Commercial Investment Real Estate Spring 2020 | Page 32

A
10 BIASES IN RETAIL
s much as commercial real estate is a
ARE NET LEASES SAFE OVER THE LONG HAUL?
INVESTMENT
game of numbers, data, and analysis, the
Even when you know the material contractual
human component plays a huge role in
differences between a lease to Home Depot and
what deals are made and how they get done. Ex-
another to an Ashley HomeStore licensee, many
amine your decision-making process — can you
tend to remain unmoved. After all, they have the
comfortably say you’re free of unknown cogni-
credit and support of an A-rated company. Such
tive biases? Probably not. In that case, what biases — psychological, feelings of security arise from another cognitive bias:
emotional, and/or cultural, for instance — influence your choice to go
• High credit quality can be expected to be maintained
this way instead of that?
over the long term.
To begin this discussion, let’s take a simple hypothetical: You
But credit migration statistics tell a different story. Over a
have an opportunity to invest in either a store operated by an Ash- 10-year period, an A-rated company can expect to lose invest-
ley HomeStore licensee or a nearby Home Depot. If all significant ment-grade status more than 40 percent of the time. Over a 20-year
variables are eliminated, which do you choose? When I ask graduate
lease, that credit rating migration will rise to more than 63 percent.
business students, they generally opt for the Home Depot. Those who
As time passes, up to 85 percent of migration can be expected to
don’t are reluctant, still preferring the Home Depot but assuming arise from credit rating abandonment, wherein the company sim-
some subterfuge on my part. After all, Home Depot has exceptional
ply elects to be non-rated. In my opinion, credit migration statistics
brand awareness, a high investment-grade A credit rating, and is the tend to be even worse for companies like Home Depot, which does
nation’s largest home improvement chain, with approximately 2,200
locations. In contrast, Ashley HomeStore has about 800 locations,
most of which are operated by individual licensees. Simply put, Home
Depot as a tenant seems to make the real estate more desirable.
30
COMMERCIAL INVESTMENT REAL ESTATE MAGAZINE
Having Ashley HomeStore as a tenant may have advantages not seen at first glance.
not depend on credit ratings for its successful business model. For
such companies, credit ratings are optional and easy to abandon in
favor of capital strategies having the potential to deliver higher rates
of shareholder return. Netting out the impact of credit migration:
Chasing after investment-grade tenant credit quality typically comes
with the expense of lower yields, lower lease escalations, and inferior
contract quality in the hope that you will be among the 26 percent to
37 percent of investors who still have an investment-grade tenant at
the conclusion of a primary 20-year lease term.
A fourth cognitive bias bears mentioning here:
• Leases are safer than unsecured bonds issued by
the same tenants.
I have frequently spoken with net lease investors who take
pleasure in the good deals to be had when net lease yields exceed
bond yields offered by the same tenant. Their palpable excitement is
typically compounded by the notion that leases are backed by assets,
whereas corporate bonds are generally unsecured obligations. Have
they considered that landlords have different risks than corporate
noteholders? When tenant credit migration invariably happens,
bond holders will generally be fully repaid. And if the migration hap-
pens as a result of credit ratings abandonment in association with a
change of control or corporate recapitalization (which is often the
case), noteholders stand to receive prepayment premiums. Mean-
while, real estate investors will not be so lucky. Their real estate val-
uations will materially decline with tenant corporate credit ratings.
SPRING 2020
TWO COGNITIVE BIASES IN FAVOR OF NET LEASES
Respondents to this question about potential tenants assume that
the investment choices are equivalent. They know that they will
have to accept a lower rate of return with the Home Depot op-
tion, but they think this is like the fixed-income markets, where
A-rated bonds command a much lower yield than speculative
grade bonds. This approach is consistent with the thought that
they are buying a bond-like instrument, and so they raise their
hands for the comparatively higher perceived security offered by
Home Depot.
They have made assumptions potentially based on two cogni-
tive biases:
• The net lease market is as consistent as the corporate
fixed-income markets.
• Net leases are effectively priced with cap rates that
reflect all known information.
The net lease market is anything but efficient and consistent —
and the choices between Home Depot and Ashley HomeStore stores
are seldom equivalent. The Home Depot lease may require the land-
lord to maintain the roof and structure, which entails unknown ex-
pense risk. The lease will also likely have a shorter primary term, and
the investment can be expected to cost significantly more per square
foot. The price for the real estate is important because higher costs
elevate the risk of loss in the event Home Depot elects not to extend
its lease or becomes insolvent. Home Depot can be expected not to
divulge property-level performance data, which means the landlord
will have little idea how successful the location is. Such knowledge
is important because leases on successful properties are effectively
senior corporate contracts that stand in front of most other corporate
obligations in the event of insolvency.
As a landlord, you will have fewer concerns in the event of
tenant bankruptcy if you know that your location makes money.
Home Depot can also be expected to avoid master lease arrange-
ments, wherein multiple locations can be bound into a single lease.
Master leases are likewise important and represent the best means
for landlords to obtain contract diversity and insulate themselves
from poorly performing properties. Leases to highly rated compa-
nies tend to be more tenant-friendly, offering the extended ability
to close properties or to sublease them. In the end, a landlord has a
better chance to have a longer, fully net lease contract — complete
with a lower price per square foot, unit-level financial reporting,
master lease potential, and added contractual protections — with
Ashley HomeStore.