Net Lease properties derive a significant portion of their value from the quality of the income stream associated with the lease. For a majority of net lease owners, preserving their income stream from an investment grade tenant is the most critical aspect of ownership.
Tenants know this and sometimes leverage it by threatening to vacate the property, or significantly reduce rents, in exchange for exercising their renewal options.
Tenant’s leverage becomes more significant as notice periods shorten. Recent trends in leases signed with developers have seen decreases in notice requirements from twelve months prior to lease expiration to six months. Six months is simply not enough time for a landlord to build a plan to adequately replace a tenant, and it usually results in the acceptance of the tenant’s lowball offer. Landlords should thus alter their expectations from “my tenant will exercise their option as outlined in the lease” to “my tenant will threaten to leave my location or request a rent reduction at the option renewal period”.
This seemingly dire situation can be prevented, or at least mitigated, with careful planning far in advance of the six-month deadline. We conduct property analyses on an annual or bi-annual basis during the entire term of the lease. This is critical to ensure that the tenant is performing at the same quality they were when you purchased the property. However, our reviews during the final five years of the lease pay closer attention to additional items that provide a better understanding of our client’s position in the market.
We have outlined this process below:
Schedule a property conditions assessment (PCA)
Property conditions assessments are conducted by licensed professionals and engineers. An engineer will conduct an in-person walk-through at your property to inspect physical conditions. PCA reports provide a full analysis of the physical conditions of your property, and should find any deferred maintenance issues with the roof, structure, parking area, or HVAC to hold the tenant accountable for their lease responsibilities, and provide landlords with an understanding of potential expenses over the next ten years. They also provide a single point of reference for a large portion of important zoning and municipal information.
Conduct a site tour and meeting with the store manager
This meeting may be conducted at the same time as the PCA. These meetings are important to ask questions about store performance, employee turnover, and how the manager feels about the company. Front-line employees are the first to notice signs of internal trouble and provide valuable insight into location performance.
Reach out to the real estate representative for site selection in the local market
Call or email the internal real estate representative for the tenant who covers your market. Build a relationship with them and gain a better understanding of what sites they are currently looking at in your market. Drive-thru? Signalized corner? 2,000 square feet? 4,000 square feet?
Reach out to local brokers to gauge activity in the local market
Local brokers have invaluable insight into the market around your property. They will be able to provide information on leasing activity, market rents, and new developments.
Conduct a market rent analysis for new construction properties and existing properties
Using CoStar is not, in our view, a reliable way to perform this analysis. Instead, other property owners should be called to hear first-hand accounts of rental rates being received in the market for new construction and second-generation spaces.
Review the tenant financials and performance at the site
Tenant financials should be reviewed on a bi-annual basis to detect any shifts in corporate strength. Credit rating agencies provide a good benchmark, but should not replace a review of the tenant’s ability to continue as a going concern.
Monitoring a tenant’s bond issuance, yield, and fair market value of existing debt are other important metrices to monitor. The bond market is more responsive to changes in risk than real estate. An increase in the yield of corporate bonds may indicate an expected decline in tenant performance going forward.
Perform a void analysis to determine viable replacement tenants
Void analyses are an important tool for landlords to understand their property’s position in the market. Void analyses analyze the number of locations tenants have in the MSA where a property is located vs. the number of locations a tenant has within a radius around your subject property.
For example: Chase bank may have 120 locations in the Washington D.C. MSA, but only 1 within a twenty-minute drive-time of your property in Fairfax, Virginia. They would likely be interested in leasing your space because they have a “void” in your submarket with only one location nearby. This is obviously contingent on their expansion plans, the size of your lot, rent you need to achieve as a landlord, and layout of your building.
Void analyses provide a starting point for leasing outreach, and a high number of quality tenants with a void in your sub-market will likely lead to a condensed timeframe to replace your current tenant.
Determine the risk of nonrenewal and leasing
After the foregoing, you are better positioned to determine whether your tenant will be likely to renew with the current structure outlined in the lease, whether they will renew with a rent reduction request, or whether they will close your location altogether. This step is critical, and it is important to reach a conclusion that is “more than likely”, not the “best case scenario with the help of a couple of Hail Mary’s”. You must be realistic and honest with yourself, or you will be left with a property that has lost significant value and income.
Develop a plan and desired outcome for option renewal
The final step is to build a plan. The range of strategic moves is significant and is entirely dependent on the specific aspects of an individual property, market, and lease. There is no “one size fits all” strategy, and your strategy may change periodically in the last five years of your lease. It is important to reevaluate a net lease property’s position on an annual basis.
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