A Guest Post By Bryan Gitlin, Managing Partner, Cambridge Capital Advisors

Why Investors Are Actively Pursuing Net-Leased, Investment Grade Commercial Real Estate As A Safe Haven In Today’s Troubled Economic Environment.

The investment community is slowly continuing its recovery from the effects of the sub-prime mortgage crisis as well as the collapse of the CMBS market. At this time, public and private, institutional and non-institutional real estate investors have continued to actively invest in an asset class where the laws of supply and demand are creating CAP rate compression where real estate values across the board have largely depreciated. The genre of commercial assets that is being referred to is comprised of single tenant, net leased, investment grade properties.

Analysis Factors

In acquiring an asset of this nature, the investor typically purchases a fee simple interest in the property. The property, comprised of the land and the structure that sits on top of the land, is leased by a corporate tenant with an investment grade credit rating (S&P rated BBB- or better) on a long term basis. In analyzing the merits of a single tenant, net-lease deal an investor will research and underwrite the strength of the corporate credit that guarantees the lease payments, the terms of the lease and any lease options, the landlord and tenant responsibilities that are enunciated in the lease and the relative strength of the demographics and trade corridor where the property resides. In addition, the investor will look at the intrinsic value and location of the property, the rent that the tenant is paying per square foot and the sales data for the location if available. This analysis is critical in underwriting the viability of the tenant and their ability to successfully operate in the location over the duration of the lease term. The investor will also look at the capitalization rate as a function of determining the rate of return on the investor’s equity in the event that acquisition is made entirely with cash. An investor looking to utilize leverage will also search out financing options if higher returns are mandated by that investor’s acquisition criteria and may also depend upon the amount of equity the investor is looking to place.

Risk Factors

The obvious worst case scenario for an investor in a net lease deal would arise in the event that the tenant abandons the location. This scenario emphasizes the importance of underwriting the tenant’s credit worthiness as the tenant would still be responsible for paying rent through the balance of the term regardless of their occupancy of the real estate. Furthermore, the importance of evaluating the intrinsic value and location of the real estate in addition to the rent being paid by the tenant as a function of whether the rent is in line with the local market is critical in the event that the tenant is ever declared insolvent or adjudged bankrupt as the responsibility of re-letting the building would fall on the property owner. The risk assumed in this absolute worst case scenario is more than offset by conservatively underwriting the tenant and their credit in addition to the overall market demand for the real estate.

Benefits of Asset Class

Furthermore there are a number of reasons why investors looking for higher yields in today’s economic climate are looking to invest in this asset class. Where yields in the stock market, bond market, money market accounts and CD’s have clearly suffered, investors in single tenant net-leased, credit real estate are experiencing returns in the seven to twelve percent range depending upon how the real estate is financed. Considering the non-management intensive nature of ownership, the tax benefits of real estate ownership, and the principal reduction of the debt that is afforded by the tenant in the event that the acquisition is financed, these investments are highly preferential for a wide variety of cash return driven investors including those that are in the process of estate planning.

If you are interested in obtaining further information on investing in single tenant, net-leased, commercial real estate or would like a free consultation/valuation of your investment property, please contact Bryan Gitlin via email (click here) or by telephone at 617-964-1031.

Bryan Gitlin, J.D. has been actively involved in the acquisition, re-development, management, leasing and disposition of commercial real estate since 1998. A founding member of Cambridge Capital Advisors and seasoned investment broker, Mr. Gitlin’s concentration is the acquisition, disposition, underwriting and deal sourcing of investment properties with a primary focus on single-tenant net leased properties and shopping centers nationwide.

Apparently for the first time, a Massachusetts trial judge has used a newly decided corporate successor liability theory to hold a newly formed company responsible for the debts of its predecessor, yielding a $2 million judgment for back rent and interest. The plaintiff in the case, Renaissance Worldwide, had leased space to Sitara Networks, a voice-over-Internet (VOIP) company, in a Waltham building. Sitara arranged for a creditor to foreclose on its assets and then bought them back, reopening as a new entity, Converged Access. Converged claimed that it should not be responsible for the hundreds of thousands of dollars in back rent and interest owed by Sitara.

Superior Court Judge Bruce R. Henry said “not so fast,” and ruled that Sitara’s plan to reemerge as Converged Access was improperly designed to shed the company’s unsecured debt, scrubbing the books clean with the transaction. He ordered Converged Access to pay a whopping $1.2 million in back rent plus $800,000 in interest and attorneys’ fees. Judge Henry’s ruling is reportedly the first major decision relying on a year old Milliken decision from the Massachusetts highest court on corporate successor liability. The judge wrote:

“That plan causes me the same concerns as did the similar plan of the defendant in the Milliken case,” Henry wrote. “As the Supreme Judicial Court found in Milliken, ‘Notwithstanding our respect for the integrity of corporate structures, we are troubled by the notion that by merely changing its form, without significantly changing its substance, a single corporation can wholly shed its debts to unsecured creditors, continue its business operations with an eye toward returning to profitability, and have no further obligation to pay such creditors.’”

A Young Company Pursues VOIP Technology But Runs Into Trouble

Sitara, the young company was pursuing voice-over-Internet protocol technology – or VoIP – which essentially allows phone service to work over the Internet. In April 2002, Sitara stopped paying its rent and began talking to Renaissance, the landlord, about renegotiating the lease, but the two never reached a revised agreement. Sitara failed to pay the rent over the next 15 months, accumulating a $1.2 million debt. (Why the landlord let the rent accrue this much is beyond me).

Meanwhile, it owed Lighthouse Capital Partners, a secured creditor, $1.1 million. In 2004, Sitara began working with Argus Management Corp., a consulting firm that specializes in helping distressed companies. Argus tried to negotiate a reduced rent, but the two sides never agreed to terms. In April 2004, one of Sitara’s founders, Malik Khan, sent an e-mail to some colleagues discussing the rent negotiations with Renaissance and outlining several options, including selling the company to Lighthouse and buying the assets back. “We hand the keys to Lighthouse and then purchase the assets back from them,” he wrote. “We have spent time working this last option out with Argus, who have much more experience at this than we do. … Financially, this is a better deal for all of us but more complicated.” In a later e-mail to an investor, Khan spelled out the plan in greater detail: Lighthouse would take over the assets and a new company would buy them, getting “Sitara’s current business, assets, IP, brand names, trade marks and copyrights, with no debt on its balance sheet.” And he noted that, if done “expeditiously,” there would be “a seamless transition from employees, customers and the market, with minimal disruption to business.”

Not So Fast Says The Judge

After several years of litigation, the Judge ruled in a jury waived trial that the plan “engineered by Khan with assistance from Argus and the cooperation of Lighthouse was designed to permit Sitara to continue its business, albeit with a new name, and to shed its unsecured debt.” He ordered the defendants to pay $1.2 million in rent plus roughly $800,000 in interest, as well as attorneys’ fees, which have not yet been calculated.

Take Away

The take-away from this case is think twice before you engage in an end-game corporate foreclosure strategy under which a new related corporate entity is formed to “cleanse” the debts of the predecessor insolvent company. This applies not only in the real estate leasing context but for all types of corporate debt situations. With the economy still recovering, I would expect to see more of these “loan-to-own” successor liability cases as companies squeezed by the credit crunch look to get rid of debt while avoiding the longer, more expensive bankruptcy process. There is still much distressed corporate debt out there and otherwise sound companies that are victims of the credit crisis.

I’ve been waiting for an opportunity to write about commercial leasing and this new case which just came down provided a great opportunity. The case, Renaissance Worldwide Inc. v. Converged Access Inc., can be read here.