How to Invest in Commercial Real Estate

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Episode #034 - How Commercial Leases and Guaranties are Structured and WHY?!

by Criterion, Braden Cheek, Brian Duck
June 25th 2021

At the end of the day most people just want a safe outlet to invest in commercial real estate. Today our hosts Brian Duck, Braden Cheek & Joel Thompson from The Criterion Fund review how most c... More

there's some value to a national brand, like a kiddie academy. Uh, even though the franchise, he may be new or only has one or two locations, it's still better than, you know, joe's childcare, you know, on the corner. First of all, if you're sending you get jobs, childcare on the corner, stop, stop right now. Yeah, yeah. Welcome back to that investing course, real estate guys. Uh, it has been a busy couple of weeks for us. We're swinging deals were about to break ground on, on a deal here in Owasso in august were about to close on a deal in Vegas here in a couple weeks. Um, I know you got a deal you have going on right now. We're just finishing up an equity raise on a multi tenant retail deal in a fast growing county of ST louis Missouri and we're about 80 85% funded on that. Pretty cool. Pretty cool. Anyway. Uh, there's a lot going on. So I mean just if you would have been on our two um, investor email list, you probably would have gotten hit with 345 investment opportunities over the past month. So sign a reminder, precision equity dot com criterion fund dot com.

Absolutely, super easy typing an email name, boom. All the investment opportunities you want to, your email. Um, anyway, today is all about the different types of guarantees or structures on commercial lease. So, you know, when you buy a commercial building, it's typically occupied by a tenant. Uh, several tenants, they've got a lease and you need to understand the financial weight behind that least because that leases is really the only thing that you have to rely on, that you're gonna get paid month over month and hopefully have a profitable commercial real estate venture and you need to kind of dig in and do some due diligence on the tenant. Um and and looking into the different types of credit they have or their lease structure is the best place to start. Yeah, I mean, we we typically put them in three categories. You've got a national credit tenant uh which is gonna be walmart, it's gonna be Starbucks, Walgreens, Home Depot. You know, these these groups typically are publicly traded. They typically have, you know, hundreds, if not thousands of locations. We've got regional credit tenants, which uh, you know, it could be anything from a, like we have a regional credit tenant are Memphis Deal, it's a private equity group, it owns 600 Planet Fitness is across the country.

Uh So they're not, they're not a publicly traded group, but they, they are really strong financially. And they've got a bunch of locations kind of spreading out their risk, right? And then then you've got what we call local tenants or mom and Pop is a term we use in the business where they, you know, they may have a nail salon, they may have a doughnut shop, uh maybe a restaurant of some kind and or they're selling their their knickknacks and they just have that one location and the strength of that leases just on on their guarantee and their financial, so that that's kind of the broad categories that we can discuss today. Yeah. So let's let's start at the top, let's go back to national tenants. You know, let's say um somebody wants to buy a chick fil a. You know that that would maybe be pretty appetizing. You would think man chick fil a is always going to pay their rent. They're never gonna default, man, they're so busy, they've got lines out the tail. If I want to own a piece of commercial real estate, I want to own a chick fil a I mean it seems pretty safe, right? Why can you not own a chick fil a. Well you can you can own a chick fil a I think just don't make any money. Well there's pros and cons to each uh each of these tenants.

And so uh it all depends on what your goals are and that will help you decide which tenants you're gonna go after. It's a great point. Yeah. So chick fil a uh you know you're gonna get typically along a longer lease. Uh you've got a great strong company that you can really just kinda forget about that 10ant. So it's more of a preservation of capital. Like hey I don't want to lose my money, you're not going to lose your money at least in the short term, you're not gonna lose any money. And in fact, they're gonna make sure they pay you every month. It's just stress free ownership of commercial real estate. That would be a positive. The negatives are uh you know, the cap rate that you're going to buy it is going to be really aggressive if you don't have a substantial bumps in the lease. The future growth of the value of that property is limited, uh even though guaranteed or semi guaranteed, it's limited. And how much the value of that property can increase. Um your cash flow is going to be lowered. The returns are gonna be lower in the in the near term because of the cap, right? You're buying it on, so you're trading uh security uh for lower returns, Your trading optimal location for returns, all kind of geared around safety and security versus a higher risk return profile.

And that's because they're there more of a sophisticated buyer also, right? Aren't they gonna negotiate a little harder? They've got probably a whole group dedicated to negotiating leases, Right? And so, so as opposed to maybe a couple of these others on the lower tier, they're they're very sophisticated. They're gonna, they're gonna negotiate pretty hard, aren't they? Yes. And and, you know, example of that, I was negotiating with ross a billion dollar group for their deeds concept in one of our our locations. And, you know, so the positive in getting them is that I'm gonna get a 10 year lease. Uh, and the center with the national Credit tenant on a 10 year lease, I'm gonna be able to sell that at a lower cap rate. Yeah. So that, that's really, really positive fun facts known share the ross doesn't pay anything in, right. They are a very good lease negotiator to the point of absurd. Um, and So what we ran into is not only do they not want to pay rent a lot of rent today, but they also want 55 year options, 10, 5 year options with minimal increases.

So they've literally locked in your upside. So they think what were so big and we're such a great credit risk that they can negotiate a better deal, right? That's exactly right. And so we ended up ultimately not doing the deal with them because we were able to get a lot higher rent from someone else that was still had some credit. But those are the pros and cons of working with these national tenants is that they are going to be really tough negotiators. And uh, you know, they're gonna negotiate things in that least to obligate the landlord to a bunch of different risks that you don't have with a mom and pop, you can kind of steer the discussion with a mom and pop and put the risk on them where the national credit tents are gonna put future risk of, you know, Capex expenses or roof repairs or whatever on you. So, and another advantage is even if that location, let's say you have a property in that particular location for this big national tenant is not doing well. They've got the backing of their home office to, to make sure that they pay that rent it, right? Yeah, yeah. Go ahead. Yeah. A lot of the times and you can just, I mean they're publicly traded companies so you can just look up the, you know, the financial stability of these companies ross.

You can just go look how they're doing, how they're performing, how their shareholders feel. You know what their board is doing. You know, we bought a center with a Gamestop in it. We assumed that Gamestop was gonna be vacant because Gamestop stock, you know, went from an all time high down to nothing. You know, who's buying video games and strong anyway, it's just, you can look at that kind of stuff and it helps you make assumptions because you're going to go in, you're gonna say, am I going to keep this 10? Am I going to lose this tenant? Am I gonna be able to replace that rent? Am I gonna be able to back fill this space? And you've got to be able to plausibly say, I've asked that question because when Gamestop leaves and your investors come to you and say, hey, why did Gamestop leave? And you're like, man, I have no idea. I thought they were doing great. But then like they're a publicly traded company and they weren't doing great. You're, you're in a world of hurt. You should have been able to find that information, right? So let's go down to the next level regional. You talked about. Is there any difference between regional and these big, these big national change? Really? Yeah, I mean, I think there is a difference. Uh, you know, a regional could be, like I said, you know, 10 locations, 50 locations typically not public yet not public.

Um, So they're just going to be perceived as slightly more risky, slightly less guaranteed than a national credit tenant, Right? Because the national credit tenant things go up and down. But as long as you're checking their financials, you know, it's, it's thought that, well, they have so many locations, they can absorb, uh, some downturns and still be in it for the long term. Uh, franchises could be considered regional credit. You have, um, you know, T Mobile, T Mobile may have, you know, Tens of thousands of corporate stores, but they have 10 times more franchise stores. So you may have a regional operator of T mobile stores. Where like you said, you know, with the planet fitness or whatever. Some franchisees, Yeah, they may have, they may franchise, I don't know, maybe Subway or something and they've got 30 Subway Subway locations, right, Their experience, their financials are gonna be stronger. And, and so they're, they're going to be a better tenant, uh, you know, long term, once again, it's all relative. But that's, that's the next here on that deal. Does the corporate office back it because it's a franchise or not?

Typically, you know, I would say no, like, um, you're, you're going to get that, that franchisees credit. So if they have one location, they're obviously going to provide more risk versus someone that has 30 proven operating locations. Okay, that makes sense. Yeah, I would, I would say the same thing for a kiddie academy. You have a national brand, but you have kind of a regional or local operator. Um, you know, it's just, you need to know either way, you need to know where your recourses, whether that's on the tenant or on the operator on the franchisees and you need to just go down and ask questions along the way of, of how each person, each different level could help you. Uh, maybe a recourse or at least negotiation or, or you know, acquiring debt or whatever. Right? And there's some value to a national brand, like a kiddie academy. Uh, even though the franchisees may be new or only has one or two locations, it's still better than, you know, joe's childcare, you know, on the corner. First of all, if you're sending you get jobs, childcare on the corner, stop, stop right now.

But you know, it's a national, uh, so that, that means when, when parents are looking up where to send their kids, you have a brand at your location, it's, it's going to be safer and better to have that. That's just a mom and pop. So you know, as we kind of moved from, from regional to local, you know, local could be where the money is made. A lot of people can get scared of of local tenants. Um, you know, a lot of bigger corporations may be on the coast or a lot more sophisticated buyers and local tenants. Um, I, I found that most often more often than not, the owners of those centers are probably local themselves because they're the ones that can truly appreciate this stability that they would bring. You know, if, if you've got a local pizza restaurant that you know, is slammed every night of the week, but it's the only location you should still feel some comfort knowing hey, this, this pizza joint is slammed. Maybe talk to the owner. Hey, you're doing great house sales. You know, maybe you lose them because they're doing too good and they need a bigger space. But I mean there's still that in person element and a lot of times there could be some value.

Um, you know, we had a center in contract with um, a regional jim tenant and we want to buy it and the gym tenant defaulted in the middle of covid and it was kind of upset and you know, we told seller, Hey man, if you get retested, we'd like to buy it. You have a nice center. Whatever they come back with, what they think is this tiny local tenant, you know, a pretty undesirable tenant church at that. If I'm going out of my market and I find a local church tenant, I'm typically pretty hesitant because it could be fairly risky. I don't know anything about the church or the local aspect of it. You know, a lot of churches are bet on like one person if that one person goes south whole church itself. Anyway, churches are kind of not the most ideal when you're looking at buying a shopping center anyway, this, this seller says they get a local church church on the move is going to occupy the center and where is like. Mhm. Yeah, they're pretty strong, Pretty strong, pretty strong, they've got the strength of, of national brands, but they're 100% a local tenant and there, there can be a lot of comfort in that just by you digging in and knowing um you know, the the credit of him, even though it's not publicly accessible.

So I want to talk about some of the positives of looking at deals with mom and pops because obviously that's kind of what we own and uh you know, I would say that there's gonna be less competition for centers like this just off the off the bat is you have national credit tenants. Not only is our the rent's gonna be lower in the cap rates and the return is gonna be lower because you don't have as much risk, but there's less competition for these deals. Uh And so for me that's a big plus. Another one is local tenants. You typically are able to negotiate way more favorable lease terms and they're gonna be shorter leases. And you may say, well joe, why do I want a short lease? Like a three year lease? Well, uh it depends if you're buying a center that is lower than market rate on your rent, then the ability to increase that rent comes at the at the least renewal. So if you have a ten-year lease, a 15 year lease, you don't get to change the income substantially. Uh you may be guaranteed to get that income. But for us we're value at guys. And so for me that's that's been a big positive for us is is like on our village south centre, we walked in to rent at $10 a foot and we're renewing them at 14 at 15 and that's 40% increase in bottom line in a y uh because that's what the market could bear.

But a national credit tenant gonna, for one, they're gonna be on a longer lease. But to they're not, they're gonna be cutthroat on their negotiations that we're gonna accept a 30% increase in rent. Uh If they would they move across the street and get a developer to build him a brand new building. Yeah, I would think it would be easier to to negotiate a shorter lease with the local firm because they're not exactly sure what the future holds right. They may grow, they may, they may string and they want a shorter lease probably right. They're willing to pay a little bit more with a shorter lease hoping that they grow and next time maybe they say, okay, well maybe we can negotiate a longer lease. They pay more for the flexibility in a sense, they should pay more for the flexibility to get out of it. But once again, if if we're buying at the right level price per foot and rent per foot in the market, Then we're not worried about losing a mom and pop 10ant at $10 because we know that that's a competitive rate. We can we can backfill Just 100 downside protection. That's right. And so you know what I'll say just for people listening is uh there's something to be said for high quality real estate. Uh And I'm all for people that can afford that that want those returns.

And if you get in the right market the appreciation and a high growth market could very well be a huge return. You're talking about the chick fil a at the Starbucks on the busiest corner of town. Yeah, something like that. If you can get in in in in in inflation and that and that growth in that, it helps you awesome. But for me what we've had success in doing is whenever there's uncertainty, whenever there's risk there's opportunity and so I want people to hear that is that the more uh you're not gonna be able to be super competitive with the national credit tenants and the huge properties and the best locations at first. So these this is why we kind of preach these these style of units is because uh you know we can evaluate the mom and Pops and yes it's messier and yes you've got a little risk and a little turnover and things to worry about. But the return is in those numbers. Uh if you buy it right. Yeah if someone on the on the local level comes to you. And do you have them give their financials and if their financials or low do you ever turn them down on the lease or do you just a 100%.

It's just like renting an apartment. In my opinion. If you go rent an apartment, you're gonna fill out an application, you're gonna have a job stuff and they're gonna say you make 2.5 times the rent or whatever, maybe three times spending where you live in maybe four times it's gonna be similar and commercial, you're gonna fill out an application with the manager, you're gonna you will what's my net worth, what's my balance sheet, here's my financial statement. Depending on how sophisticated you are. You may not have to submit that. You know what I mean? Your weight may speak for itself and they may not want to show their cards before they start negotiating. But for for me though, I'll say this, let's say I have a vacant, uh, vacant parcel or whatever that, that someone comes to me and they want to rent and they don't have good financials. Well, if they say, hey, uh, we don't want any improvement dollars, we're gonna sign this lease and 30 days later we're gonna start paying you and we'll build out the space the way we want it done, I'm gonna let them because it doesn't cost me anything and I've had a hard time leasing that space. And so for me, it's just like, let them go to town and if they're successful, we both win. If they're not, why didn't give them a bunch of money. Yeah, you're the big blind is free to see the flock for sure. But if it's flipped, if they come and they say, hey, we need, we have this new pizza concept and we just happened and we want $100,000 to build out our space and, and by the way, our financial suck.

Well why am I going to spend 100,000 building out a pizza joint for this. These people that don't have any money and have not done this before. To me. that's risky or so yeah, then I'm gonna probably turn them down, this is too big a risk up front for me. Yeah, I mean, I feel like we literally just chose this. I mean you were picking between a couple of tenants on a restaurant deal and you know, one was maybe less rent, one was maybe high rent, but the less rent paid today, you know, hey, we're willing to take the risk. We know this concept is going to work, we may not be the highest paying rent, but we're gonna start today and and we believe in it versus the next guy is like, hey, I'll pay you a ton of money if this works, but I need 678 months for free to see if that works and the risk is on you. So, you know, I'm not saying there's a right or wrong decision there, you may end up better one way, but you know, money day one and putting the risk on them is sometimes the best decision anyway. Um I hope we enlightened you the ability to go and and read the lease and understand the guarantee structure and understand, you know, where the credit is coming from, where you're recourses, how that helps you with acquiring properties are acquiring the debt or, or just how you look at deals and where you want to buy them.

Obviously there's a lot more discussion to be had on this, but it was just an intro to say, Hey, be looking at what kind of credit tenants you have and what are the pros and cons for each tier of 10 at national, regional and local. And and understanding those will help you increase your potential to be profitable. Absolutely, Anyway. Thanks guys, we will catch you next time. Okay. Thanks.

Episode #034 - How Commercial Leases and Guaranties are Structured and WHY?!
Episode #034 - How Commercial Leases and Guaranties are Structured and WHY?!
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