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Net Lease Economics

The proliferation of national chains, franchises, and the marketing concept of "branding" has produced a real estate investment commonly known as the "single tenant net lease investment". This vehicle essentially trades as real estate's equivalent of bonds with two important differences. First, the final payment of a standard bond is usually a fixed, known amount. In the net lease investment, the reversion of possession at lease expiration makes the residual value of the property the equivalent "final payment". Second, while bond interest rates are typically fixed for the term, net lease payments are rent, typically adjusted at regular intervals over time, based on a fixed escalation or cost-of-living increase.
The mathematical challenge has to do with the frequency of income payments and the variability of the final payment (reversion). Most national credit tenant leases call for an initial period during which rent is flat (often for 5 or 10 years) prior to the first adjustment, with increases spaced uniformly thereafter. The permutations are endless. This Demonstration chooses reasonable ranges of the variables.
Two performance standards are often miscalculated. The first is the rate of increase in rent. Often the increase of "5% every 5 years" is naively represented as 1% per year. This notion is of course not true because of compounding. The resulting error increases as the initial flat term grows. The second performance standard, the internal rate of return (IRR), presents similar problems. The escalation regime is a step function so care must be taken to consider how the IRR is calculated. Finally, while the calculation of the terminal ("going out") capitalization rate is not difficult, specifying it involves predicting the path of various related rates of interest and return and their ending values, typically at a point very far away in time. The most that can be said about this situation is that a final cap rate lower than the initial one benefits the yield calculation. The converse statement is also true.
You can adjust five variables: holding period, initial flat term, going-out cap rate, escalation period, and escalation rate to produce an IRR and a continuous compounding rent increase for each set. As the 2D slider adjusts, the red dot on the graphic moves to the point that produces the numeric outputs below the plot.
  • Contributed by: Roger J. Brown
  • Reproduced by permission of Academic Press from Private Real Estate Investment ©2005

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The negotiation process between landlord and tenant becomes an important aspect of this analysis. The consequence of transferring possession of a well-located parcel of realty to a user for decades has a material effect on value. Both parties overwork their respective crystal balls as they balance the trade-off of initial rent, future escalations and terminal value at expiration.
The valuation of the reversion is the subject of much speculation, namely because it is so far into the future. There are also ramifications over time as local rental market conditions fluctuate. Over a 25-year period at different points in time, depending on the relationship between market rent and contract rent, there will either be a "bargain element" in the rent for the tenant when market rents exceed the lease rate (making the lease an asset in the tenant's hands and a liability in the landlord's hands); or for the landlord when the contract rent exceeds the local market rent (making the lease an asset to the landlord and a burden on the tenant).
A popular variation to the net lease concept is the net ground lease. Under this scenario the landlord leases only the ground and the tenant builds its own building on the land. Many new issues emerge in this scenario. The building may be viewed as a large "security deposit" assuring performance of the lease. The reversion of the land means the landlord receives the tenant's building (a variation on the notion that "you can't take it with you"). Typically this results in a longer net lease term (or a series of renewal options) that permits the tenant to amortize the building.
More information is available in Chapter Four of [1] and at mathestate.com.
Reference
[1] R. J. Brown, Private Real Estate Investment: Data Analysis and Decision Making, Burlington, MA: Elsevier Academic Press, 2005.
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