Expert weighs REITS vs. other capital options
Pick a market: Commercial real estate prices are going up and up. It’s not just the major cities like New York or San Francisco that are exploding. Satellites like Oakland, California, hip meccas like Austin and important hubs like Louisville, Kentucky, and Dallas are too.
While it can be a nightmare for operators looking for a new location, it could be a dream come true for real estate owners.
Take Austin, for example. The Texas hot spot has seen real estate asking prices grow by more than 8 percent in the last year alone, but market rent has only ticked up 0.1 percent, according to statistics from commercial real estate firm LoopNet. That makes it an enticing market for a sale-leaseback where the owner unloads the property and signs a lease with the new landlord.
Bill Lenehan, commercial real estate guru and CEO of Four Corners Real Property Trust, said owners large and small can tap into the value of their underlying dirt. It’s just a matter of finding the right solution for the operation, and we asked him to sort through the options.
“There’s all sorts of different ways to unlock value of a property. One, you can put a mortgage on the property which gives loan capital,” said Lenehan. “Then there’s a robust desire for individual assets in the 1031 exchange—that’s more true when things get small.”
Then, he said, there are the real estate investment trusts or REITs. Lenehan’s company is one, and there are dozens of others with various specialties and regional affinities.
For owners looking for capital to renovate their franchise location, a mortgage might be a straightforward way to squeeze a little capital out of these high valuations. But of course owners must then deal with fluctuations in value and the risk of refinancing down the road.
Any operators looking to retire before the end of the mortgage term will also have to balance the value of a renovated location versus having a mortgage on the books when it comes to sell.
Then there’s the 1031 exchange, where owners can trade up to three like-valued properties, and realize two times the value of their trade.
It’s also the best way to avoid taxes since in the eyes of the IRS, there are no capital gains in straight exchanges, but any cash proceeds are taxed. After the exchange, the new owner pens a lease for the operator who remains at the site.
Lenehan said that’s the best opportunity to make some money on the land, but he likens it to a budget airline—it’s a hassle with a short timeline. A like property must be named within 45 days, and the entire deal must close within 180 days.
“The closure rate of 1031 exchanges tends to be quite low. So if you’re willing to go through that brain freeze of not having that go through, it’s a good option,” said Lenehan.
“It may not close because someone gets sick or they go on vacation. If you can deal with that it’s likely to get the best return.”
As for the REIT option, Lenehan said sophisticated owner-operators get access to capital for growth or cash out at high valuations without all the work.
“I think what happens is a lot of the franchisees we do business with, understand that the real path to wealth for them starts with picking the right franchisor to align themselves with, but will really come down to how many properties they can grow into and how well do those operate,” said Lenehan.
“While they might make a little money here and there in the 1031 exchange, all that time and effort if they allocated it to growing their unit count and producing better results at the buildings they own, they will create more wealth for themselves and their families by doing transactions with REITs.”
There are, of course, some things to consider with the institutional ownership groups. First, there is the due diligence. REITs are investing in properties for the long term so they are going to look closely at the property, the owner and the market.
“Where we do due diligence on the strength of the operator, the strength of the guarantor, how the property performs compared to others, we do full environmental work and read the lease closely,” said Lenehan. “Sometimes individual buyers will be less careful.”
The rent increases are still going to come, but under a REIT, those terms will be well documented. Four Corners bumps rent 1 percent each year at Darden properties, for example. But it won’t be the surprise 10 or 20 percent that most long-term operators have seen at one point in their careers.
In return, REITs may be the ideal landlord. Specialized firms know their industry. Four Corners, for example, was created when Darden, the parent company of non-franchised Olive Garden, sought to spin off its real estate holdings. Given its deep restaurant experience, Lenehan said the company can right-size the partnership for the industry while other landlords may not be so flexible.
“The first thing that we typically work with our tenants to figure out is what is the appropriate level of rent at the property. I’d say a quarter are grossly over-rented,” said Lenehan. “We want the tenant to be very profitable so they reinvest and stay.”
REITs also tend to keep a close eye on their investments, with a staff dedicated to ensuring they are operating well.
“It’s really important to us for a long period of time that our properties look good and are renovated and are clean, etc.,” said Lenehan. “Individuals that might provide a day-one purchase price, the only relation they’ll have with the reminder will be receiving rent; they’re not going to have any interest in being flexible.”