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Single Tenant Net Leased Investments: Bond Replacement Strategy

With over 157 failed banks this year, and the likelihood of more failures in the months and years to come, Commercial Real Estate (CRE) is experiencing record disruption within all asset types. The speculative lending market is all but dead, and the few remaining banks lending on CRE assets are seeking only high quality loans paired with substantial equity invested. Most major CRE asset classes have been hammered by exposure to a variety of economic conditions such as high unemployment and poor underwriting fundamentals. The assets with shorter lease terms and non-credit tenants have all been plagued with higher vacancy rates and a high percentage of troubled and distressed loans.

The attraction for a leased asset is that the investor can create a sustainable revenue stream by renting the asset to a tenant. In order to achieve the highest return on investment, most major asset classes require a professional manager to assist with collecting rents, maintenance, and marketing, which eats away a substantial portion of profits. The multi-family and office sectors are sometimes referred to as the 3 T’s - toilets, trash, and tenants – which keep all landlords awake at night.

One asset class that provides the least risk and management responsibility is the Single Tenant Net Leased category, referred to as STNL. Unlike other asset types, the STNL investor can Sleep Well At Night, thus this low-risk & pain-free investment strategy was coined “SWAN” (as an acronym). The SWAN strategy could be represented by the following formula:

SWAN = CREDIT + LONG LEASE + RENT BUMPS

Credit – Many STNL tenants lease prototypical facilities in order to gain a competitive advantage in the marketplace. For example, the top drug store chains are located on primary intersections with traffic counts adequate for the tenant’s business model. Many tenants utilize off-balance sheet lease structures in order to leverage the company’s balance sheet with minimum corporate cash invested. Some retailers guarantee rental payments by a parent company that has an investment grade credit rating of BBB- or better according to Standard & Poor’s or Baa3 or better according to Moody’s. Below is a partial list of STNL companies with investment grade credit ratings:

Company Name

Symbol

Moody's Rating

S&P Rating

Advance Auto Parts

(NYSE:AAP)

Ba1 Positive

BBB- Stable

AutoZone Inc.

(NYSE:AZO)

Baa2 Stable

BBB Stable

Best Buy Co.

(NYSE:BBY)

Baa2 Stable

BBB-

Brinkler International

(NYSE:EAT)

Ba1 Stable

BBB- Stable

CVS Caremark

(NYSE:CVS)

Baa2 Stable

BBB+ Negative

Darden Restaurant Inc.

(NYSE:DRI)

Ba3

BBB Stable

Dell

(NASDAQ:DELL)

A2 Stable

A- Stable

Federal Express

(NYSE:FDX)

Baa2 Stable

BBB Stable

HEB

Private

A

A

Home Depot, Inc.

(NYSE:HD)

Baa1 Stable

BBB+ Stable

Kohl Corp.

(NYSE:KSS)

Baa1 Stable

BBB+ Stable

Kroger

(NYSE:KR)

Baa2 Stable

BBB Stable

Lowe's Companies, Inc.

(NYSE:LOW)

A1 Stable

A Stable

Sherwin Williams

(NYSE:SHW)

A3 Stable

A- Positive

Starbuck's Corporation

(NASDAQ:SBUX)

Baa3 Positive

BBB Positive

Tesco

(NASDAQ:TESO)

A3 Negative

A- Stable

Verizon

(NYSE:VZ)

A3

A Negative

Walgreen Co.

(NYSE:WAG)

A2 Stable

A+ Negative

Wal-Mart

(NYSE:WMT)

Aa2 Stable

AA Stable

There are also other STNL tenants that are just below the investment grade credit mark (BBB-/Baa3) or not rated due to minimum or no long term debt:

Company Name

Symbol

Moody's Rating

S&P Rating

Aaron Rents

(RNT)

NR

NR

CBRL Corp.

(NASDAQ:CBRL)

Ba3 Stable

BB- Stable

Dollar General

(NYSE:DG)

NR

BB+

Haverty's

(NYSE:HVT)

NR

NR

Ingle's

(NASDAQ:IMKTA)

Ba3 Stable

BB- Stable

Jack in the Box

(JBX)

Ba3 Negative

BB- Stable

PetSmart Inc.

(NASDAQ:PETM)

NR

BB Stable

Tractor Supply Co.

(NASDAQ:TSCO)

NR

NR

Historically, a company with a lower Investment Grade rating profile (Ba1 – CaC) has a much higher probability of default than an investment grade rated company (Baa3 – Aaa):

Cumulative Historic Default Rates (in percent)

Moody’s

S&P

Rating category

Muni

Corp

Muni

Corp

Aaa/AAA

0.00

0.52

0.00

0.60

Aa/AA

0.06

0.52

0.00

1.50

A/A

0.03

1.29

0.23

2.91

Baa/BBB

0.13

4.64

0.32

10.29

Ba/BB

2.65

19.12

1.74

29.93

B/B

11.86

43.34

8.48

53.72

Caa-C/CCC-C

16.58

69.18

44.81

69.19

Averages

Investment grade

0.07

2.09

0.20

4.14

Non-investment grade

4.29

31.37

7.37

42.35

All

0.10

9.70

0.29

12.98

Source: U.S. Municipal Bond Fairness Act, 2008.

Clearly, a company’s balance sheet and credit rating are an important component to the SWAN strategy; however, there are two other important legs to the investment stool. In order to balance the strategy, the investor should also consider the lease structures.

Lease Term – Most STNL Retail leases are between 10 and 25 years. As a comparison, hotels typically lease by the day. Mini-Storage rents by the month and Apartments rent by the year. With a long term lease in hand, STNL investors spend considerably less time managing and marketing than owners of other asset classes.

Rental Increases – Most STNL assets have rental increases during the base lease term; however, many of the other asset classes have rental increases that are determined by current market conditions. For example, hotel, multi-family, and mini-storage rents are determined by a variety of factors, including supply & demand. Many of these operators have had to decrease rents in order to stabilize occupancy rates and to meet debt service and operating expense requirements. On the other hand, most STNL assets provide for fixed rental increases and some include percentage of sales multipliers. Having growth and income incorporated into a sustainable revenue stream makes the STNL asset class very appealing for many investors.

The SWAN investor is seeking a fundamentally safe investment strategy where principal preservation and sustainable income (and growth) are a must. Essentially, this investor is seeking a bond-type investment in a real estate wrapper. While you can invest in Walgreen’s (WAG) stock paying around 1.8%, alternatively, you can acquire an STNL property leased to Walgreen’s (with more security than the stock) and achieve an unleveraged return of approximately 6.5% to 7.5%. Most Walgreen leases are 25 years (excluding options) with minimal to no management responsibilities - making this type of investment comparable to a bond. Of course, the credit profile and lease term of each tenant is directly related to the return, so an investor should consult with a professional advisor to determine investment portfolio strategies. There are quite a few STNL products ranging from public REITs (O and NNN), non-traded REITs (Cole Capital, American Realty Capital, W.P. Carey, Inland), alternative co-ownership products (TIC, Delaware Statutory Trust, Reg. D funds), and customized investments. With bond returns at an all time low (e.g., IBM’s 1% - 3 year note) and many other CRE classes underwater, now is the time to consider investing in Single Tenant Net Leased assets as a bond replacement strategy…and you will Sleep Well At Night.

Source: Single Tenant Net Leased Investments: The SWAN Strategy