Importance of Lease Term Remaining in NNN Valuation

Importance of Lease Term Remaining in NNN Valuation

The length of the firm lease term remaining (initial lease term remaining before the expiration date, excluding option periods) is one of the most critical determinants of value. Since a STNL NNN asset only has one tenant and one income stream, the length of the contractual lease in place forecasts the future guaranteed income stream in place. The longer the lease, the longer that guaranteed income stream, the less risk and thus the more secure an asset is perceived. Due to this, long term leases will trade for substantially lower cap rates than leases with a shorter term remaining until expiration. This is for a number of reasons. Overall Demand for NNN Assets with Long Term Leases is much stronger than the demand for shorter term leases. A long-term lease is typically one of the main requirements of 1031 Exchange Buyers who largely control the NNN STNL market. Publicly Traded REIT’s also love to tout to Wall Street & their investor base the combined Weighted Average Lease Term remaining of their portfolio because it demonstrates that their portfolio is low risk. The length of the lease term remaining also impacts financing availability and financing decisions from lenders. Typically, a lender will not agree to a loan term that is longer than the lease term remaining. Additionally, lenders will also keep the lease term remaining top of mind when offering the maximum LTV of a loan they are willing to make and whether to offer a long or short amortization period, both of which can affect an investors cash on cash return.

A long-term lease is typically defined as a lease with 10 years or more remaining before expiration, however some leases can come with 20 Year or even 25 Year initial lease terms. A short term lease is typically defined as having 5 Years or less remaining. As described above, there is a large drop off in demand after a lease crosses that 10 Year remaining mark. If it has less than 10 Years a lender will not agree to 10 Year financing, additionally many investors segment their internet searches looking for assets with 10+ Years remaining. Due to these factors, there is significantly less demand for assets with slightly less than 10 Years remaining when compared with assets with slightly more than 10 Years remaining. Let’s illustrate this with an example using Dollar General STNL assets which we have compiled an immense amount of data on. We use Dollar General as a case study example because most of these assets have very similar qualities.

Dollar General Lease Term Remaining Example:

Due to Dollar General's immense growth developing 1,000 stores or more in any given year, it makes sense to keep their leases uniform templates for efficiency. Since their leases are almost always the exact same structure, their locations are very similar nationwide typically located in small, tertiary markets with limited population base. The only real differences between each dollar general asset is the level of rent that is set which is based upon a formula of the total development cost.  Due to the above factors, it is very easy to control for all the other variables that impact value to illustrate the pure impact lease term remaining has on the cap rate. Currently, a 15 Year NNN Dollar General trades at roughly a 7% Cap Rate. Every year that ticks off, the cap rate increases roughly 10 Basis Points (BPS) so a 14 Year Dollar General will trade at a 7.1%, a 13 Year will trade at a 7.2% and so on. However, a 5 Year Dollar General Asset will trade between an 8.75-9% Cap Rate. So while there is a 50BPS variation between a 15 Year Dollar General and a 10 Year Dollar General, there is a 125-150BPS difference between a 10 Year Dollar General and a 5 Year Dollar General. This means there is an accelerating deterioration in value. Using a numerical example:

15 Year Dollar General: $100,000 @ 7.0% Cap Rate = $1,428,571

10 Year Dollar General: $100,000 @ 7.5% Cap Rate = $1,333,333

5 Year Dollar General:   $100,000 @ 9.0% Cap Rate = $1,111,111

Difference between 15 Year and 10 Year Dollar General: 50 BPS = $95,238

Difference between 10 Year and 5 Year Dollar General: 150BPS = $222,222

As evidenced by the above, while there is approximately $95,000 of value deterioration in the first 5 years of lease term (from 15 to 10) there is almost $225,000 of value deterioration during the 2^nd period of 5 years (from 10 years to 5 years)… This is primarily due to the increased risk as the lease comes closer to expiration and the reduction of demand for shorter term lease assets. Now, Dollar Generals are a very unique case study in STNL net lease. Since they are typically located in very tertiary locations, the ground and buildings are practically worthless without the Credit Tenant Lease in place giving Dollar General immense negotiating leverage when the lease term expires. It is not uncommon for a vacant Dollar General to sell for only a couple hundred thousand dollars or take years to find another tenant. This is a key example of inflated real estate value due to the long term credit tenant lease in place.