Catch Business with Triple-Net Leases

Despite the economic downturn and the fact that many aspects of the commercial real estate industry still need time to season before true recovery takes place, some niche segments of the market are actually performing extremely well. In fact, some are at the same level they reached at the height of the market. Triple-net-lease investment properties, in particular, may be a true bright spot on the commercial investment horizon. Here’s why.

Triple-net-lease properties are probably some of the most commonly noticed commercial real estate in the market. Most of the assets are drugstores, bank branches, restaurants, home-improvement centers and the like. These are core assets that have daily users and requirements. Typically, they are single-tenant buildings where, through the lease structure, the tenant is responsible for the taxes, insurance, and maintenance and management of the building — the three “nets.”
Investors have a strong appetite for passive income in today’s market, as there are few alternatives for them to receive a return that is equal to or better than what netlease assets provide. Additionally, it seems that lenders are becoming more comfortable with the asset type — many transactions in today’s market are using some sort of lender-provided leverage.
Mortgage brokers are an integral part of the lending process for net-lease investments, especially because one lender won’t provide the best rate and terms for a particular investor every time. Brokers who want to increase their business in this asset class should understand what goes into funding triple-net-lease properties and be aware of the market’s emerging trends.

Like in any underwriting process, lenders consider the real estate’s value first. With net-lease investments, however, the current tenant’s credit also is weighed heavily.
Because tenants occupying single-tenant buildings typically sign long leases — sometimes for as many as 25 years or more — lenders want to know who is actually paying the rent to support the property for that long. Therefore, the underwriting of the tenant’s credit becomes a key factor for lenders considering net-leased assets.
There is some standardization for rating tenants, which comes primarily from credit-rating agencies such as Standard & Poor’s (S&P), Moody’s Investor Service, Fitch Ratings, etc. These agencies each have their own alphanumeric system to report how a particular company is performing from a credit perspective. S&P, for instance, has ratings that begin at AAA as the best-possible credit and incrementally go down to D.
In today’s lending environment, net-lease tenants with an S&P credit rating of BBB or greater have a better chance of getting a lender’s attention because they are seen to be less risky. Tenants with credit ratings less than BBB are perceived to be more likely to default over the term of the lease.

In fact, a Moody’s study quantified this phenomenon, stating that companies with a BBB- credit rating have a 4-percent chance of defaulting on their lease within any five-year period. Conversely, a company that has rating of B- has a 43-percent chance of defaulting on its lease within the same period. As a matter of comparison, companies with AAA ratings have a 0.15-percent chance of defaulting. It is pretty clear why lenders focus their underwriting on the potential tenant’s credit.

Although mortgage brokers unfamiliar with this asset class may think this type of debt comes from sophisticated sources housed in a class-A skyscraper on Wall Street, the vast majority of loans for netlease investments come from banks.
Real Capital Analytics, a market-research company, recently reported that 51 percent of single-tenant acquisition transactions completed to-date in 2010 came from a traditional bank. It also reported, however, that 40 percent came from a national bank and 11 percent was from a regional or local bank.
It seems that when a recession hits, the lending environment changes to a point that sophisticated financing instruments are no longer needed to drive the market. Instead, individual relationships between borrowers, lenders and their conduits (i.e., mortgage brokers) are the primary source of transaction volume.
In addition, Real Capital Analytics reported that 30 percent of the transactions completed this past year used existing financing that was assumed by a new buyer. Anecdotally, investors active in the market at the beginning of this year did not have as many sources of capital. Those who made purchases that required financing were given financing quotes that were outrageous and did not allow the transaction to make sense to the investor. Therefore, they assumed the debt from the previous owner because the terms and interest rates were more favorable than the market at that time. Sourcing debt for net-lease investments is becoming easier, however.

Single-tenant properties have become so popular this past year that they comprised roughly 35 percent of all commercial real estate transactions completed in the first two quarters of the year, according to data from Real Capital Analytics. By comparison, when the market was at its peak in 2007, only 20 percent of all transactions included the asset class.
With more than $425 billion in total commercial sales in 2007 — which included $85 billion in single-tenant sales — compared to $35 billion in total sales for these past first two quarters — which included $12.25 billion in single-tenant sales — it is apparent that with fewer transactions, more people are steering toward stabilized and lower-risk properties.
Capitalization rates — or cap rates — are a quick snapshot of an investor’s return. In today’s market, cap rates are roughly 6 percent to 8 percent for creditworthy properties. When a basic comparison is made using other passive investments, it is fairly clear why investors are seeking to put their capital to work in the property type.
Most investors who have cash available to make passive, nonspeculative investments are using basic money-market or savings accounts to hold the cash. When returns for those investment vehicles hover around 1 percent, the investor is motivated to find alternative investments for that capital while also maintaining a steady and safe cash flow over a period of time. Netlease properties are filling that void.

There are different periods where lenders will have a strong appetite for a particular tenant and less so for other tenants, and this changes over time. Brokers who stay on top of these kinds of trends in their markets and leverage their relationships with lenders can help clients find the best rates and terms at any particular moment.
As an example, Walgreen Co. drugstores — a common triple-net-lease tenant — have an S&P credit rating of A+. As such, lenders are comfortable with these stores’ credit and viability as a longstanding tenant. At the beginning of this year, however, there were more than 450 Walgreens stores available for purchase as netlease investments.
Because most investors need financing to purchase a single store and the average sale price for a Walgreens store is about $5 million, mortgage brokers were engaged to find the best debt. Lenders, however, found that they had too many Walgreens loans on their balance sheets and started to slow down the distribution of debt for that tenant. Brokers show their value in these scenarios by finding other lending sources that aren’t as saturated with one particular tenant.
Supply and demand dictates the rate and terms of a particular tenanted-occupied building. Because of their popularity, Walgreens investments typically garner a higher interest rate. Other companies that have S&P credit ratings of A+ and similar lease terms, but higher price tags and therefore fewer buyers may have substantially lower interest rates.
Lenders, therefore, dictate rates and terms based not only on the tenant’s credit, but also on subjective factors that move markets in different directions at different times. Mortgage brokers should be cognizant of these trends and have their arsenal of lending sources available for their clients as market indicators change.

Net-lease properties have proven to be a strong asset class in this recovery-drivenmarket. Lenders are seeking assets for their portfolios to maintain strong balancesheets. It’s always better to have a stabilized net-lease investment earningincome for the lender and the investor on the books as opposed to vacant, speculativeland that likely has an undetermined value for future development.

Mortgage brokers who focus on this assetclass can take advantage of the new,demand for these properties, as they aresome of the only properties getting funded,with rates and terms last seen at the height of the market.

Real Estate Premium Near Record to U.S. Bonds Signals Time to Buy Property

via Bloomberg News
Sep 1, 2010 , By Hui-yong Yu -- U.S. commercial real estate yields are near the highest level relative to Treasury bonds on record, a signal to some investors it’s time to buy property.

Capitalization rates, a measure of real estate yields, averaged 7.22 percent in the second quarter, based on an index calculated by the National Council of Real Estate Investment Fiduciaries. That was 429 basis points, or 4.29 percentage points, higher than the yield on 10-year government bonds as of June 30, according to data compiled by Bloomberg. It’s about 475 basis points higher than Treasury yields as of yesterday.

That spread is near the record 539 basis points in the first quarter of 2009, when the U.S. was mired in the worst of the financial crisis and property prices sank. Risk-averse investors are seeking the highest-quality office towers, hotels and apartments as the gap widens, according to Nori Gerardo Lietz, partner and chief strategist for private real estate at Partners Group AG in San Francisco.

“The data indicate that real estate is poised for a rebound,” said Gerardo Lietz, who advises pension funds on property investments.

Some buyers already are acquiring buildings at lower cap rates, which move inversely to price. In June, a group of South Korean pension fund investors bought the 33-story Wells Fargo Building in San Francisco for $333 million from Principal Financial Group Inc. in one of the largest transactions in the second quarter, according to Real Capital Analytics Inc., a property research firm. The office tower sold at a cap rate of about 7 percent, said Goodwin Gaw, the developer who helped broker on the deal.

New York Rates

In Manhattan, RXR Realty LLC bought a stake in 340 Madison Ave., a 22-story office building, at a cap rate of 6 percent, according to New York-based Real Capital. Cap rates are calculated by dividing net operating income by purchase price, so the lower the rate, the higher the value of the property, and vice versa.

The NCREIF index measures 6,066 U.S. properties with a market value of $234.5 billion. The spread over Treasury yields was calculated using transaction cap rates, which are based on actual sales -- 48 in the second quarter -- and are usually more reliable than appraised values, according to Chicago-based NCREIF. The organization’s measure, which it began publishing in 1982, represents current yield before any price appreciation.

Comparing Yields

Investors compare property yields with Treasuries to determine how much potential profit real estate offers relative to an investment that’s considered low-risk. The spread shrank to less than 80 basis points, the narrowest in 16 years, when commercial real estate prices peaked in 2007. Property values have dropped more than 40 percent since the October 2007 top of the market, according to Moody’s Investors Service.

The gap’s widening follows a plunge in bond yields after the global financial crisis spurred a flight to safety and the Federal Reserve slashed interest rates to a record low. Treasury bonds yesterday completed the biggest monthly rally since the end of 2008 amid signs economic growth is faltering, with the benchmark 10-year note yielding 2.47 percent.

“Property is attractively priced versus the fixed-income market,” said Ritson Ferguson, chief investment officer of ING Clarion Real Estate Securities in Radnor, Pennsylvania, which manages about $12 billion.

The wide spread carries a warning signal to some investors because the economy remains weak, hurting commercial rents and occupancy.

Being ‘Picky’

“It’s questionable how much growth you’re going to get,” said James S. Corl, managing director for distressed real estate investments at Siguler Guff & Co., a New York-based private- equity firm. “Yes, there is value in real estate but you’ve got to be very picky. If you pay up for existing leases, it’s very hard to manage your way out of that situation.”

For much of the past two decades, institutional real estate was valued at about a 9 percent cap rate, according to Jeffrey D. Fisher, a consultant to NCREIF and a real estate professor at Indiana University in Bloomington, Indiana. Cap rates on some commercial deals fell to less than 4 percent during the peak.

The rate declined in the second quarter as transactions began to increase, he said.

“What I’m seeing is a two-tiered market right now,” Fisher said. “For properties that have high occupancy, that’s where you really have seen the price appreciation and cap rates falling.” For buildings with low occupancy rates, “there is very little interest,” he said.

Sales Rebound

U.S. sales of office, retail, industrial, apartment and hotel properties totaled $20.7 billion in the second quarter, according to Real Capital. That was up 86 percent from $11.1 billion a year earlier.

The deals were still 85 percent below the peak of $135.7 billion in the second quarter of 2007, Real Capital data show.

Corporate bond yields are a better comparison than Treasuries and also indicate that properties are undervalued, said Michael Knott, managing director at Green Street Advisors Inc., a Newport Beach, California-based company that specializes in analyzing real estate investment trusts. Bonds rated Baa by Moody’s are perceived as investments with moderate risk, similar to commercial real estate, said Knott.

The spread between NCREIF real estate cap rates and Baa- rated corporate bonds is more than 200 basis points, Knott said. The average during the past 25 years is about 140 basis points.

“Underlying real estate looks cheap to us relative to where moderate-risk corporate bond yields are priced,” Knott said in a telephone interview. The exception is publicly traded REITs, which trade at a premium to asset values, he said.

“Smart managers today are being very selective because they realize a lot more property has to clear the market,” said Corl of Siguler Guff. “The volume of deals is definitely going to go up.”

Commercial-property values continued to rise in March

They were up by almost 15% since hitting lows in May
April 11, By Dan Jamieson -- The commercial-property markets continue to firm up: The Green Street Advisors Commercial Property Price Index rose by 2% last month, continuing a trend of higher values since prices bottomed in May.

Property values have now risen by almost 15% since hitting their lows in May, according to Green Street Advisors Inc., but values are still off about 30% from their late 2007 peak.

“Pricing has been firming since the middle of "09, especially in the last six months,” Mike Kirby, the firm's director of research, said in a statement. “Sellers are feeling less pressure to act, the outlook for fundamentals has become clearer, well-capitalized buyers are becoming plentiful, and return requirements across capital markets have come down.”

The independent real estate investment trust research firm claims that its index is more timely than other gauges of the commercial-property market. Green Street's index tracks high-quality properties valued at a total of more than $300 billion, estimating private-market values of real estate held by REITs.

The firm also incorporates information from brokers, REIT executives and market participants, and uses data from closed transactions.

And in another sign that the hard-hit property sector may be recovering, apartment rents rose 0.3% during the first quarter, the first gain in five quarters, according to a separate report from Reis Inc., a real estate research firm.

E-mail Dan Jamieson at djamieson@investmentnews.com.

Yale Cuts Hedge Funds to Hold More Private Equity, Real Assets

March 19 (Bloomberg) -- Yale University, whose endowment is the top performer in the U.S., is cutting its target allocations in hedge funds to allow for bigger stakes in private equity and real estate, the asset classes that hurt the fund last year.

Yale boosted the fund’s private equity target to 26 percent from 21 percent and its real assets allocation, which includes real estate and commodities, to 37 percent from 29 percent, at its June 2009 investment committee meeting, according to a report released yesterday. The report said Yale, in New Haven, Connecticut, anticipated capital gains in those asset classes.

The university, the second-richest after Harvard University, generated an average annual return of 12 percent in the decade through June, beating Harvard’s 8.9 percent gain. David Swensen, Yale’s investment chief, was a pioneer in outperforming a conventional portfolio of stocks and bonds by loading up on assets such as private equity, real estate and commodities and is sticking to that model even after investments shrunk by a quarter in the fiscal year ending in June.

“Alternative assets, by their very nature, tend to be less efficiently priced than traditional marketable securities, providing an opportunity to exploit market inefficiencies through active management,” the report said. “The endowment’s long time horizon is well suited to exploiting illiquid, less efficient markets such as venture capital, leveraged buyouts, oil and gas, timber and real estate.”

Private Equity

Over the past decade, Yale’s private equity investments were the top performing assets, gaining 26 percent each year, while real assets returned 14 percent annually, the report said. Private equity investments have gained 30 percent a year since the school started investing in them in 1973, the report said.

To make room for more private equity and real asset stakes, the Yale investment committee approved a 6 percent decrease in its hedge fund allocation to 15 percent, a 5 percent decrease in foreign equities to 10 percent and a 2.5 percent decrease in U.S. stocks to 7.5 percent.

In the 12 months ended June 30, Yale’s real assets, the school’s largest asset class, performed the worst, losing 34 percent, the school said in September as energy investments plunged 47 percent, dragging down the category. Private-equity assets dropped 24 percent. Such investments lock up money for years, and Yale and other schools were limited in how much they could reduce their holdings as financial markets tumbled after the September 2008 bankruptcy of Lehman Brothers Holdings Inc.

Over the past fiscal year, the value of Yale’s fund fell 29 percent to $16.3 billion including gifts from donors and $1.2 billion in distributions to the university, the school said in September.

The §721 Tax Deferred "UPREIT" Transfer

An alternative to section 1031 exchanges is the use of an umbrella partnership real estate investment trust (UPREIT), which involves a tiered ownership structure encompassing a realty operating partnership (OP) and a REIT that is a partner in the OP. Property owners wishing to divest their realty can contribute their property to the OP and, pursuant to IRC section 721, receive a tax-free partnership interest in the OP. This interest is convertible after a period of time into cash or shares of the REIT.
This structure is often problematic if the REIT does not want the property owned by the taxpayer.
Should this be the case, an alternative is for the taxpayer to exchange for a property the REIT has deemed an acceptable addition to its portfolio. This could mean a property already identified and about to be acquired by the REIT.
The problem is that when the taxpayer subsequently contributes the exchanged property to the UPREIT, the exchange may be disqualified due to the requirements of section 1031(a) which specifies that the property be held for investment or business purposes and not for immediate resale as in Magneson v. C.I.R., 753 F.2d 1490 (1985). A creative solution to this problem may be for the UPREIT to be given the option to acquire the property through a "call" option.
Essential to this structure is for the UPREIT to have the right, but not the obligation, via the "call" option contract to complete the placement of the property into the UPREIT. Otherwise, the IRS would likely apply the "step transaction rule" and take the position that the property was immediately contributed at the time the option was granted.
  *A “step transaction” is when the IRS treats a series of formally separate “steps” as a single   integrated transaction because the IRS views the steps as integrated, interdependent and    focused towards a particular end result.
  *Since the "call" option provides the right but not the obligation, it has been deemed unlikely    that such a position would be defendable by the IRS.
Of course, the relinquished property in a §1031 transaction may not garner the equity capital necessary to purchase 100% ownership of an institutional grade, REIT quality property. There also may be concerns about diversification when the investor is making decisions about appropriate replacement properties.

The §1031 TIC Exchange - §721 "UPREIT" Opportunity

In the alternative, an investor may wish to consider the concept of incorporating a §721 "UPREIT" transfer into the structure of a §1031 Tenant-In-Common (TIC) program. This is simply a combination of these two proven tax-deferral mechanisms under the Internal Revenue Code.
Essentially, investors may have the opportunity to take the tenancy-in-common interest they acquired pursuant to their §1031 exchange and contribute it back to the REIT on a tax-deferred basis in exchange for the REIT's Operating Partnership (“OP”) Units.  These OP Units are the substantial economic equivalent of the REIT's common shares, and are convertible into the REIT's common shares on a one-for-one basis.

This program may provide a wide range of benefits to investors completing tax-deferred real estate exchanges including:

• Assuming that the REIT is actively acquiring new properties, the program may serve as a source of readily available replacement properties for investors completing 1031 exchanges.
• TIC interests acquired as the replacement property in a §1031 exchange can be “right sized” to match an investor’s exact needs.
• Investors requiring indebtedness in order to avoid “mortgage boot” pursuant to their §1031 exchanges may be able to borrow precisely the amount they need.

Benefits Upon Receipt of OP Units:

• Access to a diversified portfolio of institutional-quality properties which are leased to creditworthy corporate tenants and managed by an experienced team of real estate professionals.
• Regular quarterly dividends and returns substantially equivalent to those of the REIT's common stock.
• A standardized redemption program that provides investors with far more liquidity than owning whole properties or tenancy-in-common interests.
The decision to redeem OP Units is strictly in the investor’s hands (unlike tenancy-in-common programs where the sale of the property requires 100% co-owner approval).
• Redemption of OP Units can occur in stages, allowing an investor to manage taxable gain recognition.
• An investor’s heirs receive a step-up in tax basis in the OP Units, effectively eliminating the Federal income tax on any capital gain inherent in the OP Units at the time of their transfer to such heirs.
• OP Units are an effective estate planning tool since multiple heirs can make independent decisions with respect to the sale of their inherited OP Units (unlike an investment in property where a single decision must often be made collectively).

How Does It Work?

• The investor enters into a real estate purchase and sale agreement (the “Relinquished Property Purchase and Sale Agreement”) for the sale of the Relinquished Property to a third-party buyer.
• The investor also enters into a qualified intermediary exchange agreement with a Qualified Intermediary and assigns its rights under the Relinquished Property Purchase and Sale Agreement to the Qualified Intermediary.
• The sale of the Relinquished Property takes place and the sales proceeds are deposited into an account (the “Exchange Account”) held by the Qualified Intermediary.
Step #2
• The investor (through a newly-formed LLC) enters into a real estate purchase and sale agreement with the REIT or a subsidiary thereof for the purchase of the Replacement Property.
• The Qualified Intermediary uses the proceeds from the sale of the Relinquished Property held in the Exchange Account to acquire the Replacement Property.
• The Qualified Intermediary then transfers the Replacement Property to the investor’s newly-formed LLC.
Step #3
• The investor leases the Replacement Property to the REIT or a subsidiary thereof pursuant to a Master Lease.
◦ Through the provisions of a “call” option, the REIT is afforded the right, but not the obligation, to acquire the Replacement Property from the investor for a fixed purchase price.
Step #4
• If the REIT exercises the Individual Structure Call Right:
◦ The investor will transfer the Replacement Property to the REIT in exchange for OP Units.
◦ The transfer of the Replacement Property to the REIT is subject to any liabilities securing the Replacement Property.
Because there is a possibility that the Individual Structure Call Right will not be exercised, the investor must acquire the Replacement Property with the understanding that he or she will be holding the Replacement Property for investment purposes and may not ultimately receive OP Units.

Once an investor receives OP Units, how can he or she redeem those units?

• The REIT Operating Partnership has the right to redeem investors for either cash or REIT common stock.
◦ The receipt of cash or REIT common stock in exchange for OP Units brings an end to an investor’s tax deferral.
• Assuming an investor receives REIT common stock, the investor may liquidate such stock (prior to its listing) pursuant to the REIT's redemption program.
• With respect to the redemption of OP Units, it is important to keep in mind the following:
◦ Like REIT common stock, OP Units are best suited for investors with a medium to long term investment horizon.
◦ Unlike investments in TIC interests, investments in OP Units can be liquidated in whole or in part, with the decision to liquidate resting solely in the hands of the investor.
◦ Should the REIT become listed on a national securities exchange or an over-the-counter market, OP Unitholders are no longer subject to the REIT's redemption program.
Instead, investors can simply convert their OP Units into the REIT's common shares and sell them in the secondary market at whatever price the market dictates.

Investment Real Estate: An Alternative to Fixed Income

Walgreens, CVS, 7-11, Dollar General, BP gas station, McDonalds and even the U.S. Postal Service offices all have one thing in common: they are situated in prime locations selected on the direction of their underlying corporation. The developers that construct these properties many times offer them for sale with a long-term tenant lease to an investor who collects the rent and owns the real property. Many investors, and perhaps financial planners, do not have sufficient knowledge of investment real estate to include it in a diversified investment portfolio. However, real estate in its various forms has become part of an investor's overall portfolio for those seeking higher risk-adjusted returns.

Commercial investment real estate discussed in this article focuses on net leased properties that may be appropriate for various investors' portfolios. Investment real estate can provide current income as well as have the potential for appreciation. If leveraged, investment real estate provides future appreciation, as the rent from the lessee will pay for the debt service on the property. Real estate enhances the return of a diversified portfolio of stock, bonds and cash due to its low correlation with stocks and bonds.

Generally, its analysis and review is outsourced to a competent and experienced real estate attorney to determine the suitability for the client, a review of the lease terms, an evaluation of the tenant's creditworthiness, business expertise, financial strength and the inclusion of a guaranteed income stream. Selecting corporate tenants having a defensive outlook, such as drug stores, grocery stores, or staple goods, will benefit consumers in down times, and they will be in a better position to withstand the cyclical nature of the economy.

The last six or eight years have made investors skeptical of reaching historical rates of returns on their stock and bond portfolios. The volatility in the real estate markets gave rise to investment in the real estate bubble. The residential real estate market has fallen greatly in these past months. However, investors might want to explore fixed income alternatives and turn their attention to investment in income-producing real estate-in particular, net leased property.

Net leased property is the deeded ownership of real property and its improvements (buildings) whose tenants are under contract to lease the property for a specified period time at specified rent terms. In a net leased property, the tenant takes responsibility for maintenance, repairs, property tax, and insurance on the property. The benefits of net leased property take into account that the investor receives predictable monthly rental income from the tenant without the responsibility for property maintenance, operating expenses, property tax, and insurance. An investment-grade tenant affords the investor hands-off property management combined with a minimum of risk due its guaranteed escalating lease payments by the investment-grade corporation. An added advantage to ownership is that it is probable the investors in real estate can monitor the financial condition of the publicly traded corporation leasing the property. Corporations who elect not to own property are not encumbered with real estate debt service.

For the purpose of this article, the focus is only on net leased property. In a double net lease (NN), the tenant is responsible for taxes and insurance and for most operating expenses other than the roof and structure. In an absolute or triple net lease (NNN), the tenant is responsible for all operating expenses including insurance, property tax, and interior and exterior maintenance.

Reasons for Investing in Net Leased Real Estate

Long-term leases offset many of the factors negatively affecting real estate value, mainly due to its guaranteed production of fixed income and its potential for long-term capital appreciation. Real estate offers diversification in an investment portfolio due to its low correlation to stocks and bonds, which is especially important in a volatile stock and bond market. Therefore, real estate acts as a hedge against inflation. For retirees, investment real estate adds a measure of predictable income certainty in a climate of uncertainty of Social Security benefits in the future and the lack of defined retirement benefits.

Factors Affecting Real Estate Values

Real estate value may be negatively affected by economic, regulatory and tax changes as seen in the current devaluing of residential real estate. Vacancies in retail stores due to the current recession reduce marketability of releasing or selling the property and threaten the viability of the commercial real estate market. It is therefore essential to purchase property with stable cash flows, strong tenant creditworthiness, and a guarantee for its payment of rent.

If cash is needed in the short term, real estate's lack of liquidity will be a detriment because of its long holding period-between 10 and 25 years. There are no annual investment fees for holding real estate, however there are higher acquisition costs for attorney review of the property and the lease contracts attached to it.

Obtaining credit to purchase net leased property today is more difficult, however the best opportunity for credit emanates from smaller-cost net leased properties that can be secured from a banker with whom the buyer has an established relationship or from a local banker if the property is located outside the buyer's home locale. Generally speaking, however, non-recourse financing may not be available. Credit for larger net leased properties is usually secured through a commercial mortgage banking company with a broad capital base with access to various lenders such as insurance companies, private equity, or pension fund advisers. The creditworthiness of the underlying tenant corporation is a determinative factor if obtaining credit. For instance, a Walgreen's net leased property with a credit rating of AAA may qualify for non-recourse financing.

Benefits of Owning Net Leased Real Estate

Tangible deeded real property is relatively easy to understand and the investment-grade tenant's choice of location eliminates the buyer's need to search for excellent property locations, taking into consideration demographics and lifestyle characteristics. Furthermore, net leases remove the need for property management while the investment-grade corporations guarantee the income generated. The average historical annual yield of net leased properties is between 6 percent and 10 percent with leverage increasing the cash-on-cash return.

Sample of Actual Purchase: Points to Examine

Tenant: national corporate tenant with an S&P investment-grade rating of BBB.

Address: rural America

Location and description: Single tenant, freestanding building located 15 miles from a state university on a corner lot on a U.S. highway. Within a quarter mile radius of the property is the county seat high school, middle school, an all brick senior citizen center, an auto park, a regional office for an electric company, a new office park, and a new locally owned grocery store under construction.

Building size: 8,125 square foot, pro-engineered Nucor building that is under warranty.

Base lease term: Corporate guaranteed lease commenced May 1, 2004 with an initial term of 10 years and three to five year options to renew.

Net Operating Income (NOI)*: $45,000

Capitalization Rate**: 8 percent

Price: $562,400; price per S/F: $69.22; rent per S/F: $5.54

Rent Schedule

Years              Rent                CAP                FMV @ 8% CAP***               

Base term       Years 1-3        $45,000           8%                   $562,400

                      Years 4-6        $48,000           8.5%                $600,000        

                      Years 7-10      $54,000           9.6%                $675,000

1^st Option       Years 11-15    $59,400           10.6%              $742,580

2^nd Option      Years 16-20    $65,340           11.7%              $816,750

3^rd Option       Years 21-25    $71,880           12.8%              $898,500

Percentage Rent: 2 percent over breakpoint of sales over $1.5 million

* Net Operating Income (NOI) is rental income less operating expenses excluding mortgage payment and income tax.
** Capitalization Rate (Cap Rate) is the ratio of the purchase price to the NOI; i.e. NOI/purchase price.
*** Property value is computed by dividing the NOI by the current market Cap Rate (8%); i.e. NOI/cap rate.
Please note: Total retail sales in 2008 were 11.2% higher than 2007.

Taxes

Tax advantages motivate many real estate investors. Tax advantages for NNN properties include interest deduction for debt service, depreciation, 1031 deferral of capital gains, and the stepped-up basis at death. The tax code provides for cost recovery (depreciation) of real property, which is the presumed annual decline in value for obsolescence. This non-cash deduction shelters some of the taxable rental income, making real estate ownership a form of tax shelter. The 1031 exchange allows for the deferral of capital gains tax on appreciating real estate when the owner reinvests the entire sale proceeds of investment property in replacement investment property. The stepped-up cost basis at death affords heirs a possible tax-free transfer of property at the owner's death.

NNN Acts Like a Corporate Bond

A NNN property acts like an investment-grade 10-year corporate bond with some exceptions. The bond coupon rate is fixed for the period, its value fluctuates in price according to interest rate changes, and its principal is returned at maturity. The financial stability and business reliability of the corporation must all be analyzed prior to purchase.

The NNN property has stated periodic increases in rent throughout the period, potentially appreciates in value at end of period, and has the added advantage of tax benefits. There is the possibility that the tenant will exercise its options to continue leasing for 25 years with rent escalations along the way. The rent escalations, which should be included in the terms of the lease contract, increase yield and fair market value.

At the end of the lease period, the property, which is owned by the investor, can then be sold or leased to a new tenant at presumably higher rents. The stability of the retail operation (as noted above), the size of the building, the cost per foot, the rent per foot, the location, and the demographics of the property all need to be analyzed to secure the viability of re-leasing or selling the property in the future.

Both real estate and bonds are dependent on the creditworthiness of the underlying corporation that guarantees its rent and interest. The risks involved in bond ownership are that the bonds can be called early with resultant reinvestment risk, in addition to default of the corporation or bankruptcy. The risks involved with the real estate include illiquidity, lack of a single central marketplace, long holding period, and bankruptcy of the underlying corporation. However, with a default of the tenant, the investor retains ownership of the property with all its rights. Just as some bonds are insured against loss, the NNN property is guaranteed by the underlying corporation, a bond, or a third person guarantor.

As always, the right location and demographics of the property chosen are critically important for renewal of leases or sale of the property. Due to increasing rents throughout the lease term, the value of the property increases by dividing the net operating income from a reasonable comparable capitalization rate. Both long-term bonds as well as real estate can be negatively affected by tax regulation and economic downturns.

Considerations for Purchase of Real Estate

Leverage on real estate increases the cash-on-cash return-the rent from the tenant services, the debt, and future appreciation. For investors, particularly young investors who are not in need of income, the purchase of leveraged net leased property may offer the opportunity to invest for the future. It is also possible to include real estate investments in a self-directed retirement account, which offers investors the option to invest in traditional investments, such as stocks, bonds, and cash, as well as non-traditional investments, such as real estate and businesses. A tax counselor must be consulted.

Real estate has a low or negative correlation with stocks and bonds and is an appropriate diversifier, as it tends to offset systematic risk in a stock and bond portfolio. Conversely, real estate has a strong correlation with inflation and can act as a hedge against a rising inflation environment. The usual allocation of real estate as an alternative asset is between 5 percent and 15 percent percent of the investment portfolio. However it may be difficult to obtain appropriate diversification in the real estate asset class if individually owned property is held due to its cost.

Comparison of NNN property to Bonds

Summary
The higher acquisitions costs of purchasing real estate may be offset by the lack of annual investment management fees of a stock and bond portfolio. To mitigate systematic risk in an investment portfolio, real estate and its asset allocation should be carefully considered for diversification. A financial adviser should include the present value of a guaranteed income stream, such as Social Security benefits or guaranteed rental income, in the asset allocation of a balanced portfolio. The value of the income stream would be attributable to the fixed income asset allocation and would allow for more quantifiable allocation to equities for diversification. (Source: Individual Investor August/September 2008 Published by AAII, the American Association of Individual Investors.)

Institutional investors, foundations and pension funds all include real estate as an asset class when determining their asset allocations. Allocating part of investment portfolio to fixed income for stability reduces risk for investors needing to generate current income.

Financial planners might want to offer clients the option to invest directly in individually owned real estate to enhance their risk-adjusted returns. While net leased property may not be appropriate for everyone, it may be an appropriate asset for investors considering building a real estate portfolio. The critical points to examine include its long-term financial stability, its defensive outlook, its reasonable size, an attainable rent per square foot, the inclusion of escalating rents and the lease payment guarantee. The advantages and disadvantages of comparable appreciating income-producing assets should all be included in a discussion of the investor's goals and objectives. As with all investments, the merits of the real estate investment must be monitored at least annually.