NNN single-tenant properties, especially NNN single-tenant retail commercial real estate properties can pose real challenges for investors in 1031 exchange vehicles such as the commonly-used Delaware Statutory Trust (DST) transaction construct. NNN properties represent the proposition of accepting tenant quality risk in exchange for an earnings opportunity on the investment that is based upon the tenant’s current risk profile. In the DST/1031 exchange construct, this agreement really means we are investing in the prediction the tenant’s business prospects will not change over a 10-year period. That’s a pretty bitter pill to swallow and when we add the retail vertical to the equation, it starts to be a little bit scary given the yields are typically projected to be quite low compared to what are supposedly much more risky transactions such as commercial real estate acquisition, development and construction investment transactions that have much shorter holding periods. This places a special burden on the commercial real estate finance due diligence and underwriting.
Recent history is replete with examples of NNN single-tenant CRE retail properties where the tenant quality picture changed drastically within a 10-year period. The e-commerce driven implosion of retail points to the reliance on a back-up plan as a condition precedent to investing capital in these transactions. DSTs are usually constructed with a “Springing, LLC” mechanism that comes into play when things have become a disaster and that is a good start to be sure. The reality is that technology risk will continue to hold the entire CRE vertical hostage to future market disruptions that innovation and advances in technology manifest in the form of new and/or additional competition for the property’s local trade area. While the sheer number of consumers in almost every market continued to expand over the past 10 years, the market penetration opportunity for many retailers continues to be eroded. Some thought that merely having an online presence or connection to Amazon would stave off losses, but this has not played out as being an effective strategy for Sears, ToysRUs or any of the other recent disasters.
All of this points to the requirement in underwriting to create proactive alternative use plans for re-positioning or re-developing the site and land improvements in a real-time environment if the CRE vertical is to continue enjoying capital market support.
What does it say to you?