Capitalization rate adjustments can be a subject of confusion for many brokers, lenders, and appraisers alike. Ultimately, however, they can be broken down into two components: credit rating of the tenant and the tenant’s cash flow, i.e., how much they put in their pocket after rent is paid. The National Retail Properties (NNN) market is so strong that a lot of owners and small oil companies are doing sale leasebacks. Here is the frightening analysis:
If we look at the cash flow of a going-concern fee simple gas station at $100,000, a going-concern cap rate will likely be >9%, we can round to 10% to simplify. That is a going-concern value of $1,000,000 including real estate. However, consider what would happen if this same operator does a sale leaseback at $90,000 and puts that lease on the NNN market. If it is a well-branded station that is relatively modern, it will command the 6% to 7% cap, but at 6.5%, that’s a leased fee value (real estate only) of $1,385,000. That is $385,000 more than selling the business, M&E and Real Estate. The tenant has to pay rent for the next 20 years but it will be inconsequential because they got more money than if they sold their going-concern.
Fuel margins are the highest they have been in 10 years, skewing operator cash flow upwards. This is temporary and will not last the duration of typical holding period. It will only be a matter of time before the tenant cannot pay the rent and walks away. If it is a true credit tenant like Chevron, for example, it is not a problem, but the majority are not generally leasing real estate anymore. Most investors see the Chevron flag, whether dealer operated or franchisee and assume they are protected. They are not. When margins scale back to normal levels, cash flow will drop and the tenant’s cash flow will not cover rent, or provide enough incentive to keep the tenant running the business. We saw this happen after 2007; certain mid-sized oil companies who did just this ended up walking from many of their properties, leaving investors with a vacant gas station worth substantially less than what they originally paid for it.
RPC has a methodology that addresses this concern. We do two things in addition to conventional methodologies to support rent and tenant cash flow:
- When establishing rents we look to landlord rates of return, which usually track 50 up to 100 basis points above cap rates. We support this by finding similar type retail/commercial properties that are both offered for sale and offered for lease in the subject’s geography. Based on a Cost Approach, we apply the landlord rate of return to support rent, in addition to analyzing leased fee deals and comparable rents. The Oil Companies follow a similar method (landlord rate of return applied to Cost Approach) for dealer leases, although not many of these exist as the majors have sold off most their real estate assets to the dealers. The Oil Companies were changing between 8% and 12%, and averaging around 10%. When Oil Company executives are asked why their rate of return appears higher than market, the response is often that it is because the tenant is not only leasing the Real Estate, but the flag, an uninterrupted fuel supply, advertising, etc. In addition, a good portion of the assets leased are short lived like fueling dispensers. This analysis is based on a return of the real property and is not based on tenants cash flow which can change drastically over time.
- In an effort to better support a cap rate, we also look at the tenant’s cash flow. Though this data may not be readily available, having appraised 6,000 plus stations we have the data to support these figures, and will compare estimated tenant’s cash flow to the rent they are paying. If the spread is minimal (or negative) there is increased risk and support for higher cap rates. If the spread is wide and the tenant is cash flowing a significant residual to their business, then risk is reduced. Rents are usually structured to go up over time, whereas gas station cash flows are very erratic and depend on economics and fuel prices, factors that may not affect typical NNN properties.
It is often assumed that a single tenant NNN leased property is the easiest property to appraise, however, this is not the case when they involve gas stations or car washes. These are special use properties that are generally not leased, but owner occupied. The strong triple net market is creating a lot of sale leasebacks of gas stations that are much riskier than investors perceive.
It is important to note that lower fuel prices mean higher margins and cash flow. Margins are currently almost 2X their “normal” rate. A typical gas station will likely lose 20% of cash flow/value when fuel prices return to 2010 – 2013 levels. This drop will cause the NNN sale back lease rates to be higher than the tenant’s cash flow, the tenant will walk, and why not, they will have been paid more than what they could have sold their going-concern for.
Unfortunately, investors often do not understand this and will overpay for NNN leased gas stations. They are what is driving the market but, with a lack of understanding in retail petroleum, this is dangerous. Many State of the Industry (SOI) publications used by Wall Street, see retail gas stations as less risky when prices are high because sales increased. This shows a fundamental lack of understanding of the retail petroleum market. Higher prices are usually the result of higher fuel prices.
Assume c-store sales are flat, for example. A station is selling the same volume at 1,000,000 gallons but retail pricing goes from $2.00 to $3.00 per gallon, sales went up $1,000,000. Industry surveyors generally only look to gross sales as their barometer and trending thereof. The $1,000,000 increase in gross sales looks good on the top line but, in reality, the dealer is making less. When fuel prices increase, people will shop for better pricing and use less fuel. The result is that either volume goes down or margin goes down. Operators will lose their margin in an attempt to maintain their volume, ultimately affecting inside sales. If they keep the same margin they will do so at a lower volume.
Credit Card fees are another factor to consider. Most gas is purchased with a credit card and the fee is based on a % of the sale, at about 3%. Because fuel margins are cents per gallon, they are more stable with fluctuating pricing. As fuel prices go up, credit card fees go up but not margin. Here is the example mathematically:
- $2.00 per gallon gas at a $0.20 per gallon margin. Dealer margin is $0.20 less credit card fees at $0.06 per gallon, dealer net margin is $0.14 per gallon.
- $3.00 per gallon gas at a $0.20 per gallon margin dealer margin is $0.20 less credit card fees at $0.09 per gallon, dealer net margin is $0.11 per gallon.
- $4.00 per gallon gas at a $0.20 per gallon margin. Dealer margin is $0.20 less credit card fees at $0.12 per gallon, dealer net margin is $0.08 per gallon.
It is for this reason that, when fuel prices rise significantly, dealers’ will offer a discounted cash price to cover their losses.
I found your analysis of cap rates interesting. While it clearly addresses the variation in the business cycle and the potential manipulation of value through excessive rents, I’m not sure it accurately reflects the market. If buyers are willing to purchase a gas station at a given rate with inflated rents (assuming there are a number of these transactions), would that not reflect the actions in the marketplace and market value? I agree this may be short sighted, but if the point is to estimate market value do we not have to reflect what is going on in the market as of the effective date of value? Your methodology is more fundamentally sound from a financial standpoint, but I’m not sure it is compatible with the definition of market value. This is a complex issue and difficult to analyze without a specific example. But kudos for the effort nonetheless. Impressive.