The first thing to ask yourself before you make an offer – is the property priced right?
Look at other properties and their cap rate – that will help you decide whether the triple net property is priced right for that market, location, and business.
The cap rate is a ratio between the price of the property and the NOI.
NOI is determined by dividing the net operating income by the cost of the property. The resulting percentage is meant to represent the estimated return on the property per year and is a good way to compare properties quickly.
If you look at cap rates over a period of time for either a particular industry or area, that will also give you an idea of whether or not the price of the triple net property is reasonable.
Triple net lease properties vary considerably in terms of cap rates – anywhere from 4% to double digits.
Higher Cap Rate=Less Expensive
The higher the cap rate, the higher the cash flow and the risk, and the less expensive it is. The lower the number, the safer it is – but it’s more expensive.
If you have a creditworthy tenant like McDonald’s, and the cap rate will be somewhere around 4%-5%. In this case, you’ll end up paying a lot for the property, but you’ll end up with a premium tenant who will stay in that property for the long-term.
Higher cap rates – generally those above 10% – involve less creditworthy tenants who will most certainly be leaving at the end of the lease.
Practically that means you know right from the start that once the lease is up (usually under 5 years) you’ll have to start looking for a new tenant, and unless you’ve identified several factors that point to a successful location, you could end up dealing with a troublesome vacancy.
There are three important components to look at when you consider the price:
Is The Property Suitable For Other Businesses?
In the case of an industrial-grade tenant like McDonald’s, there’s no question that in the highly unlikely chance there is a vacancy, dozens of businesses would be happy to take its place.
McDonald’s and other creditworthy tenants choose each location with great care, so in addition to the prestige of occupying a well-known property, the location is guaranteed to be high-traffic with great demographics.
A bank, on the other hand, may not remain in the same location for twenty or thirty years.
Online banking and a host of other trends could mean that the number of physical branches for a particular bank could be cut down to minimal numbers. On the other hand, banks tend to be located in excellent locations, often on corners.
The Creditworthiness Of The Tenant
During the last ten years or so, commercial real estate has seen a shift not only in the way commercial properties are being used but also in terms of the companies seeking out commercial spaces.
Startups and new ventures, rapidly growing tech companies, and other types of businesses will be too new for a credit rating, yet can still be fully capable of paying expenses. Taking a deep look at the tenant’s business, the market, the source of revenue, and other factors will help you determine the viability of a prospective tenant.
The Terms Of The Lease
While the property is important, the terms of the lease are equally important. There is a tremendous variety of commercial net leases, and as an investor, it is essential you take into account how the lease will perform over the entirety of the time covered by the contract.
A poorly structured or weak lease can easily leave you in the lurch with an unexpected vacancy or worse, a financially weak tenant who is unable to pay the expenses on a triple net lease property.
One thing you should always verify is whether the lease is actually a net lease and if it is what type. Don’t rely on what the owner or the tenant tell you – read the lease carefully and take note of who is responsible for repairs and maintenance, taxes, and capital expenditures.
A true triple net, for example, requires tenants to pay all expenses on the property. Don’t get stuck paying triple net prices for a property that isn’t more than your basic commercial income property.
Making The Offer
Once you’ve done your due diligence, reviewed seller financials, and checked the numbers, it’s time to make your offer.
If you’re new to commercial real estate, then when you do decide to make your offer, you’ll want to make sure you’re not overpaying and avoid negative cash flow. Keep in mind that commercial real estate is different from the residential real estate, and unlike residential real estate, lowballing owners will put you out of the running.
If you make an offer above 90-93% you’ll get a response; less than that, the seller will reject the deal. These deals trade on cap rate and basis points, so if you offer 70%, your offer will be rejected.
Here’s How To Calculate A Reasonable Offer
Find Three Comparable Properties
Locate three properties similar to the property you’re interested in, which were sold in the six months. They should be similar in terms of type and age of the property, square footage, have similar amenities, and be located within 3-5 miles of each other.
Next, calculate the cost per square footage of each one. The highest-priced property represents the highest sales price you’d offer, the lowest cost per square footage the lowest price offer. Average the three to find a good starting offer.
The NOI Method
Another method to decide on a starting offer is through calculating the NOI. The first step is to calculate the NOI according to the actual income and expenses, not the proforma given by the owner.
Next, try calculating what the NOI would be if the offer price were the actual price of the property. In this case, divide the NOI by the cap rate to get your middle offering price.
Your lowest offering price is calculated the same way, but you take the NOI you calculated in step one and raise it by 1%. To find the highest offer price, simply decrease the cap rate by 1%.
Now you have your highest, lowest, and average starting offer; as long as your offer falls somewhere within this range you can be assured that your offer is a reasonable one, and the price reflects the true value of the property.Tags: cap rate, commercial leases, commercial real estate, commercial real estate investing, due diligence, NOI, tenants, triple net properties