Triple Net & Send Me the Check!

There’s a new player seated at the triple-net investment table, and its ante is being tossed-in from sales of dental floss, shop rags, and Spam to moderate-income Americana. The player, Dollar General Stores (NYSE:DG), is no stranger to the real estate investment community, but until this year its leases had mainly been attractive only to local, regional, or “one-off” purchasers. That changed in early 2010 when DG rolled out its latest investment product—the 15-Year NNN lease. These leases, which require no landlord responsibilities, have attracted sizable attention from institutional and national investors which had previously viewed DG leases as too cumbersome, unpredictable, and/or management-intensive.

“Most REITs, private equity groups and pension funds are not equipped with the infrastructure to manage large portfolios of double-net leases, thus they have not invested in Dollar General properties in the past,” said Wes Forlines, a broker with Tri-Oak Commercial in Atlanta. “The new triple-net lease structure has opened the door to a new pool of investors—the large institutional buyers,” said Forlines.

Dollar General’s foray into NNN deals is viewed as a positive for both the company and the investment community. The current NN format, which for the last couple of years had been DG’s flagship, requires landlords to be reimbursed for taxes and common area maintenance (DG has typically paid insurance directly) while also saddling landlords with roof, HVAC, parking lot, and structural “major repair” and replacement responsibilities. The absence of these responsibilities will now make Dollar General properties viable candidates for even the most passive investors.

The new NNN deals will be even more drastically different than much older DG leases—those entered into prior to 2000. Many of these properties operate under gross or modified-gross lease formats, where landlords are saddled with all or almost all of the costs of operating the real estate. Many of these were struck with only five or seven year original base terms and are now operating in option periods. Many of these landlords, saddled with most if not all of the property responsibilities, are now dealing with mounting maintenance expenses and increasing real property taxes, among other costs.

“Last winter was unusually harsh, and we incurred higher than average snow removal costs,” said one SVN/Fiducia Properties client—an Iowa DG landlord. “I also spent $60k on roof and HVAC replacements for my stores,” said the same landlord. Another one of our clients, the owner of multiple Kansas Dollar Generals, agreed: “I’ve dealt with a number of costs such as taxes, insurance, and major repairs that I wouldn’t have had in a NNN lease,” said the client. “Sometimes I become weary of dealing with some of the landlord responsibilities.”

If, or how soon, these gross leases will be replaced is unclear. Dollar General has demonstrated a commitment to move into more prototypical construction, but with over 8,000 stores in 35 states, it’s unlikely that shift will occur overnight.

The move should help Dollar General by enhancing the success of its preferred developers. “There were so few preferred developers that could sell their finished units for enough money with the NN lease to make the effort worthwhile, so they were starving and dropping out,” said Peter Colvin, a Sperry Van Ness broker in Grand Rapids, Michigan. “So, DG listened and adjusted their leases where necessary to keep their preferred developers healthy with product that could be financed and sold,” said Colvin.

What sort of premium would an investor expect to pay for a NNN Dollar General over that offered in a NN lease? When scanning the marketplace, it appears investors are willing to let go of approximately 50 basis points to be able to sleep easier at night for 15 years of relatively worry-free check-cashing. This might be the difference between an 8.5% asking cap rate for 15-Year NNN stores vs. a 9.0% asking cap rate for a similar deal with a 15-Year NN lease. Both Colvin and Forlines support this notion, although Forlines speculates a larger differential and cap rate “compression” for NNN DGs once the deals become more popular. Currently the 50 basis point premium appears to be reasonable, as the difference in purchase price between NN and NNN stores, both with NOI of $80k, would be a little more than $52,000.

It appears investors will continue to have both choices, as new Dollar General leases are not exclusively NNN and many new NN leases remain in the marketplace. Geographically the NNN deals at this time seem to exist primarily in the Sunbelt, with a handful trickling into the Midwest. Geographic distribution may depend on a variety of things, most notably the geographic concentration of preferred developers and Dollar General’s priorities in new store development.

For now, there are a variety of opportunities for all investor types, as value-added deals flow into the marketplace. Many opportunities for higher cap rate acquisitions exists for those willing to endure the risks associated with Dollar General’s gross and NN leases and the relocation risks which accompany non-prototypical stores (those less than approximately 9,000 SF with no off-street parking). However, we believe the NNN deals will gain traction as investors seek to shed themselves of the uncertainties that are linked to shorter-term and management-intensive leases.

Despite the lease term and type, Dollar General should continue to fill an important niche in the investment marketplace. That niche—national credit for under $1 Million and at less than $100 PSF—should continue to be a reasonable play in this current recessionary environment.