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.