Best Ways to Capitalize Net Lease Development

Best Ways to Capitalize Net Lease Development

Many people think net lease transactions are fairly cut-and-dried—that the properties and procedures involved are standard and do not vary much. In reality, net lease transactions have become far more diverse than they used to be due to lease restructures, small-cap company credit underwriting and more creative deals. Developers are aggressively pursuing single-tenant projects that they can build-to-suit for a tenant looking to enter into a net lease.

Brokers across the country are working to raise money for build-to-suit projects where the developers have zero co-investment. Additionally, brokers are able to get pursuit costs reimbursed out of the first draw by structuring a joint venture in which, at the end, the property is sold to a trade buyer who becomes the long-term, stabilized owner. The developer typically earns half of the development profit—sometimes more—without having to rely on local bank guarantees and “friends and family capital.” The equity partner gets extraordinary risk-adjusted returns with a fully executed long-term lease from a strong credit tenant.

There are three main options for capitalizing net lease developments. The most common scenario is the waterfall equity structure described above: a joint venture with an equity partner who eventually sells the stabilized product—usually to a 1031 exchange buyer—at a significant profit.

Another alternative is to bring the eventual long-term owner into the deal at the beginning. That owner buys the land and funds the construction though monthly draws. At the end of the process, the developer is bought out at a pre-determined cap rate that is favorable to the new owner.

If the development entity wants to use its own debt and equity, a broker can typically arrange a forward commitment contract. In this scenario, a buyer agrees to sign a non-refundable contract with a deposit—usually between five and 10 percent. The deposit must be large enough that if the buyer does default, the developer would have significant compensation that could also be thought of as a hedge. The hedge would be against the value decreases as a result of interest rate rises that could eventually drive up market cap rates. This way, the profit margin, or spread, on the development cap is firmed up before cap rates and interest rates rise, and if the developer does need to find a new buyer at a higher cap rate, they can afford to adjust pricing on the deal.

When experienced and knowledgeable brokers are consulted before the lease is signed, they are able to provide developers with credit research on potential tenants, comparable deal structures, current market cap rates and comparables, as well as consulting on specific tenants’ lease structures. With regard to the lease, an in-depth review allows the broker to determine if both parties could benefit from slight changes—for example, altering which party is responsible for which expense, or other nuances that impact the stabilized asset’s value. Some tenants have standard lease contracts that they use consistently; brokers are often able to show the tenant advantages to deviating from that standard document, and by securing the most cost-effective capital, they can give the tenant a lower occupancy cost. By providing enough funding to push the project forward, they meet the investment needs of private and public investors.

One recent examples involves the development of Arizona General Hospital—a 38,900-sq.-ft. medical hospital located in Phoenix. This was approximately a $20 million development, fully leased to First Choice ER LLC, under a long-term, triple net lease with built-in 2.0 percent annual rental increases. In this case, the tenant agreed to a 20-year lease. The developer assigned the land with the equity partner and entered a development services agreement by which they went into a waterfall structure to divide the value creation. Thus, the tenant secured the project early on, and now has a turn-key facility. The development team was able to get cost effective capitalization from a strong partner’s balance sheet, and the equity partner, and eventual owner, got a better unleveraged yield on cost.

Josh Pardue is senior director with Stan Johnson Co., a net lease investment brokerage firm.

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