Competition in the single-tenant, net-lease market has gotten so desperate that executives at Orlando, Fla.-based Commercial Net Lease Realty recently found themselves in the parking lot of a small regional chain in Florida canvassing customers in an effort to determine whether they should partner with the company or not.

“It was a very small operator, but it had a solid business and good business plan,” says Jay Whitehurst, Commercial Net Lease's chief operating officer. “At the end of the day, we were comfortable that it would be a successful business, and it was such a tremendous location that we felt we could not lose money on it.”

Executives at single-tenant, net-lease investment companies, such as Commercial Net Lease, are going to great lengths to find partners and meet deal goals. The big firms more frequently stray from the known world of rated, public tenants and search for nuggets in the rough: smaller, regional, private players. But to get such deals done requires a lot of legwork and means that firms have to do all of their own due diligence and credit background checks.

The transparency and safety of the single-tenant, net-lease property market has generated tremendous new interest. Risk-averse investors in search of yield know exactly what they are getting when they plunk down cash for a Walgreen's or CVS drugstore. But that security in a time when few other investments are considered safe has driven prices way up for single-tenant assets.

“It is so much more competitive than it has been in the past. Prices are ridiculous and out of proportion with yields,” says Tom Lewis, chief executive of Realty Income in Escondido, Calif. The company specializes in sale-leaseback financing and owns more than 1,500 net-lease properties — the majority of which are smaller, non-investment grade tenants.

An estimated $3 billion in sale-leaseback transactions occurred in 2004 with an average cap rate of 8.0 percent compared with average caps of 8.7 percent in 2003 and 9.9 percent in 2002, according to New York-based Real Capital Analytics. Intense competition for investment grade transactions, such as A+ rated Walgreen's, has pushed cap rates below 6 percent in some cases.

“Those prices do not make sense to us at this time,” says Whitehurst. “But cap rates for local and regional retailers are well within our target range.” The acquisition strategy for the REIT in 2005 is to focus on regional and local operators, where it expects to achieve returns above 9 percent.

Detective Work

Perhaps the biggest hurdle is finding retailers that are willing to disclose that confidential financial information. It starts with finding the right management team. “If we're dealing with management on a possible transaction and they are not comfortable opening up the books to us and letting us understand what their current financial situation is and financial projection for the future, then we just move on to the next guy,” Whitehurst says.

“You need to look for a company that is willing to partner with you,” says Paul McDowell, chief executive of New York-based Capital Lease Funding, Inc. Management has to understand that investors need to know what the retailer's financial condition is today and what it's likely to be in the future. This concept has been difficult for some small companies to grasp. A regional player with a 50-year history and 80 stores may prefer to keep its finances a closely guarded secret. “Those guys are not going to get good execution, because it is difficult to finance without a solid financial profile,” McDowell says.

In this regard, Realty Income conducts a comprehensive unsecured credit analysis of prospective partners. The company requires audited financials — income statements, balance sheets and statements of cash flows for at least three years. Some local retailers either don't have that information or don't want to disclose it. But without it, Realty Income won't do the deal, Lewis notes. Realty Income uses that data as input in its in-house credit rating system. Essentially, the firm created its own rating system similar to that which the ratings agencies use to valuate company credit.

In addition, Realty Income looks at trend analysis for that industry. Generally, the company already has a formal research report on a particular industry on file. For example, one of its tenants is Sports Authority, and the company has a report on the sporting goods industry that is updated every year. Another rule of thumb is to sit down with management to assess the company. “We won't buy anything without meeting with management,” Lewis says.

On the credit side, the most important factor Commercial Net Lease analyzes is the management team. “It is very important to us to visit with the management team, get to know them, understand their business plan and what they want to do with our proceeds,” Whitehurst says. “We want to see that the money they are going to raise from doing a deal with us is used to expand their business in some fashion.”

Many of the sale-leasebacks that Miami-based United Trust Fund (UTF) buys are with firms that are not household names. Instead of having 3,000 locations across the country, UTF might invest in a retailer that has 150 locations in four states. “It's a function of finding good companies with good management. They don't have to be as large,” says Fred Berliner, a senior vice president and director of acquisitions at UTF. In addition to financials, the investment firm scrutinizes the management team and their strategy for running the business, as well as take into account retail trends.

Another important component is examining profitability of individual stores. Most retailers jealously guard store operating data. However, that data is the best credit measure. Buying a store that is a solid performer is the best protection if a chain does go into Chapter 11 bankruptcy and can opt to accept or reject the lease of individual stores. “That is purely based on how profitable a store is. So knowing whether a store is making money is key,” Lewis says.

Real estate plays a more important role in underwriting local and regional retailers, because there is a greater risk that the investor will be stuck with an empty building if the retailer does fail. Buyers need to scrutinize the location and trade area, and assess rents, vacancies and growth potential. Investors must determine how much competition exists in finding replacement tenants, and what kind of rent they can anticipate. Realty Income puts people on site to do appraisals and assess rent comps and the universe of tenants in the market. “We do very in-depth real estate due diligence,” Lewis says.

Such intense analysis of both credit and real estate can be time-consuming, but well worth the extra effort in reducing risks and ensuring higher returns. “When the market gets competitive, investors tend to go to riskier, small tenants for higher returns. But most buyers are not doing enough analysis to offset that risk,” Lewis contends. Since Realty Income was founded in 1969, the company has purchased more than 1,900 net-lease properties and collected 97 percent of the rent it was owed.

One reason Realty Income has been so successful is that its rigorous underwriting practice helps to eliminate riskier prospects. In 2004, the firm conducted due diligence and analysis on $2.6 billion worth of transactions, but purchased a fraction of those deals with $215 million in transactions.

In part, Commercial Net Lease is using its diverse portfolio to buffer some of the risk in buying local and regional retailers. The REIT currently has 370 properties in 39 states, 60 percent of which are investment grade tenants. “We have the ability to do private company deals with lower credit and still have an extremely strong portfolio. But that doesn't mean that we're going to take unnecessary risks,” Whitehurst adds.

Commercial Net Lease Realty applies a staunch credit and real estate underwriting process to each potential transaction involving a local and regional retailer. “By the time we make the investment, we are confident we are investing in a good business run by solid management teams,” says Whitehurst.

CAP Rates Fall

About $3 billion in sale-leaseback transactions took place last year, with an average cap rate of 8.0 percent, down from 9.9 percent in 2002. Intense competition for investment grade retailers has at times pushed cap rates below 6 percent.

Year Average Cap Rate
2004 8.0%
2003 8.7%
2002 9.9%
Source: Real Capital Analytics.