JF1003: What the Big Box Companies Look for When They Lease Commercial Real Estate
Curious about what Best Buy, Staples, and other big bucks brands look for when finding a commercial lease? This episode will show you all the inside numbers of what a large franchise versus a small franchise is required when leasing commercial property.
Best Ever Tweet:
Joel Owens Real Estate Background:
– Principal commercial real estate broker at All World Realty, developer, and investor
– Current clients 1 million to 100 million in net worth
– Hosts a video blog called “Commercial Straight Talk.”
– Specialty is in retail properties
– Based in Atlanta, Georgia
Made Possible Because of Our Best Ever Sponsors:
Want an inbox full of online leads? Get a FREE strategy session with Dan Barrett who is the only certified Google partner that exclusively works with real estate investors like us.
Go to adwordsnerds.com/joe to schedule the appointment.
Joe Fairless: Best Ever listeners, welcome to the best real estate investing advice ever show. I’m Joe Fairless and this is the world’s longest-running daily real estate investing podcast. We only talk about the best advice ever, we don’t get into any of that fluffy stuff.
With us today, Joel Owens. How are you doing, Joel?
Joel Owens: Pretty good.
Joe Fairless: Nice to have you on the show. I saw you present at a conference – J. Martin has a conference in San Francisco and I went to that, we both spoke… This was August 2016. We didn’t have a chance to meet in person, but I was really impressed with your panel and the discussion that you were leading. It was around retail properties, and that’s what we’re gonna focus on.
A little bit about Joel – he is a principle commercial real estate broker at All World Realty. He’s a developer and investor. His current clients have a net worth of 1-100 million dollars. He hosts a video blog called commercial straight talk, and his specialty is in retail properties, and that’s what we’re gonna focus on. He is based in Atlanta, Georgia, for all of our Georgia Best Ever listeners. With that being said, Joel, do you wanna give the Best Ever listeners a little bit more about your background and your current focus?
Joel Owens: Sure. I’ve been in the business for about 14 years. How I got started was a friend of mine had an old laundry that they inherited from their mom, and a commercial real estate developer approached them to buy their Laundromat that was built in the ’50s. I did the contract for him, reviewed the contract, met the developer, and usually people might catch only two or three outs in the contract, and I caught every single out in the contract, and the developer called me and wanted me to come on in and work with them on assembling the best of the parcels there. There were about 20 parcels and 25 acres, about 650,000 square feet of mixed-use retail development, [unintelligible [00:03:53].22] value of 150 million dollars, and I spent about two-and-a-half years working on assembling those land pieces.
After that, the economy went down around 2008, and it was cheaper to buy existing than it was to build, so a lot of the land development stopped. I moved to single tenant net lease property [unintelligible [00:04:13].25] it was at the bottom of the cycle. Then I actually moved more onto the retail strip centers. They vary across the spectrum from most passive to where you have to be more involved. One of the low ends you might have, where it’s for very passive, you might have T-Mobile, Starbucks [unintelligible [00:04:35].13] backed by thousands of locations, 2% annual rent increases. You have the property manager in place, you might look it at a report once a month, set it and forget it. Across the spectrum is the [unintelligible [00:04:48].29] a mixed retail center that has some mom and pop tenants, or regional, maybe one national, and then on the opposite spectrum you might have all mom and pop tenants in the center. The cap rate is higher, but you have to be more careful in your evaluation of those tenants, because so many of them go out or roll out; the actual return could be less than if you had bought the national tenant at a lower cap rate, but they’re not going out, so you don’t have to spend money on leasing commissions with a tenant rep broker, or tenant improvement costs to get another tenant into that space.
Joe Fairless: Do the mom and pop retail strip centers have the same structures of leases that you’ll find with the more — what is the term for the T-Mobiles or the Walgreens of the world?
Joel Owens: They’re national tenants backed by parent corporate guarantees on the leases. As far as the structure of the leases, you have what’s called typically my five-level. You can take, for instance, a Taco Bell tenant that’s owned by Yum! Brands, which also owns Pizza Hut. If you had a lease guaranteed by Yum! Brands itself over tens of thousands of locations, it’s backing that one location, so even if it makes money, loses money, they signed a ten year lease, they’re gonna keep paying the rent like [unintelligible [00:06:05].25] to protect their credit rating, their borrowing costs and things like that.
The next level down would be a subsidiary of Yum! Brands [unintelligible [00:06:13].08] ten states that have Taco Bells in them, or 500 Taco Bell stores are guaranteeing the lease.
Next level below that would be a large franchisee that maybe owns 150 Taco Bells and has been a strong operator for 15-20 years, and then below that would be a small franchisee for the guarantee on the lease that maybe only owns one or two locations.
Then below that would be not even a Taco Bell concept, it would be Joe’s Taco – it doesn’t have an operating manual, training manual, franchise support, advertising or anything… It’s just someone opening up their own small business, trying to grow an individual brand. So across the spectrum, that’s the level of lease guarantees.
Then on the center itself you generally have a triple net lease. Sometimes you’ll have a gross lease, which can be okay… If it’s a brand new center, you might actually come up better with a gross lease, because if you can control your costs more, your net rent that you would get might be higher than an absolute triple net lease. But if you have a center that’s getting older – 5, 10, 12 years – you’re gonna start having costs with the roof and the parking lot and everything else as part of your overall common area maintenance expenses that the tenants pay for above their base rent. Then you want that triple net lease in place, because if it was gross lease and they’re just paying you that rent, then you’re the landlord and you’re paying for the parking lot and roof and all these things; it can get very expensive, and it can take your overall yield down.
So when we look at mom and pop tenants, we look at them a lot more intensively than national tenants. We look for their total liquidity and net worth, we look at the financials if the lease requires them to disclose ongoing sales and financials, to look at their health ratios with the business. Different businesses have different overall health ratios.
For instance, if you take a restaurant, we usually don’t wanna see more than a 10% rent to sales ratio. If they’re paying 100k in rent, we wanna see the sales of at least a million dollars a year or higher for that particular tenant. If they’re going into the 12%, 13%, 14% in rent-to-sale ratio, then likely they’re either gonna leave the space, or they’re gonna come at you for some kind of rent reduction because they’re not making enough money after they add in their food and labor cost to sustain that business.
Joe Fairless: And that’s the rent-to-sales ratio – it’s monthly rent to monthly sales?
Joel Owens: Yes, so generally the barometer you take — because the rent goes up every year generally on these triple net leases [unintelligible [00:08:44].10] 2% or 3% a year; you look at their overall annual sales compared to what they’re paying in base rent. If their base rent was 100k/year, you would wanna see at least a million dollars in sales to be at that 10% ratio. If they’re down in the 6% or 7% ratio, then they’re generally crushing it and they’re very healthy as far as a food establishment goes. If they’re above that level, then they’re in trouble.
The other thing that you have to watch out for is sometimes when the developers build up the centers, they’ll pay a lot of up front tenant improvement costs on behalf of the tenants, so they might give them a $60,000 tenant improvement credit, and if market rent is $25/foot, they sign them on a lease of $29/foot, $4/foot above market, and then they’re hoping over than 10-year time of the primary lease term that the market rent, with increases, will catch up to become the new market rent. So what they’re paying, it will catch up with that amount. Instead of being $25 marked, it will be $30, and then they’re paying $30.
The problem is when you buy a property, that tenant doesn’t last and your market rent is $25 and they’ve got $29 or $30 on their lease, and then they go out and you have to re-lease it again in the market a year later, you’re not gonna get that $30/foot, that you paid an 8-cap for; instead, you’re really now having a 7.2-cap on that center once that goes away. So you have to measure… That tenant has a liquidity of 1 or 1.5 million dollars, even if the business isn’t making that much money or it’s kind of teetering on the edge of that health ratio, they’re gonna stay around for maybe two or three years and they’ll be able to float that business, versus if they’re way undercapitalized and they have to make a profit; then the four or five months that you spend on the tenant improvement credit, and then you could have to [unintelligible [00:10:30].02] that space right away, within a year’s period. All that eats into your returns.
Even if you find someone immediately right away for that space, they do the letter of intent for the tenant, and then it has to go to the lease execution with the commercial attorneys, and then they need tenant improvement built out, and then they have to take the certificate of occupancy that the tenant does for that space, and generally there’s maybe one or two months of free rent if they’re opening the business and getting it going, so there could be a four months time period there where you’re not getting income on that particular unit.
The way most of my deals go – we generally deal with ultra high net worth investors, so if we’re buying a four million dollar center and they’re putting a million down, typically the break-even occupancy after your 25% down is about 68%. So if you had a ten-tenant center and it was full, you had to lose three of those tenants to be almost at a breakeven point with payment mortgage each month… Versus a single-tenant net lease property or if you own an AutoZone and the AutoZone goes out, until you get another tenant in, you’re paying that mortgage every month. So you’re not bringing in anything to be able to service that at all, like you are with a multi-tenant retail center.
Joe Fairless: Or multifamily and single-family investors – we’re seeing a parallel.
Joel Owens: Well, on the single-family residential I get some clients that wanna come in and wanna make that transition from residential to commercial [unintelligible [00:12:00].02] for a while and they just don’t wanna deal with it anymore, and they wanna move into the commercial space.
The one thing is if someone bought a couple of houses and they doubled or tripled in value, or small multifamily buildings, one of the things is at 2.5 million and under range is hyper-competitive because there’s a bigger pool of buyers that would be trying to transition from residential to commercial, and typically the cap rates are more compressed, but just because of the buyer demand and the loan rates that you can get are not as good because it’s a smaller loan balance in the commercial space.
Typically, if you can be in that 3-15 million dollar range, that’s kind of the sweet spot; it’s what I do with a lot of my clients, because anything above 15 million you get the [unintelligible [00:12:45].25] insurance companies, pension funds – they wanna buy the bigger stuff and they tend to get special financing that even a group of investors going in together couldn’t get for [unintelligible [00:12:54].11] because of their track record… So generally, it’s not competitive to buy those types of properties.
And under three million is hyper-competitive, whereas if you’re buying a five or six million dollar property, with a larger loan you might get a 20-25 basis point reduction on the interest rate, and then on the cap rate, instead of buying at a 7.2 in the three million dollar range, in the five million dollar range, because there’s less buyers that can afford, you might be able to get like an 8-cap or an 8.1-cap. By getting 25 basis points reduction on the interest and getting another 60-70 basis points on the cap rate by going to a larger property, you get about 100 basis points of additional return there.
Joe Fairless: I want to ask a clarification question about annual rent to annual sales ratio. You said 10% or lower is good for (I believe you said) a food establishment. Is it only for food establishments, or can you use that ratio for any type of tenant?
Joel Owens: Actually, different tenants have different costs associated with their particular type of business, so the ratio varies. There’s a book that belongs to the International Council of Shopping Centers. For retail, that’s a specialty organization that’s been around since the 1950s. There’s over 70,000 members worldwide, and it only focuses on the retail sector. They have a book that breaks down those ratios by the of business, what ratio to look for.
Joe Fairless: Can you buy that on Amazon?
Joel Owens: I don’t know if you can buy it on Amazon… I know there’s a specific place for ICSC, and they have different offices, and I believe the one in New York or Washington has it. I can look it up in my notes and give it to you as a link for people if they’re interested in it, where they can buy that book.
Joe Fairless: Yeah, that will be helpful. Or why don’t we google? Let’s just do that. Because as much as I’d like to promise I can put that in the notes afterwards, with a daily podcast I’m not sure if I’ll be able to… So what should they google? And if they’re really curious, they can reach out to you, or something…
Joel Owens: I’m trying to remember the name of it off-hand. I think it’s a “cost in sales news report, ICSC”, so put in maybe “ICSC cost in new sales report”, or something like that.
Joe Fairless: So that’s ICSC…
Joel Owens: Yes, it’s International Council of Shopping Centers.
Joe Fairless: Cool. I think we will be resourceful and we’ll be able to figure that out through a Google search. Thank you for sharing that. The 3-15 million dollar range is a sweet spot – what knowledge should an investor have before getting into retail?
Joel Owens: Well, there’s a lot of talk lately about online sales taking away from brick and mortar and that kind of stuff, but if you’re in it every day you have a much clearer view of the overall picture. I have known, for instance, for over the last 4-5 years that big bucks retail is eventually downsizing and changing the landscape of retail for a while. So if I have a high net worth client worth 20 million, I’m not telling him to go out and buy single tenant Best Buy or Coles or something like that, because bigger spaces take longer time to fill. You could be a year or two years filling a big space like that, because if you have a 100,000 square foot space there’s not as many tenants that can fill that space, versus if you’ve got a small strip center and you’ve got a 2,000 square foot space that opens up – there’s thousands of tenants for that space.
Typically, the companies where it makes sense for them to buy something like that is like [unintelligible [00:16:41].03] they can still remain positive on their cashflow, versus an ultra high net worth investor that owns some big property and it goes dark and they have to keep paying that huge mortgage. That could hurt them a lot more, so I typically tell my clients to stay away from that.
In regards to online sales, it’s been going up at about 2% a year, but they’re only about 8%-10% right now of the overall retail sales, and of that growth, about 6% of those are existing brick and mortar businesses that are just expanding their online internet presence. It’s not like you have this huge wave of online-only companies opening up over the internet and taking away sales from brick and mortar. Most of the brick and mortar that’s suffering is OfficeMax staples, the office supply industry, the clothing industry is over-saturated right now… People will go in somewhere and they’ll try the clothing or look at it and touch it, then they’ll go on their phone and try to get it cheaper on Amazon.
Actually, online is not posed to grow as big with individual small companies because it’s like 35 states right now have legislation where they’re gonna start charging sales tax for companies that even sell one product in one state, even if they’re not based in that state. Amazon is actually excited about that, because they’re already paying sales tax in all the states, so that will take away the competitive advantage some of the smaller companies have to try to compete with Amazon where they’re not charging the consumer sales tax.
So what I focus on and what I tell my clients to focus on is destination-type tenants. When we look at a strip center – which is what a lot of my clients buy – we’re looking for restaurants, doctor’s office, veterinary office, workout gym, a nail salon, hair salon, environmentally-friendly dry cleaners’… These are places where the consumer has to go and spend cash and pay your tenants to where they can pay the landlord rent. It’s not like a clothing store, or an antique shop, or a hobby store, where they can just go look around and they can buy it cheaper online. Then your businesses suffer. So we focus on mainly the destination-type tenant.
Joe Fairless: Smart. Makes a lot of sense. What is your best real estate investing advice ever?
Joel Owens: If you’re looking at investing in a real asset class, get with someone who is an expert in that, not a dabbler; some of the mistakes that I’ve seen is people will use a [unintelligible [00:19:13].28] practice attorney for commercial real estate, or they’ll try to use a basic forum instead of paying 10k for legal costs, but it ends up costing them hundreds of thousands of dollars down the line. When you’re looking at buying these properties, you really want a specialist.
For instance, all I do every day is I look over a thousand properties a week, [unintelligible [00:19:36].13] all over the country. My database (that I built up over 14 years) has thousands and thousands of contacts for properties, from other retail brokerages to retail property management companies to developers to individual groups and owners all across the country. In some states alone I have 280 different companies (in one state). I’m able to usually source and look for the best properties.
So for someone that’s new that’s looking at retail, they might be looking at two items that they think might be a concern, whereas I’m looking at 100 different items with a property, and I’m looking for my clients with that before I actually give it to them. I only like maybe 15% of the stuff I see, for various reasons. We’re looking at traffic counts of the road, is it on the going home side or going away side, what are the [unintelligible [00:20:30].28] is it down in a hole or up on a hill where you can’t see it? Is there a median on the road where it’s hard for consumers to turn in? Is the construction [unintelligible [00:20:40].12] to be widened from two to four lanes and access to the properties could be hard for the next year, year-and-a-half? Is it gonna affect your tenants? Are all the leases coming due at the same time or are they staggered? Is the rent going up each year, or is it blocked rent? Blocked rent is where it goes up maybe 10%, but it goes up every five years. Starbucks will have a ten-year primary term lease and then it will go up 10% every five years, which is okay for Starbucks, but with the franchisees types of tenants, if it goes up 10% in year five, they go out business in year three or year four, you’ve had a flat rent for those 3 or four years. That type of tenant you wanna get the rental increase every single year, so if they go out early, you extracted the most rent out of the property.
Then you look if there’s gross lease or if it’s triple net. In the leases I’ll look for any early termination, language clauses… There’s just a lot of things. These assets are mainly passive, but the process of buying them and getting financing for them and looking for all the potential problems with them – you’re looking at a three-month process. But once you get set and you get your management in place, it’s pretty passive after that, but leading up to it, you’re gonna have to put some work in.
Joe Fairless: Are you ready for the Best Ever Lightning Round?
Joel Owens: Sure.
Joe Fairless: Let’s do it. First, a quick word from our Best Ever partners.
Joe Fairless: Alright Joel, what’s the best ever book you’ve read?
Joel Owens: The best ever book… Specifically for retail investing there’s a guy called Gary Rappaport, and it’s on retail investing and syndication partnerships.
Joe Fairless: Best ever deal you’ve done?
Joel Owens: On the brokering side, I have a client that contacted me off of Bigger Pockets a couple years ago; he’s one of my higher end clients, and he bought two [unintelligible [00:23:26].28] of properties for about 22 million dollars, and I made about 410k in commission on that one.
Joe Fairless: Best ever way you like to give back?
Joel Owens: I’m a moderator in Bigger Pockets, I’ve known Josh since he started the site a long time ago; we’ve got over 730,000 members now, and I’ve got about 12,000 posts on there, and I usually go on there once a there… I don’t have time to help everybody individually because I’m working with my clients and my own investments, developing deals for myself, but if I can put something on there and then it can stay on there 24 hours a day, seven days a week, and thousands and thousands of people can read it… So I’ll usually try to answer questions or put information on there that people find useful.
Joe Fairless: And what’s a mistake you’ve made on a deal, either investing or brokerage side?
Joel Owens: There was one deal one time, it was a multifamily building that I bought, it was around 20 units, and it was [unintelligible [00:24:20].08] was showing that the tenants were all paying, but the owner actually took a home equity line of credit out for their personal property, and they were putting that into the units. Only two were supposed to be vacant, 18 were supposed to be occupied, and you looked through the business bank statements and it was showing that 18 of them were paying, but found out post-closing that half that money was coming from the home equity line of credit. They were taking that and putting it in like they were collecting those rents from those tenants. That is considered fraudulent, but an attorney told me that basically I could take him to court and we could spend a year, a year-and-a-half of my life on it, and even if I win [unintelligible [00:25:06].26] I’d still have to chase him for the money. I lost about 15k on that and spent a lot of my time, effort and energy on it. But it was a good learning experience, and I just learned from that that the residential space – I hate dealing with those types of tenants every day; it’s just not my cup of tea. I just like retail, national tenants backed by thousands of stores; it’s more passive, I can be traveling, I can do whatever and I’m not worried about bigger headaches, residential landlord laws being changed more in favor of the tenants. When you get into business landlord law, it’s a lot more favorable to the landlord.
Joe Fairless: Really quick, what would you do differently if you were presented another deal like that? How would you determine that they are using a line of credit?
Joel Owens: I’ve thought about that… I’m trying to figure out if someone’s doing something fraudulent. I think I should have looked at the records more; it was many years ago, I was just getting started, and you get excited when someone’s willing to owner-finance something. I should have looked at the purchase price I was paying more, and I should have conducted more tenant interviews, and I should have looked at these files that they presented with the leases and really saw what wasn’t there that should have been there as far as [unintelligible [00:26:22].03] tenant and the income levels, and everything else… There were probably more red flags, but at that time I wasn’t as seasoned an investor, and so it goes back to it, again — if I had had someone looking at that asset for me that had that deeper level of experience, maybe I would have never gotten into that property in the first place, because they would have known to look for things that I didn’t know to look for at that time.
It’s the same principle with retail – if someone’s willing to buy something, they need to use somebody or go through someone that has that level of experience that sees a hundred things, versus the three things they might be looking at.
Joe Fairless: How can the Best Ever listeners get in touch with you, Joel?
Joel Owens: My website is awcommercial.com. There’s a form on there they can fill out to get in touch with me. They can also e-mail me at JoelOwens@comcast.net. Then they can always call me at 678-779-2798. The only thing I ask of investors when they are looking at investing in retail properties, a typical process is they get in touch with me, I send them a one-page Excel form for their liquidity and net worth statement, to show they have the capability to purchase and they’re a serious purchaser, then we’ll get on the phone call, kind of like we’re on now, where I’ll go over their individual needs and the type of return they’re looking for, if they want a stabilized property or if they want value-add retail where they can increase their returns, and then we’ll kind of set a direction for what they wanna do.
I only work with clients one-on-one. That’s just what I do now, just because of the time that I have. I have to allocate only to clients, and they’re working one-on-one with me. So I just work with people one-on-one, I don’t do anything where they’re trying to work with 10-20 brokers at a time and all that kind of stuff. I don’t have time for all that.
Joe Fairless: Well, Joel, this was educational as I thought it would be – learning all about retail strip centers, the five levels of lease guarantees for retail properties, the lease guarantee by (and using) Yum! Brands as an example, backed by thousands of locations is one, the subsidiary of a Yum! Brand would be the second level, a large franchisee who has hundreds of stores would be the third, a small franchisee four, and then you affectionately called it Joe’s Taco’s, number five. Those different levels have different risks associated to them, and holy cow, a bunch of other stuff that you talked about… The annual rent to annual sales ratio – 10% or lower is good for food establishments, and you gave us some other resources on the show.
Thanks so much for being on the show. I hope you have a best ever day. I really enjoyed our conversation, and we’ll talk to you soon.
Joel Owens: Thanks a lot, I appreciate it.