Most likely, you know how important your credit rating is when you mortgage a residential property, but did you know that in commercial real estate, the tenant’s financials and credit rating influence the strength of your investment, the property’s value, and your ability to get financing? It is imperative for a reliable, lucrative NNN investment that the corporation backing your lease has a strong credit rating or that the franchisee has strong credit and proven financial stability.
It is easy to assume that because you’re investing in a single-tenant triple net (NNN) property, that the well-known corporate tenant is automatically creditworthy. However, it is not uncommon to find financial instability at the corporate level or with an inexperienced franchisee who operates on the bare minimum. So, what defines a “creditworthy” tenant?
Creditworthy corporations are financially strong with a low risk of default, proven by their investment-grade ratings. Corporations of BBB- or better from the bond rating firm Standard & Poor’s are considered “investment-grade” tenants and tend to have the most stable financials. The higher the credit rating, generally, the more stable the company. When it comes to NNN lease tenants, most will have high ratings and corporate-guaranteed leases – but buyer beware! It is just as important to ensure the actual tenant or franchisee is also creditworthy by performing a thorough financial assessment and requesting the historical and store performance.
A great selection of corporate-backed absolute NNN tenants includes Dollar General, McDonald’s, Walgreens, CVS, Dunkin’ Donuts, and 7-Eleven. There are also quite a few modified NNN lease investment-grade tenants with notable growth, such as O’Reilly Auto Parts and DaVita.
Who Are Non-Credit Tenants?
Small, local, or regional businesses and manufacturers, and some franchises are typically non-credit tenants. Unlike large, publicly traded companies, they are usually smaller in total revenues and may not be publicly rated by Standard & Poors or Moody’s. This, however, does not necessarily make them bad investments, but additional due diligence should be performed when assessing the long-term viability of these tenants.
Tenant Credit Determines Property Valuation
The financial strength of the tenant affects the property’s price, which affects your financing availability and cash-on-cash (CoC) return. Single-tenant property investments differ from other real estate in how their loan-to-value ratio (LTV) is determined. The number one factor in calculating the LTV is – you guessed it – the tenant’s creditworthiness, followed by the length of the lease, rent increases over the term of the lease, and location. Even if the real estate market in the area fluctuates, the property itself typically maintains its value because that value is not defined solely by the real estate.
Since LTV influences the amount of leverage a bank or credit union is willing to lend, most often, the better the tenant, the higher the leverage.
Risk & Reward
The biggest risk factor when buying CRE is not having a financially stable tenant. If you own a property leased to a small franchisee who has 1-3 stores and does not have the credit strength of a corporation like 7-Eleven behind him or her, this poses a higher-risk investment. Even if the franchise is a nationally known brand like Panda Express, Sonic, or Freddie’s, that does not guarantee creditworthiness. These franchises have independent who are solely responsible for the revenue of the stores they operate. If the one you own hits on hard times, is mismanaged, or in a poor location, it can be unpredictable.
For less risk and greater reward, Westwood Net Lease Advisors recommend responsibility-free absolute NNN properties with corporate-guaranteed leases and experienced franchisees who own multiple locations. These owners have the management and business experience and the buying and advertising power to be most efficient, along with the financial strength and experience to ride out slow periods. If you choose a location run by a franchisee with strong financials, you want that franchisee to guarantee the lease, effectively putting the larger, multi-unit organization behind that individual location, thus ramping up the creditworthiness and property value.
To Wrap It Up – Ensure Your Potential Tenant is Creditworthy
There is no such thing as a “risk-free” investment. However, if you choose a NNN lease property with an investment-grade tenant or a strong franchise tenant, you will reap the rewards of a reliable, low-risk investment with steady monthly income and no responsibility, while meeting your financial and lifestyle expectations, worry-free.
As you begin your property search, each potential NNN investment requires up-front, in-depth evaluations including, but not limited to, risk analysis and tenant creditworthiness and calculations of the uninflated cap rate, after-tax cash-on-cash return, and the timeline for your return-on-investment (ROI). To obtain expert help with all of this and more, it’s best to connect with a Westwood buyer’s advisor who represents you and your best interests and walks you through the entire process from the property search to financing and closing, saving you time and the possibility of making a costly mistake – all at no cost to you. Contact us today for your free, no-obligation consultation. 314-997-5227