Ground Leases Attract Passive Small-Cap Buyers - And Savvy Entrepreneurs As Well
November 06, 2012
As we reported at the beginning of the year, small-cap properties net leased to credit tenants are very attractive investments these days for buyers seeking reasonable risk-adjusted yields - and no active management responsibilities. Indeed, cap rates tied to net lease acquisitions have steadily narrowed for quite a few calendar quarters running to this point.
But a subset of triple-net investments - one that under some circumstances can generate better long-term returns than straight-forward fee-simple investments - has been attracting increased attention of late. It involves the trading of the dirt beneath structures that are owned and operated (via long-term leaseholds) by the merchants with their names on the doors.
Market values of land alone logically come in somewhat below what ownership of both land and improvements would fetch. And buyers just as logically expect a return premium for full ownership relative to ground leases.
Hence the historic differential in cap rates between ground leases and outright trades of land and net leased structures is typically in the range of 50 to 100 basis points depending on location, tenant credit, lease term and structure and related factors, notes active net lease investment broker Andrew Fallon, assistant vice president with specialty advisor Calkain Cos.
Well-positioned ground leases in major markets tend to trade at cap rates in the vicinity of 6 percent or a bit below these days, compared to roughly 6.5 to 7 for land and improvements subject to net leases. One potentially exploitable factor likely to generate outsize returns for the savvy small-cap investor is that full ownership of both land and improvements reverts to the landowner when the lease terminates.
Hence a forward-looking investor able to track down and land a replacement tenant (ideally with minimal retrofitting expenses) might be able to essentially secure ownership of a functional structure sooner rather than later - without really paying for it. Another strategic approach here is to actively trade in ground leases, insightfully buying and selling based on timing of built-in rental-rate escalations.
And when an existing tenant does opt to exercise renewal options again and again, the more typical passive high-net-worth individual playing this space today still owns land that should retain value throughout economic cycles, Fallon relates. Given that small-cap ground leases are mostly in high-traffic locations - and tend to trade in all-cash transactions - cap rates are generally less volatile than with leveraged real estate investments as interest rates rise and fall, he elaborates.
"The marketplace views ground leases as a very secure type of investment - even more than ownership of both land and (net leased) structures," continues Fallon, who has brokered deals for ground leases of properties occupied by the likes of 7-Eleven, KFC/Taco Bell, McDonald's, Chick-fil-A, Wells Fargo, Bank of America and others.
"The thinking is that if the tenant is willing to spend the capital on the improvements (knowing they'll eventually revert to the landowner), then it's a location worth committing to."
Long-term ground leases these days have exceptional appeal for high-net-worth individual investors tired of dealing with "tenants, toilets and trash" - and who also seek better fixed-income returns than today's dismal bond rates, and far less wealth-preservation risk than the stock market entails.
But again, given how NNN leases are structured, ground lease investing can also offer savvy small-cap real estate entrepreneurs opportunities to generate even better returns through active trading strategies - or embracing re-tenanting risk under the right circumstances.
Some look to buy ground leases a few years before the regularly scheduled five-year bumps in rental rates - then sell once the higher NOI kicks in with the improved revenue stream. Many of these active players then exchange on a tax-deferred basis into another ground lease, perhaps with 10 years remaining on the initial term - and repeat the process looking toward the next rent bump.
Other real estate pros boasting successful leasing and operations experience - and higher risk tolerance - might look to buy a ground lease with a relatively short lease period remaining, getting a higher cap for taking on the renewal risk. These players conduct plentiful due diligence on the location's performance for the tenant - and are prepared to re-market the facility they'll own upon reversion if the tenant opts to vacate.
Of course there's no guarantee the investor will be able to secure a replacement tenant matching the creditworthiness (and corresponding value enhancement) of the existing occupant - and that's where the local market expertise comes into play. Ideally a solid replacement tenant will also require only minimal custom improvements to the existing structure - which the investor has now secured with the price paid for the ground lease.
And if the existing structure isn't exactly compatible with what the prevailing marketplace demands, insightful real estate entrepreneurs might instead seek an acceptable new build-to-suit arrangement - or perhaps even pursue a higher and better use for the site.
Again as for pricing trends of late, cap rates for ground leases and net leased retail/restaurant properties have generally continued to compress. A report by Calkain and Chandan Economics pegs the June average for net leased properties generally at 7.1 percent, while specialty advisor Boulder Group calculates an average second-quarter asking price for net leased retail properties factoring to a 7.5 percent cap (down 25 basis points from the first quarter).
Boulder's average cap rate for ground leases for the second quarter was unchanged at 5.75 percent - nevertheless indicating strong investor demand given the sharply lower yield relative to full land/improvements purchases. The benchmark McDonald's price (land plus improvements) factored to an average cap of 4.8 percent - down 20 basis points from the previous quarter.
Fallon, who just sold a 20-year McDonald's ground lease in Fredericksburg, Va., for $2.9 million to an exchange-motivated buyer from California, notes that cap rates for ground leased to the giant hamburger chain range from the low-4s up to maybe 5 percent.
While most ground leases trade all-cash, banks of all sizes are willing to look at low-leverage recourse loans secured by these assets, Fallon notes. And some life companies are willing to lend non-recourse against ground leases where strong-credit tenants are involved.
Depending on that credit and the borrower's financial strength, five- and 10-year loans are generally available at rates below 5 percent - which can give a welcome cash flow boost when you're buying at a 6 cap.
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