Small-Cap Tenants: The Solution to Today’s Net Lease Product Shortage?

By Joshua Pardue, Director, Stan Johnson Co.: If an investor is working with a small-cap tenant, trying to get financing to buy or build his or her property, there is quite a bit of homework to be done.
J Pardue-LV 2012 (13)

In today’s market, it is becoming increasingly common for owner-occupiers to sell their buildings and sign a long-term lease with the new owner. These sale-leaseback transactions allow the business owner to free up capital for higher yielding projects. Similarly, tenants seeking new facilities may consider a build-to-suit project, signing a long-term net lease for newly developed space. In either scenario, potential net lease investors of these buildings frequently find that the tenant does not offer investment grade credit. Moreover, buildings that are leased to investment grade tenants are not being brought to market at a rate that matches current demand. In an effort to search for alternative strategies that will lead to higher yields, the normally risk-averse net lease investor may need to consider a non-investment grade tenant as an option. This can be an effective strategy to achieve risk adjusted yield, as long as the investor is willing to conduct the proper analysis to evaluate risk. Knowing how to thoroughly and accurately analyze companies for potential investors has helped me conduct a significant number of transactions over the last few years, with the majority involving small-cap tenants – or companies whose annual revenue ranged from less than $1 billion down to $1 million annually.

When one invests in a net lease property, the investment is made according to the anticipated yield and the risk-adjusted probability of receiving this income. Thus, the decision to invest or not will be largely based on the tenant’s credit, or their ability to pay the rent for the term of the lease.

If an investor is working with a small-cap tenant, trying to get financing to buy or build their property, there is quite a bit of homework to be done. First, the tenant’s financials will need to be reviewed, and the use of ratio analysis will help determine if the tenant is trending in the right or wrong direction. Following that, an industry analysis should be conducted to see how the company is positioned in the industry, and where the industry as a whole is going.

In addition to composing a traditional offering memorandum, a separate business summary must be created in which the company’s narrative is told. The business summary should address whether or not the tenant is well positioned in its market and help build a case for why the tenant will be able to fulfill the financial terms of its lease obligation. The organization’s leadership structure should be outlined, the story of the local economy should be addressed – not just focusing on the town or city, but taking a close look at the neighborhood and immediate surrounding area – and a full explanation of how the tenant’s industry fits into the local environment should be included. All of these considerations will play into the company’s probability of long-term success and the likelihood of the long-term net lease investor receiving rent for the length of the term.

Putting these company narratives together is a process of going from broad to narrow. Look at the economy in which this tenant is involved. Is it cyclical? What national or international trends may influence the tenant? Are there regulatory or technological issues that could affect the tenant or the overall industry?

Once the tenant’s strategy is known, the following questions can be asked: can the tenant successfully achieve that strategy operationally, and is the tenant’s success represented or supported by the financials? Where are they today, compared to where they are going? And finally, it is often helpful when examining a company’s financial trends to conduct a SWOT analysis (strengths, weaknesses, opportunities, threats) to see how they compare with their peers or competitors. The outcome of this analysis, along with all the other insights collected, will help the investor decide whether or not to proceed with the transaction.

Despite the fact that underwriting private companies without a credit rating can be arduous and challenging, we have been able to secure capitalization rates in the sixes and sevens for buildings tenanted by sub-investment grade companies. By knowing how to thoroughly and accurately evaluate these offerings, you can help to facilitate the acquisition goals of your net lease investor clients. Just during this decade, we have watched the industry grow from less than $20 billion in single tenant sales volume to more than $45 billion last year. And as the market continues to grow, we expect more and more transaction volume to be driven by small-cap tenants, or non-credit deals.