Cap Scratch Fever

Flu season is among us, and many are protecting themselves by heading to their doctor or pharmacy for annual vaccinations. Unfortunately, no immunization exists for a malady affecting many commercial real estate investors. That malady is something we call Cap Scratch Fever (CSF), an affliction affecting legions of investors on myopic quests for ROI.

The first noticeable symptoms of CSF occur when investors toss a comprehensive investment strategy into the wind and only look at a property's capitalization (cap) rate. A quick survey of Loopnet reveals that many single tenant assets can indeed be acquired at prices boasting cap rates well up into the teens. These yields are being offered for a reason, however, as many of the assets are fraught with downstream risk.

Some examples include Dollar General stores which occupy retrofitted, earlier-generation properties (see above photo). Many such stores are being offered for sale at very attractive cap rates. However, since these older properties do not fit into the Dollar General prototype, the company has in some cases abandoned such properties in pursuit of new, relocated, build-to-suit stores which fit into the company's overall brand and development strategy. This has included stores with uniform size (approximately 9,000 S.F.), off-street parking, and consistent architectural elevations (the prototype). No one can blame Dollar General for wanting consistency in its real estate. However, this pursuit has left many investors holding vacant, older properties with residual values which fall well short of the numbers at which they were acquired.

Fortunately for investors, CSF, while dangerous, is not terminal. Recovery rates are quite high for patients who do not tarry and are rushed by police escort to see a competent commercial real estate professional. If a competent commercial real estate professional is not found within your HMO or PPO, then we suggest you follow these homeopathic steps when attempting to rid yourself of CSF:

1. When evaluating a high cap rate deal, evaluate and forecast the property's residual value. Ask yourself what the asset would be worth if and when the tenant vacates the building. Can the building be leased or sold to other users at prices relatively close to the price you're paying for the current income? If a huge chasm exists between the two, then the risk may be too great.
2. Consider looking beyond the cap rate by digging a little deeper. Consider running an internal rate of return  (IRR) analysis with a future sales price at a level below the acquisition price. As an example, if the building is held for 4 years and sold at 75% of acquisition, is it still a reasonable risk given this "worst case scenario."
3. Put your "tenant cap" on. What are the advantages and disadvantages of the tenant staying and/or leaving? In some cases the store manager or district manager or real estate representative may provide valuable information. Beware of this information, however, as often store managers are the last to know what the company's plans may be for your investment.
4. Understand the market rents in the area. Is your net leased asset commanding rent that is out of whack with other available properties in the area? If so, this is a red flag.

Hopefully by following this regimen you'll find the symptoms of CSF will slowly fade away, and you will no longer be fighting the urge to make bad investments.  If you have personally overcome a dehabilitating case of CSF yourself, please post a comment as we'd like to learn how you overcame it.

Factors Impacting Capitalization Rates

I was recently asked to respond to the following question: What factors are taken into consideration when determining capitalization rates on triple-net investment deals?

To answer this question comprehensively, we'd need more time that it will take to analyze tonight's election results. And what's worse, we'd probably be just as boring. But let's give it a whirl--in an abbreviated sense….

Capitalization ("Cap") rate differentials are driven by a variety of factors, but perhaps most notably by the tenant's creditworthiness and thus its ability to fulfill the terms of its lease obligation(s). That's why we see lower capitalization rates, and thus higher relative prices, for solid, national, and recognizable tenants such as Wal-Mart, Walgreen's, and Sherwin-Williams. The converse is true when dealing with lesser known, financially weaker, or even suspect tenants. Investors will typically demand higher cap rates, and thus lower relative prices, for assets leased to a mom-and-pop operation. The mom-and-pop might have a stellar business plan and possess market dominance, but its lack of a track record and deep pockets will penalize it in the marketplace. Too many questions exist regarding the tenant's ability to perform. Combine a lack of track record with a suspect business plan and the cap rates will catapult into the stratosphere. Imagine looking at a sale-leaseback offering from Looney Larry's Liposuction Clinics…. What sort of cap rate reward would you require to weather the risk posed by relying on a monthly rent check from Looney Larry?

Once an investor is satisfactorily comfortable with the tenant's ability to perform, other factors will be evaluated in determining a cap rate. A key factor will be the length of the primary or "guaranteed" lease term. Usually the longer the guaranteed term, the better, although some investors may disagree in that long-term leases may lack protection against inflation. Walgreen's, besides its excellent reputation and financial strength, also usually provides 25 year primary terms. Such leases are typically rewarded in the investment community in the form of lower caps/higher prices. Investors will simply pay a premium to take as much uncertainty out of their investment as possible.

Other factors can be categorized as "real estate specific" and "geographic." These categories may bleed into one another a bit. By real estate specific we might think of things like the overall cost per square foot of the asset or the age and condition of the building. To understand these factors let's assume we have two brand new Pizza Huts for sale. They're located in two similar but different markets. Suppose the land cost at one of the locations was higher than the other and consequently the one with the higher land cost was for sale for $500 per square foot (PSF) while the other was offered at $400 PSF. One would expect the cap rate to be slightly lower for the lower cost PSF building because the overall risk of the investment would be perceived to be slightly lower.

Perhaps a better example would be two Pizza Huts in the same market where one was a new build-to-suit while the other was placed in a renovated, 30-year-old building. Presumably investors would accept a lower cap rate for the newer building because the underlying real estate is perceived to be of higher quality and expected to enjoy a longer useful life.

Geographic factors can be macro or micro. Macro factors would account for cap rate differentials among regions of the country. California, for instance, will typically command a lower cap rate/higher price for an investment than its counterpart in say, Fargo. Micro factors include location factors within a specific community. Is the location "Main and Main" or is it a second tier site where one would have to rely on advance GPS technology to find it? Presumably the Main and Main location would have more residual value and thus command a higher price/lower cap rate.

While these factors should not be considered exhaustive, they will probably be found in most investors' decision-making matrix. We may have missed something, so if you're an investor, know an investor, or simply play one on television, please leave us some feedback in the "Comments" section below. We'll all benefit from your expertise.

And with that we'll get you back to the election results. We sincerely hope you've approved of this message.