The burgeoning market for investments in Single-Tenant Net Lease (STNL) properties makes such properties, as well as facilities being considered for conventional STNL financing, prime candidates for ownership by their users—and in particular for an ILPS Preferred® financing to accomplish such an acquisition. When viewed in conjunction with the new FASB/IASB lease accounting standards, recent capital market dynamics increasingly challenge the longstanding corporate bias for leasing such assets.
STNL Leases and the Flight to Quality. Since 1998 two major stock market corrections have provoked investor flight to safe havens from investment losses and reduced returns. In the early 2000's the market for Single-Tenant Net Lease properties expanded from a handful of investment funds to a broad-based secondary market catering to investors’ flight to safety. Today, the STNL market in the US alone approaches $500 Billion. After the latest market crash in early 2009, worldwide reduction in sovereign interest rates has forced investors to look for alternative, higher yielding though stable, investments. In the last four years, returns on STNL properties have compressed from 8%-10% to 4%-6%, increasing values of the leased properties by 15% to 30%. A close correlation between these historically low capitalization rates and commercial properties leased to credit tenants, however, demonstrates that such remarkable value premiums are less a function of general appreciation in commercial real estate or economic recovery, and more a function of demand for the tenant company's credit.
Value Added by a Credit Tenant Lease. Value added to properties by the market’s “thirst for yield” is most visible in the case of newly-constructed single-tenant buildings. For example, assume a developer builds a new warehouse to be leased to a credit tenant for 15 years at initial rent equal to 8% of total development costs, or $16.00 psf of rent based on $200 psf of total project costs. Once the building is completed, occupied and paying rent, the developer in today’s market could conservatively sell the building at a 6% capitalization rate, or $267 psf, representing a 34% profit over a development period as short as two years, not counting profit from the development fee. The profit in this example—based on actual transactions—largely reflects the spread between the user’s cost of capital (relevant to a purchase) and that of its landlord (relevant to a lease, especially of a new building). The latter often includes not only mortgage interest but a preferred return on outside equity at 200+ basis points higher than the incremental borrowing rate of the tenant. Largely because of this phenomenon the real estate policies of many investment-grade companies create more value for their landlords than their shareholders. In most cases the corporate tenant captures little or no value from the extraordinary demand for its lease. It is increasingly possible in today’s low-rate environment for a corporate user to realize the lion’s share of such value-added in the form of lower occupancy costs through an ownership strategy for core facilities—while avoiding the balance sheet gross-up imposed by the new lease accounting standards. ILPS Preferred® stock is ideally suited to financing such an acquisition because it takes direct advantage of the user’s in-demand credit to minimize the cost of capital associated with long-term use of an asset—the most important variable affecting cost of occupancy given an assumed purchase price and level of operating expenses. This lower cost of capital is a principal reason why in our comprehensive example ILPS Preferred® lowers the present value of earnings charges by 46% when compared to a 15-year lease.
Lease Renewals and the Flexibility Premium. While new construction generally presents the most lucrative and readily-executed model for leveraging corporate credit into reduced occupancy cost, opportunities abound in existing buildings as well. After the initial lease term many companies settle into a pattern of short-term renewal terms of five years or even less. It is not uncommon to see a company stay in a building for fifteen to twenty years exercising a series of three-year renewal options. Such a short-term approach tends to be the most costly, affording the tenant little leverage to negotiate lower rents or capital improvements made by the landlord. This “flexibility premium” over time can add over 50% to costs achievable even when compared to a long-term lease—an avoidable cost given the market reality that tenants renew their leases approximately 75% of the time. Unquestioned allegiance to a leasing model also leads a company to miss key milestones such as the 18 to 24 months prior to expiration of a lease term when a credit tenant’s leverage with its landlord—whether in the context of renewing its lease or purchasing its building—are greatest. Lack of a proactive, long-term real estate strategy can cost a company tens of millions of dollars over time.
Ownership and Profit Growth. After decades of rapid expansion, maturing of the growth curve for many established companies has led to significant cost-cutting efforts aimed at growing or sustaining profit margins. Less staff, outsourcing, increased use of technology to boost productivity, internet commerce and supply chain management are the most visible strategies being employed. One area that has received very little attention is the savings opportunity presented by owning rather than leasing core real estate assets—an opportunity that is especially attractive in today’s market for a building fully occupied by a company with high-quality credit. For companies with large portfolios, there is a multiplier effect on these savings that could have a dramatic effect on net income.