Developing Net Lease Criteria and Sourcing Properties

Net lease investors and their advisors find the best opportunities when they know what they're looking for and have the best search tools in their belt.

How do they know what to search for?

Successful investors develop investment criteria considering their objectives, experience, preferences, and risk tolerance. Investing in just any asset that looks like a good deal can get principals in over their heads, stuck in a suboptimal asset/position, and exposed to more risk than is suitable for their objectives.

In this article, we'll discuss the parameters that investors and their advisors should define when developing their net lease investment criteria, risk tolerance, and how to leverage Net-Trade.com's niche-specific search tools to find opportunities that fit.

1. General and market criteria

You probably already have a good idea of your criteria, but in due course, let's review the general considerations and then dig deeper into more specific components.

Most importantly, your investment criteria should align with your objectives. Not all properties/assets will provide the same benefits or perform in a way that will support your portfolio growth strategy. As part of your objectives, look at the:

• Type of commercial real estate property and owner responsibility you want to achieve.
• Rate of return and amount of cash flow that makes an investment viable for your strategy.
• Size and time frame targets for the development of your portfolio.
• Degree of risk you're willing to and capable of accepting.

• Types/classes/locations of assets you're most interested in.
• Which property types you have the most experience with.
• Your budget for an acquisition.
• Strength of your personal/business credit.
• Access to and availability of equity and debt — if needed.
• Interest in involvement in the management of the asset/property.

While property-level criteria are important (you have a relatively high degree of control over value, e.g., expense optimization, revenue growth, improvements, etc.) — the geographic market you choose to operate in will dictate the potential or limits on growth due to latent demand and related fundamentals.

Market/location demand factors to consider include:

• Demographics.
  • Population growth/decline rate.
  • Annual Household Incomes (AHHI).
  • Age distributions.
  • Population density.
• Site.
• Proximity to anchors (large national tenants).
• Synergy with other businesses/tenants.
• Ease of ingress, egress, and parking (vehicle/pedestrian access).
• Vehicular and pedestrian traffic levels.
• The proximity of educational facilities, churches, hospitals, entertainment, major employers, government facilities, etc.
• Shortage or surplus of net lease asset inventory.
• Rate of ongoing development and construction starts.
• Supply.
  • Shortage or surplus of net lease asset inventory.
  • Rate of ongoing development and construction starts.

Tax considerations will also find their way into your criteria selection.

If you're looking to trade up and need tax deferral on your gains, a property that will fit with a 1031 exchange strategy may be a good choice. If going this route, you'll need to identify replacement assets of equal or greater value to the property you're selling/exchanging. Also, note that you have to identify the replacement asset within 45 days of selling your property, and you must be able to close the deal within 180 days.

Another tax deferral strategy, for which we won't get into details, is opportunity zone investing. If opportunity zones fit your objectives and tax deferral requirements, identify markets that qualify.

Another factor to look at is state income tax and its ramifications for your portfolio. For investors that prefer to bypass state tax liability, nine U.S. states do not require residents to pay taxes on their income, including:

• Alaska.
• Florida.
• Nevada.
• New Hampshire.
• South Dakota.
• Tennessee.
• Texas.
• Washington.

Under the Tax Cuts and Jobs Act of 2017, owners/operators, under certain conditions, can take an 80% bonus depreciation deduction (as of 2023). To learn more, consult a cost segregation tax specialist.

3. Property-level criteria and exposure to risk

The specifics of the property play a central role in developing your criteria. These include the cap rate, type of tenant and tenant credit rating, and lease type/structure — all of which directly influence risk.

The Cap Rate is a key metric by which net lease assets are evaluated. The Cap Rate describes the ‘capitalization rate’ of the net operating income (NOI) as it relates to the price, or value. The rate is figured by dividing the NOI by the value/price of the property. Example: if property income is $100,000 per year, and is given a Cap Rate of 5.0%, then the value would be $2,000,000.

The formula is often used to calculate the property's market value based on the investor's return expectations and perceived risk. The lower the Cap Rate, the lower the risk of the asset earning the net income..

Determine your return expectations based on the stability of the asset and tenant and foreseeable (and unexpected) risk. Cap rates for net lease assets generally range between 4-10% according to demand and risk.

Tenant type also provides an indication of risk. 'Recession-proof' tenants such as food/retail stocks (grocers, mass discounters, warehouse clubs, and dollar stores) are typically stable under volatile economic conditions. Conversely, tenants that may experience faltering demand in a recession, such as luxury dining/retail, are riskier.

Risk also varies with the type of lease the tenant holds. Triple Net Leases (NNN) generally present the lowest economic risk for the landlord, as the tenants are responsible for all taxes, maintenance, and insurance. As inflation rises (despite dampening by monetary policy), the tenant bears the risk of swelling operating costs.

NNN leases are typically long-term and taken by tenants with strong demand factors and credit ratings. Single and double net leases also provide some protection for the landlord, but the reduced exposure is shared with the tenant. Modified gross leases are another structure that requires the landlord and tenant to share economic risk.

Management requirements are also why many investors build their criteria around net lease assets. Net lease assets do not require management time or expense unless part of a shopping center where CAM (common area maintenance) charges are billed to the tenant or direct to the landlord for pass-through to the tenant.

In general, longer lease terms provide more stability and lower re-leasing expenses for the landlord. However, it's essential that lease terms include scheduled rent escalations to keep pace with inflation and market growth. The remaining term and number of options for tenants to renew on the current lease should also be addressed in criteria. Longer terms can reduce potential for short-term vacancy risk and the cost of replacing a tenant.

Additional criteria development tips for managing economic risk include selecting a tenant with a high credit rating, low percentage of store closures, high demand, low rent-to-sales ratio, and absence of competition (unless it's synergistic).

The tenant's credit rating is particularly critical to assess. S&P and Moody's issue credit ratings based primarily on the debt the company is holding. S&P BBB, or better, is called 'Investment Grade,' meaning it is a highly secure company.

Inflated lease rates and valuations can also be a problem for an investor — it's always a good idea to ask whether the subject is below, at, or above market.

4. How Net-Trade.com facilitates sourcing, selection, and decision-making

Once your criteria are developed, a platform is needed to efficiently find and vet acquisition opportunities that fit.

Traditionally, broker relationships were the go-to source to find deals. When the digital age took hold, multiple listing services (MLS) dedicated to commercial real estate assets took on much of the role (a development in which Net-Trade.com's founder was instrumental).

There is a difference between catch-all CRE marketing sites and the uniquely robust and tailored features of Net-Trade.com. Net-Trade helps net lease investors accelerate the discovery and selection process through greater valuation data profiling, enhanced transparency, and tools to refine and narrow options according to objectives and risk tolerance. Net-Trade provides the depth and clarity of information to make purchase selection and underwriting decisions more efficiently and assuredly.

The platform offers over 40 fields to narrow to best-fit deals for your requirements and allows you to preview much more valid and accurate net lease-specific listing facts, figures, features, and attributes. Side-by-side comparisons help you refine selections to the most attractive options. You can also post your requirements (Want Ads) and receive matching on- and off-market opportunities.

To build credibility, investors can profile their professional expertise with a bio, closed deals, requirements, and status, including 1031 status and timing, equity to invest, debt needs, proof of funds, property owned, tenant type and geographic preferences, and cap rate ranges. Net-Trade also helps new investors learn about the different property, market, lease, and tenant features used in evaluations.

Moving forward with confidence

Equipped with expertly-defined criteria and the best search technology in the industry, investors and their advisors can find suitable acquisition opportunities. When you know what you're looking for and that what you seek will fit your goals and risk tolerance, you can confidently generate cash flow, ROI, and portfolio growth.