In commercial real estate, buying below market is essential

During my intermittent career in commercial real estate investing, i’ve found that entry yield is important, but lease rates and the price level relative to market value are occasionally even more so. Especially important in sale and leaseback (SLB) deals. The pitfall is, that frequently the deal being offered is not so much a real estate deal as a structured financing deal with inadequate collateral.

Standard SLB situation

A company (the seller) wants to free up equity (for whatever reason) or needs to do so (liquidity issues, loan due dates, capital structure optimization by private equity investor). Looks for a willing buyer for its place(s) of business. Let’s assume the property is solid and the seller is at least above average in terms of creditworthiness (if not before, then surely after the SLB deal). The seller is selling at or above market yield, whatever that means for this type of property in this particular area. So based on superficial metrics the offer looks good.

The devil is in the details

In this situation it is absolutely crucial to look at how the selling price and lease rates compare to market rates. When investing in commercial real estate, the shakier the counterparty, the larger your margin of safety needs to be, meaning your options, if your tenant fails. Your plan B. Unless you’re doing an unbreakable lease with the Canadian government or a Singaporean port operator, chances are you need to consider counterparty default risk.

If the seller is selling for market yield, but at above market lease rates, then you’re clearly overpaying for the property. Because if something happens to the tenant, then your plan B involves lower future lease rates in addition to the indeterminable duration of vacancy. In this situation, if the lease rates are significantly above market, then this is not just a bad SLB deal, but an undercollateralized structured financing setup where the bank takes the senior tranche and you take the junior. Sure, you can call it “equity”, but it’s really junior convertible debt which might convert to equity if everything goes right, and even then the yield is dismal. Total equity wipeout in this scenario is lurking around the corner waiting for the tenant to default.

Sometimes, below market yield in commercial real estate is fine

Conversely, if a property is selling below market yield, it usually means the asking price is too high or there is something else wrong with the property. But not always. If the lease rates are significantly below market value, then a below market yield is sometimes ok. It’s not great, but it’s ok. In essence it’s a tradeoff between plan A and plan B. Your plan A is weaker because of lower yield, but your plan B is stronger because you can replace tenants faster and at better prices. Now, granted, this scenario almost never happens in SLB transactions, because they tend to be tailored for optimal outcome for the seller/tenant, which tends to favor higher selling price (immediate cash injection) over lower rent (long term costs), but one can come across these kinds of offers when the seller is different from the tenant, albeit once in a blue moon.

Conclusion

In my experience, the vast majority of SLB deals offered are at competitive yields and decent contract terms with ok counterparties, but above market (1.1-1.2X) lease rates (they never state this of course) to make the deal look decent to short-termists with other peoples money. They’re just weak deals. A few are even outright cons with ridiculous terms, eg 5 + 5 year deals at 1.35Xmarket lease rates, which is a fancy way of saying “I plan to take your money and run.”

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