November 2011

Investments: Net-Lease Partnerships

Net-lease deals always generate much interest when there is concern about the economy, because net leases combine an assurance of a safe return with the prospect of some growth if conditions are favorable. Now is such a time, and investors have a choice among a number of public net-lease real estate programs. A net lease partnership is one in which the lessee pays all operating expenses so that the rent received by the lessor is entirely net.

What should an investor look for in choosing one program over another? Professionals who perform due diligence work for real estate firms say there are six matters to consider before putting a client into a net-lease partnership.

Right Strategy

The first point to consider is the strategy of the sponsor, in terms of the type of property and the degree of financial leverage. Since the main goal of a net-lease program is safety, the property should be of high quality and capable of being converted to other uses in the event of a default. Therefore, office buildings might be a better choice than such single-purpose facilities as child care centers or automotive centers. Similarly, use of financial leverage can increase the overall return (particularly if zero coupon financing is used) but at the cost of additional risk, since if a default occurs and rent is not paid, debt service on the financing is still due or interest continues to accrue.

The Sponsor

As in virtually all other real estate partnerships, sponsor strength is critical. A major concern of the investor is that the sponsoring organization has enough assets under management so that it can keep operating even if it were unable to promote any new syndicates. If the sponsor’s operation depends on a continued string of successful syndications, it may not be the right sponsor to deal with. Another important feature of a sponsor organization is its ability to fill space vacancies, which inevitably will occur over the course of a partnership’s term. Investors should seek out sponsors who have been able to find tenants in the past or who have particular expertise in the type of property being net-leased.

The Acquisition

The safety in a net-lease partnership arises from the strength of the net-lease tenant or from the high quality of the real estate (which assures that vacancies can be filled easily). If the particular deal is offering high-quality real estate, the investor wants to be assured that the acquisition team is professional and experienced, since the risk of vacancy then is reduced.

The Tenants

The best assurance of safety in a net-lease deal is the quality of the tenant. A triple-A credit who signs as tenant either will pay the rent every month or will buy out the lease. The investor, in exchange, usually must accept a somewhat lower rental. In this case, the net lease thus becomes a “bond-type” lease similar to a corporate bond.

Deal Structure

Many public net-lease programs project a first-year distribution of between 9% and 10%. The sponsor normally must write leases at two points above the yield in order to cover upfront fees and costs. If a program offers a higher return, the investor should find the reason. One reason may be that the sponsor is reducing upfront fees in order to make the offering successful. Another might be that the sponsor is providing working capital or equipment to the tenant. This is not necessarily bad but may increase the risk somewhat. Overall, the net-lease market is competitive and sophisticated so that a sponsor is not likely to be able to obtain above-market rents unless a special inducement is given to the tenant.

Lease Insurance

Commercial lease insurance is not generally available. But even when it is, many professionals consider it as nothing more than a marketing gimmick. Lease insurance probably does not increase the safety of a diversified portfolio and simply is an added expense.

This article was written by Josh Weiss and originally appeared in BDO USA, LLP's "Real Estate Monitor" newsletter (Fall 2011). Copyright 2011 BDO USA, LLP. All rights reserved. www.bdo.com. Somerset is a member of the BDO Seidman Alliance, a nationwide association of independently-owned accounting and consulting firms.