How to Calculate the Value of a Zero Property

How do I calculate the possible market value of a zero cash flow property?

Values for zero cash flow properties are usually expressed as a percentage over the debt. That is to say, some percentage in excess of the debt. As an example, a brand new CVS zero with 25 years left on the lease/loan that fully amortizes would price in today's market at probably between 9% and 10% over the debt, such that if the loan balance were say $10Mil, then the total value be about $11Mil, meaning you could buy it with approx. $1Mil in equity. Further, the more seasoned that zeros become (older) the more valuable they tend to get, as you are closer to the day that you own it free and clear.

Another way to approach the problem would be to value the store as you would any other NNN property by applying a cap rate to the NOI. However, by applying a cap rate to the NOI, you would probably need to add at least 150 basis points premium to the cap rate. This helps account for the constraints of the zero deal (i.e. inability to refinance etc.). Said differently, If you have a deal that would otherwise trade at a 7.00%, as a zero it would probably value closer to an 8.5%.

It should be noted that both of these methods determine “gross” values and not a “net” value. That is to say that the net value (Gross Value minus the Debt) is the actual out of pocket cost to you to do the deal.

Lastly, as should be obvious, the real estate itself should play a role in it's valuation in that, location, possible reuse, and building condition may drive whether or not their is any residual value to the building at all in the absence of the tenant exercising their renewal options. A critical mistake that many people make when looking at zeros is to discount the real estate and simply view them as a security or abstract financial instrument. This is not the case, real estate fundamentals still apply.

Net Lease Conference 2011 – What a Difference a Few Years Makes

The 2011 net lease conference displayed the most positive atmosphere since the economic pitfall. It was easily the best attended net lease conference in years. We are continually told that things are getting better, but to see that attitude on the ground is a different story.

The most noticeable thing besides its attendance was the high level of interest participants showcased. In previous years, a sizeable number walked around in almost a trance –trying to figure out how to be active in a non-active market. 2011 saw the return of the players. This energy revitalized the event and gave it a positive attitude. People were optimistic about the future.

That said a few prominent issues kept appearing:

• Interest rate fears.
• Overall lack of supply continues to plague the market.
• Development probably won’t begin again till 2012 (and that's pending interest rates)
• Sale Leasebacks are currently popular ways to raise capital (more so than usual anyway).

Overall, the 2011 net lease conference showed lots of promise for the future.

Net Lease Profile: Walmart

Wal-Mart discount department stores vary in size from 51,000 square feet to 224,000 square feet, with an average store covering about 102,000 square feet. Wal-Mart Supercenters stock everything a Wal-Mart discount store does, and includes a full-service supermarket. Wal-Mart Supercenters vary in size from 98,000 to 261,000 square feet, with an average of about 197,000 square feet. Wal-Mart has displayed exceptional growth over the past decade and its AA S&P investment grade credit rating carries strong appeal for real estate investors.

Wal-Mart stores are rare investments on the net lease market with the transaction size, acreage and square footage of the investment (much larger on all counts than the typical netlease property) appealing to a more select group of investors. Big annual rents and relatively low selling cap rates means the typical net lease Wal-Mart transaction is over $10mm. The selling cap rate is often in the low 6's to high 7's depending on lease structure and remaining term.

Pros:

• Corporate guaranteed, investment credit.
• High visibility virtually creating a new downtown wherever it opens.
• Typically low rent per square foot.
• Low recourse and low interest rates often available.

Cons:

• Flat rental rate, minimal escalations
• Large footprint poses re-lease problems should the tenant relocate.

Bright Lights for Retail's Future?

Closure announcements for this quarter GAFO (general merchandise, apparel, furniture and other goods) fell by 53% compared to last year. Blockbuster and Talbots made up 41% of those closings. This suggests retailers are rebounding from their severe contraction.

According to ISCS, a total of 700 U.S. stores and restaurants – 10.4 million square feet and .07% of retail space – closed this quarter. A 53% decreased from the year before. This has been connected to a 3.3% increase in shopping center sales last year. 2010 did witness a 7.5% increase in GAFO closures over 2009. However, the latter half of 2010 experienced significant improvement. This improvement has trended into 2011.

High quality net lease properties in select markets have already experiences noticeable cap rate compression. Whether or not this trend spreads throughout the greater retail market is uncertain.

Note: Credit ratings have taken on increasing importance in our shaky economic landscape. S&P provides an insightful guide betweencorporate credit rating and default rate:

Stuck Beside a Cap Rate with the Second Quarter Blues Again

...Or is it Deja Vu all over again? Whether it is Dylan or Yogi there are striking parallels between first quarter activity in 2010 and 2011. Both years began with a flurry of activity, cap rate compression and a more open lending environment. Deals were transacted and the outlook was positive. Then we hit the brakes. In early 2010, the collapse of the Greek economy set off a fear of European default with repercussions that were felt across the globe – an enlightening testament to the power and perils of a truly global economy. The good news of course is that by early summer, the net lease world was right again and deal making and cap rates responded to an improving economy and a lack of quality net lease product.

Following a solid close to the fourth quarter, 2011 got off to a roaring start with further cap rate compression and transactions closed at rates that rivaled those of the peak years of net lease investing. As the second quarter of 2011 approaches, we potentially find ourselves in a place that looks an awful lot like the second quarter of last year. Will news from across the globe cast a shadow on domestic trade? Will revolution, heightened U.S. involvement in the Middle East and a historic disaster in Japan stall the US economy and net lease investing in particular? Alternatively, just as in 2010, will the volatility in the bond and securities market drive investors to net lease assets that provide bond like, secure, stable returns with solid real estate fundamentals as a backstop to their investment?

Whitey Ford was pitching for the Yankees at Yankee stadium. Luis Aparicio led off for the White Sox with a first pitch base hit. Nellie Fox batted second fouled off a couple pitches and then got a base hit. The next batter hit a home run and Yankee manager Casey Stengel went out to the mound and asked Yogi "Has Whitey got anything?" to which Yogi replied, "What the hell do I know? I haven't caught one yet!"

Like Yogi we don’t have enough information yet but let us know what you think and how global events influence your investment strategy.

Shelby Pruett on $625M Net Lease Deal

Shelby Pruett is Managing Partner at Equity Capital Management - a self administered real estate company focused on investing in institutional quality, single-tenant office, industrial, and retail properties that are net leased to investment grade and other high credit quality tenants on a long-term basis.

HIPP: What is driving your sale of up to $625 million in net lease assets?

PRUETT: ECM’s primary objective has always been to provide its investors with attractive risk adjusted returns through multiple time periods and economic conditions. We are a private equity real estate firm and in 2010 filed to take part of our platform public through ECM Realty Trust.

During the IPO process we were approached by a number of private and public companies, including public REITS, interested in entering into joint ventures, merging, and or acquiring our assets. Through conversations with these companies, we came to a global solution that met all of the constituents needs. As a fiduciary to our investor we made the decision to enter into contracts to sell our assets to some of these parties, one of which was a public REIT.

HIPP: What are your thoughts on the IPO market as it relates to your business?

PRUETT: We still believe public platforms and markets hold merit. We had positive feedback from the public markets as one of the only large scale investors aggregating institutional quality net lease and sale leaseback assets. These net leases were backed by investment grade credit tenants, at significant discounts to the assets underlying values. The platform, team, strategy, board, and structure were well received in the market.

We carefully studied the reception other firms received in the IPO market and believe that while public markets in general are attractive, a company’s timing of entry is critical. At the time we made the decision to sell, we had not launched our road show. The global solution that materialized through the sale provided certainty and was beneficial to all parties. With that said, we believe the sale supported the viability of the platform ECM was bringing to the public market and we are continuing to review an execution in this area with alternative assets.

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UPREIT Follow Up...

Well, it appears that last week’s blog post on UPREITs struck a nerve because it generated a huge response. Not just in terms of viewership and comments but also in terms of questions. Below are a few of the more common questions that got raised:

What is tax treatment of my gain when I do convert my units?

Obviously you would want to consult your tax advisor to confirm what the treatment for your specific situation might be. That said, the treatment of your gain for tax purposes should be nearly identical to that of the gain you would have recognized had you simply just sold your property in a normal sale transaction. That means that un-recaptured section 1250 gain taxed at a 25% tax rate, as well as capital gains tax at the 15% rate will be considerations. Also, any appreciation in the stock will constitute additional 15% gain, and any depreciation expense you get allocated during your holding period will generally increase your un-recaptured section 1250 gain.

Are there any other quirks associated with a property contribution?

One other consideration is that during your holding period the rental income you will be allocated from the OP will have less depreciation expense from your contributed property than you would have otherwise expected. The rules are highly complex but essentially the built in gain you had on the day you contributed your property to the REIT (the difference between your tax basis and it’s FMV) is burned off by allocating you less depreciation expense, and consequently more income. As a practical matter, this means if you held your units for 39 years (or whatever the remaining depreciable life of the property is) you would have fully recognized your built in gain, albeit as ordinary income as opposed to capital gain. At that point, upon conversion you’d only have to recognize a gain from stock appreciation. Again, you’ll want to consult your tax advisor to make sure you understand the tax ramifications of such a transaction, as it can get tricky.

What are the transaction costs associated with such a transaction? Do I need to bring money to my own closing?

Transaction costs on the seller side are remarkably low, although it could result in needing to bring a nominal amount of money to the closing table. Often times such contributions are done by conveying the LLC, which owns the property, and in many cases can thus avoid transfer taxes that might otherwise apply. Also, most of the costs associated with the deal like legal fees, etc. are borne by the REIT. One thing to note however is any cash you receive from the REIT reimbursing your legal fees would be considered income to you.

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