Click here to find out more about Grubb & Ellis's research .