Historically, these properties have been established and the real estate owned by the physician or physician group. In today’s uncertain economy, some of these owner groups are tapping into the significant value they have already created by selling the real estate to an investor, leasing the property back on a long-term lease and freeing up capital for operation or expansion.
Understanding net leases
A triple net lease is a lease agreement on a property where the tenant or lessee agrees to pay all real estate taxes, building insurance and maintenance (the three 'nets') on the property in addition to any normal fees that are expected under the agreement (rent, etc.). In such a lease, the tenant or lessee is responsible for all costs associated with repairs or replacement of the structural building elements of the property.
While the transaction volume among net lease investment properties mirrors the downward trend in all areas of commercial real estate, there is still strong demand from investors. The net lease investment provides owners freedom from maintenance duties and a higher return on investment relative to other investment alternatives, which are the driving factors behind the demand. This strong demand has been particularly true for the healthcare niche, where investors view the sector as somewhat immune to economic downturns. Net leases have become more prevalent and, as a result, the appetite for healthcare real estate has increased over the past few years.
Net lease arrangements are particularly popular among passive and conservative investors because they pass on little or no management responsibilities to the owner. In some cases, a net lease is created when the tenant, or members of the tenant’s operating entity, own the real estate and sign a lease for an extended period of time, usually 10 to 20 years. The lease provides the tenant with necessary long-term operational control of the property.
The most desirable lease structures are those in which the tenant is responsible for all maintenance, taxes and insurance. The healthcare net lease property investment is an appealing consideration for every investor, from large institutional buyers down to the individual 1031 exchange buyers. Internal Revenue Code Section 1031 permits the deferral of capital gains and other taxes on the sale of property. In the most common type of exchange, a forward delayed exchange, property is sold and the proceeds are used to purchase replacement property within certain timeframes.
Benefits of a net lease property
Both tenant and investor can find advantages to the net lease property arrangement.
Here are just some of the net lease tenant benefits.
- A significantly reduced up-front cash requirement.
- The entire lease payment is deductible for income tax purposes.
- Larger returns, since more cash is available to invest in the business and expansion plans — including expanding into additional locations — rather than owning real estate.
- The lack of a property mortgage, which would negatively affect the tenant's balance sheet if they were the owner/borrower.
- Reduced liabilities on the tenant's balance sheet, which positively affects their credit rating and reduces their cost of borrowing for other purposes.
- Continued long-term operational control of the property (through a triple net lease structure.)
Here are just some of the net lease investor benefits.
- A regular and assured stream of payments, with scheduled rent increases over the life of the lease and its exercised options.
- Depreciation deductions from taxable income.
- Little or no time commitment on the part of the landlord.
- All of the benefits of appreciation over the life of the property.
- Relatively higher return than would be available from many other investment alternatives.
Creating value for your property
The traditional mindset regarding corporate real estate was to buy land, construct improvements, own the assets long-term and lease the property back to the company. The idea behind this investment strategy builds equity (wealth) through property appreciation, typically at an average rate of 3 percent annually depending upon the market. Many companies miss the potential to create value over-and-above the value of land and improvements (“bricks and sticks”).
By structuring a net lease, a company creates an income stream which can create additional value for their property. The tenant is basically creating a financial annuity which has value as an investment. This value is then added to the value of the land and improvements. In some cases, the value of a net lease can add as much as 40 percent to the value of land and improvements. If this value is then capitalized and reinvested, or put into an alternative investment with even a modest return, the yields under this investment strategy can greatly exceed the 3 percent annual appreciation the owner/tenant would get through long-term ownership. The end result should be that the tenant builds wealth at a faster rate than with the traditional model.
But with a 40 percent increase in value being created by the lease, it makes sense that as term expires from a lease, the investment property loses value. This value declines more rapidly with each passing year of the lease.
Case study
Consider the following example: A physician is part of a group which owns property in which he/she is also part of the tenant entity. Assuming the tenant entity has five years remaining on a 15 year lease, there will be virtually no value attributed to the lease and the emphasis will be almost exclusively on the value of the real estate.
The investor assumes he will lose the tenant in five years and will incur leasing expenses to re-tenant the property, which offset the five years of income from the lease. Additionally, financing terms available to the investor will be less favorable because of the shorter term, which will negatively affect the investor’s rate of return.
The tenant, as real estate owners, has lost the equity the tenant created when structuring the lease. The owner would need 13-plus years of 3 percent annual property appreciation to achieve the same 40 percent of equity created by the net lease. If the physician owner plans to sell his or her ownership interest in the real estate as part of a retirement plan, the owner would be far better off to do so at the beginning of the lease or with a minimum of 10 years remaining on the lease.
Three components to net lease analysis
When analyzing a net lease property on behalf of an investor, commercial real estate advisors typically look at three components: credit, lease and real estate. These are often referred to as the “three legs of the stool.” If even one of the legs is weak or short in any one of the three areas, the stool will have difficulty standing up.
The stronger the investment or asset is in each of these three areas, the more value the asset will derive in a sale transaction. Investor appeal is often determined by answering the common questions under each component.
Credit
- What is the financial strength of the tenant?
- Can the deal be financed?
- Does the tenant have a favorable credit rating?
- Earnings before interest, taxes, depreciation, amortization and rent (EBITDAR)/Rent coverage ratio?
- Are earnings increasing or decreasing?
- What is the company’s net worth?
Lease
- What is the length of the lease?
- Is there a quality lease in place?
- How are rent payments structured?
- Is the tenant committed to the property?
- Are there landlord responsibilities?
- Is there a lease payment guarantor?
Real estate
- Where is the property located?
- What is the age of the property?
- What is the construction type?
- Is the property the right size and fit for the tenant?
- What condition is the property in?
- Does the property have special purpose use?
Today’s volatile lending market
Without question, the toughest challenge to completing a transaction in today’s commercial real estate investment market is the ability to obtain debt on a property. More than ever, lenders have tightened their underwriting criteria and are under great pressure to carefully analyze all financial statements as they scrutinize the credit of tenants in net lease properties. Prior to the outlay of capital, a lender wants a clear understanding of how rent is going to be paid and who will guarantee lease payments. They want to see properties with strong real estate fundamentals and with the ability to be re-tenanted should the current tenant vacate the property.
Because medical properties typically are classified as “special purpose,” (limited potential uses) investors seeking financing for these types of properties must help lenders become confident that the tenant is not going to vacate the property. If the tenant does vacate prior to the end of the lease, the owner — and potentially the lender — would be placed in the difficult position of finding a specific “special purpose tenant” to fill the vacancy. In an effort to avoid this scenario, many lenders are currently staying away from secondary, tertiary or troubled markets. Instead they are limiting funding to projects in major markets or in high growth areas where the likelihood of finding a replacement tenant is greater.
Understanding the role and benefits of a broker
Using a broker who specializes in the sale of net leased medical properties can give a company access to specific market information and data, which may enable buyers and sellers to compare special use properties to others that have recently traded. Since brokers often have knowledge of what lenders require in today’s market for a successful sales transaction, they can also assist their clients in creating a balance between achieving the right sale price and structuring a transaction that will pass lender underwriting.
Additionally, brokers can often provide guidance to companies desiring to structure a net lease and then sell their property. The broker can provide knowledge regarding the terms of a lease and how the terms will affect value.
Sellers interested in this scenario should feel comfortable discussing with the broker any possible variations to the proposed terms and how the terms could affect the long-term goals of the tenant. Brokers specialized in healthcare properties are likely tapped into the pool of buyers for investment opportunities.
Some sellers may try to avoid the use of a broker, believing they can save money by negating a broker’s fee. However, transactions managed by a broker often trade higher, off-setting the fee, and can save money and time for a seller.
Perhaps the most commonly overlooked benefit to using a broker, and one that sellers should consider taking advantage of frequently, is the management role the broken can provide throughout the transaction process. This begins with the initial analysis of a property and ends with a consummated sale. The broker can help the client to identify the most appropriate buyer type for their property, implement an effective marketing and research strategies and finalize the financial details of a transaction —tracking interest and collecting offers to qualifying buyers, assisting with due diligence items and monitoring the closing process.
-- Toby Scrivner is senior associate for Stan Johnson Co., a leading net lease broker and net lease advisor. Contact Mr. Scrivner at tscrivner@stanjohnsonco.com. Learn more about Stan Johnson Co. at www.stanjohnsonco.com.