If two properties and tenants are identical, which should trade at a higher cap rate? A NNN fee simple deal has the benefits of depreciation. A ground lease has the benefit of being able to repossess the building if the tenant stops making payments.
Also, who pays for the buildout in a NNN fee simple development deal? I'd assume the guy paying for the buildout would want the depreciation benefits. Does that make sense?
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Depreciation doesn't factor into cap rate considerations. All things being equal, a fee simple deal will trade at a tighter cap rate because the owner holds both the improvements and ground free and clear. There is a deeper market of buyers of fee simple properties vs. leasehold properties.
In a leasehold situation, the owner of the ground has a tenant to contend with and taking back the asset in the event the ground lessee defaults is not as simple as you make it out to be. So, leaseholds typically attract a smaller sub-set of buyers and they will demand a higher return, which translates into a higher cap rate.
From the perspective of a potential lender, fee simple ownership is much cleaner and therefore more desirable.
As for the build-out, the owner of the improvements pays. For example, In-N-Out Burger would pay the full cost of developing and building out one of its stores while at the same time paying rent to the owner of the underlying ground.
All great points. I think the ultimate decision is based on the kind of deal you are comfortable with. I've worked on ground lease deals in Brooklyn and they're generally older guys who have owned a chunk of industrial brownfield site that some developer wants to turn into rentals for yuppies. The owner isn't a developer who wants to operate a business or be responsible for anything related to it. You can't nnn a multifamily so his best option is a sale or a 99 year ground lease depending on his preference for exit with large sum (1031x perhaps) or cashflow his kids can depend on. Real estate has varying levels of being like an operating business so operating capacity comes into these decisions.
I would agree that a ground lease may trade at a higher cap rate if you're simply purchasing a stream of cash flows (i.e. if the ground lease were securitized). I disagree--based on my own experience and simple deduction--that a piece of property with a ground lease on it would trade for a higher cap rate than a NNN property. A leased fee land interest (ground lease) has no capital expenditure obligations and should, therefore, trade at a lower cap rate than a similar property where the ground and improvements are both owned and where capital expenditures will be required. Secondarily, a ground lease has much better security from its tenant--the entire improvements.
Edit: a quick Google search will show that the vast majority of opinions agree that ground leases tend to trade at lower caps than NNN properties.
Calculating Prop Mgmt Fee on Gross vs NNN leases (Originally Posted: 07/15/2017)
Looking at a single tenant office property that will be acquired vacant with a tenant in tow to lease the entire building.
Normally we would try to structure lease as NNN since tenant will control 100% of the GLA. That being said, since property management is a % of EGR, a NNN deal would result in a lower EGR than a full service gross lease.
Is there a standard method to normalize this? Or would the PM fee be lower in reality because of the NNN nature of the lease?
My reading of the OP's question is that he's talking about the fee interest in the ground, not the leasehold interest in the property:
Perhaps the OP can clarify.
I'm talking about the fee interest in the ground. And thank you both for the helpful replies thus far.
Uh, that's exactly what I said. To quote myself, "...leased fee interest..."
Back to the original question, a ground lease usually has a lower cap rate than an interest in the NNN cash flow.
Would the PM fee (dollar amount) come out to be the same in either situation? If you do a gross lease that in your base year is equivalent to base rent + reimbursable expenses for 100% of the building, then the base rent + actual reimbursable in a NNN scenario would be equivalent no? So long as your all in NNN base rent + reimbursables equals the proposed gross lease amount, your x% applied to your EGR would render the same dollar value. Perhaps I'm off by a ways here, but interesting question.
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