Opportunistic Investing in Single-Tenant Properties
Randy Blankstein and Noah Gottlieb
An opportunistic real estate investor focuses on a single question: Am I being properly compensated given the risk level inherent in this transaction? Investors seeking IRRs of 20 percent or more are required to heavily scrutinize the risk/reward profile of an investment. Although single-tenant properties are typically associated with long-term leases and core returns, opportunistic results can be achieved in the single-tenant sector by investing in assets leased on a short-term basis. The risk-adjusted return on these investments is pragmatic and should be acceptable to all investors pursuing high-yield strategies when rationally quantified.
This type of opportunistic investing is not for everyone, but institutions and high net-worth individuals seeking superior returns on real estate investments should do so by placing funds where high risk-adjusted returns are available. This can be accomplished by pursuing short-term leased single-tenant commercial real estate.
The critical variable in opportunistic investment is the assumption through which returns are achieved. Investors need to focus on the incremental return factors (rent growth, cap rate compression, absorption rates, etc.). For example, a developer of an industrial park would expect to achieve opportunistic returns, but would take on development risk, construction risk, leasing risk, market risk for rents, absorption, vacancy and numerous other factors. The returns on that type of investment would need to be well above average. Otherwise, the risk-adjusted returns are not worth pursuing. Compare this with a short-term single-tenant investment, where the determinant of success is most often a renewal/extension of an existing lease. Other factors, such as disposition environment, rent growth, etc., can come into play in terms of maximizing or minimizing returns; however, the general success of the investment is tied to a single outcome or variable, simplifying the investment decision. Additionally, under this investment strategy, a large incremental percentage of a return is secured from the cash flow of the property during the hold period. Unlike other alternative high-yield strategies where returns are most often achieved upon speculation of residual valuation, incremental and double-digit cash flow returns can be virtually assured in the short-term leased sector.
Short-term single-tenant deals are being doubly penalized because of a lack of demand for these assets. If the opportunistic component of a business plan is considered risky, the reward must be similarly increased to justify the investment. The greatest risk mitigation in real estate is price. The core meaning of the phrase “there is a price for everything” is the mitigation of risk achieved through valuation. All things being equal, the best way to acquire assets at attractive valuations is to purchase real estate when everyone else is in disposition mode. In the case of single-tenant commercial properties, acquire buildings that few are considering. There is currently a dearth of both equity and debt targeting short-term single-tenant commercial real estate. Very few individuals or firms target short-term leases regardless of tenant, location or product type. Concurrently, there are ample investors for long-term single tenant leases. Critics will argue that this is due to the rollover risk intrinsic in a short-term lease. While this is undeniably true, the rollover risk incremental discount factor is already priced into these assets.
Arbitrage, the practice of taking advantage of a price differential between two or more markets, is about finding deals that capitalize upon market imbalance. Assume a 10-year Microsoft-leased property trades for a 7.5 cap rate. Furthermore, let’s assume that the same building, with the same tenant, has a 3-year lease with a 7-year fair market value renewal option. Now let’s say very few bidders come to the table, and it trades for a 10 cap rate. In this scenario, the discounted valuation for the short-term lease equates to 250 basis points — same tenant, same metro, same building, identical submarket projections for rent growth, vacancy, etc. If the quantification of the rollover risk of the Microsoft lease came to a 150 basis point discount, a buyer should capitalize on the 100 basis point arbitrage opportunity presented by the transaction.
The inaccurate pricing of risk on short-term single-tenant leases does not occur in markets or business segments that are heavily covered. The efficient markets theory holds true in real estate; coverage is omniscient amongst institutions and presents excellent opportunities when it is not. Coverage is not the only reason this situation presents itself. In today’s economic climate, the risk appetite of even opportunistic investors is at an absolute minimum as capital preservation takes precedent over capital creation. Again, this becomes a conduit for opportunity, as the investment itself may have the same risk profile as it would have had 5 years ago, but a lack of buyers further depresses the valuation, ensuring an investment will be financially viable.
The crux of any argument against investing in a single-tenant deal is the rollover risk, but very few investors have attempted to quantify the percentage of single tenants that elect to vacate a property. Historical retention rates of single tenant properties are anywhere from 71 percent to 85 percent for single-tenant office and industrial properties. This is a renewal level many previously hesitant investors could surely accept if properly educated.
Portfolio diversification is another investment mantra that is a further justification for short-term single-tenant assets. On an individual property basis, an investor may not be willing to live with the worst case scenario returns of an opportunistic investment; this can be avoided by purchasing a portfolio. Utilizing the law of averages, the more properties acquired under a risk-adjusted return profile, the closer the performance of that portfolio will come to the weighted average return.
The best way to address the rollover risk of short-term properties is to acquire assets that allow for an easy transition into multi-tenant buildings. A critical component of the risk-adjusted returns profile is maximizing the returns of investments that do not proceed according to the base case scenario. Specialized spaces, undesirable locations, and shallow markets should be eliminated from consideration so that a single investment does not dilute the entire portfolio. If Wal-Mart vacates a big box retail space in a secondary market, the probability of recouping that investment is minimal. Retail assets can be cost prohibitive to subdivide and very difficult to backfill in a short period of time.
Acquiring properties leased on a short-term basis and subsequently disposing of them allows an investor the opportunity of asset repositioning without major capital contributions. The repositioning of the asset to a larger investment universe changes the discount associated with valuation to a premium. The return requirements of investments in core, core-plus and value-add assets are less then that of opportunistic investments. This further exacerbates an asset’s valuation upon repositioning because it allows a non-opportunistic investor to acquire at an increased valuation while still achieving the lower core or core-plus return hurdle. A sub-component of this demand is the availability of financing for long-term leases. While debt does unequivocally exist for short-term leases, it is easier to obtain financing for long-term leases. Accordingly, a buyer would pay a valuation in