Valuing a STNL Leasehold

Single tenant, net-leased properties (STNL) have become very popular with many commercial real estate investors. These are properties frequently featuring both well-established retail and specialty tenants such as Walgreens, Rite Aid, Home Depot, Dollar General, Sonic Restaurants, and banks, tenants whose branded improvements are located on land under a long-term ground lease, usually 20-50 years.

These properties are usually marketed with heavy emphasis on the financial strength of the tenant, and on the fact that the NNN lease relieves the owner of the improvement of almost all management responsibilities.  As such, they are presented as near-ideal, low-risk investments, especially for investors who have grown weary of management chores.

In reality, the majority of these leases are invariably very overpriced and often fail to provide adequate rent increases (if any at all) over the prime term of the lease thereby depriving the owner of the ability to keep pace with inflation. For example, a rent dollar which does not increase over a prime term of 20 years in an inflationary period of 3.0% p.a. delivers the purchasing power of only $0.55 in the 20th year.

The problem of overpricing is caused by the uninformed or inexperienced  broker who capitalizes the first year’s net operating income to establish an asking price. The capitalization approach to establishing the value of an income property is the most commonly used method by which an asking price for an income property is created.
The formula is simplicity itself: Value = NOI/cap rate. Therefore a NNN property delivering $110,000 in annual net operating income, capitalized at 6.0% suggests an investment value of $110,000/ 0.06 = $1,833,333.  What goes unnoticed is that this formula is identical to that used in establishing the Present Value of an annuity which continues forever:  a perpetual annuity. The concept of a perpetuity is inherent to the method itself.

The problem is that STNLs do not provide operating income in perpetuity. The income is limited to the term of the lease which, during the prime term of the lease either remains flat or is increased only modestly and infrequently. But the value of any investment is the Present Value of all the future net receipts the owner can reasonably anticipate, together with the Present Value of any reversionary income, all discounted at an acceptable yield rate. However, ground leases (leasehold interests) have no reversionary value at the termination of the lease because at the end of the ground lease ownership of the income-producing improvement typically reverts to the owner of the land, the ground lessor.

If the $110,000 in NOI is discounted over 20 years at 6.0%/p.a., the present Value turns out to be $1,261,691, a difference of $571,642.  It is fair to ask ‘what is the source of this difference?’

If the investor stands at the end of the 20th year, the Present Value of all future $110,000 annual receipts capitalized into infinity is still $1,833,333. But this value discounted back 20 years to today at 6% p.a. is $571,642. This amount is the Present Value of the future income stream which the investor will not receive.
Therefore the financial value of this property is $1,833,333 less the $571,642 he will not receive.
The investor who pays $1,833,333 for this property will overpay by $571,642.



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