Role of Credit Ratings In Successful Single -Tenant Net-Lease Investing
Owning Single-Tenant Net-Lease (Net Lease or NNN) properties has become one of the most attractive investment options, providing a hands-off approach to property management and safe and stable, long-term flow of income for investors. There are three crucial factors in successful Single-Tenant Net-Lease investing: property Location, tenant Brand name strength, and, most notably, tenant Credit Rating.
Credit ratings are provided by agencies such as Moody’s, Standard & Poor, and Fitch and are a reflection of the risk involved in the investment. When choosing which property to buy, it is ideal to look for net leases with an Investment Grade (IG) credit rating associated with a low risk of payment default where there is a high probability that the tenant (an individual, a business/corporation, or a government entity) will consistently pay rent. For this reason, successful net lease investing is like buying investment-grade bonds, which come with a higher guarantee that the loans will be paid back.
How Are Individuals Evaluated For Creditworthiness?
A credit rating is an assessment of an individual’s financial creditworthiness because it determines the ability of the borrower to pay off debt. As individuals, we receive credit ratings from credit bureaus such as Experian and TransUnion in the form of credit scores calculated using a formula developed by Fair Isaac (FICO). Credit scores range from 300 (extremely poor) to 850 (extremely high) and depend on our credit history. We can look up our credit scores for free by taking advantage of the “free credit scores” deals.
How Are Corporations and Government Entities Evaluated For Creditworthiness?
Investors can minimize credit risk by investing in excellent or great credit ratings assigned by a rating agency to individuals, businesses, or government entities. Credit rating agencies Moody’s, Standard & Poor, and Fitch evaluate the credit quality of businesses/corporations and government entities using rating scales consisting of the upper- and lower-case letters “A” and “B,” with each agency using a somewhat different letter designation (see the investment-grade credit rating chart below).
How Are Credit Ratings Classified By Rating Agencies?
Investments are further classified as “investment grade” or “non-investment grade” depending on their letter designations. For example, bonds rated “AAA” and “AA” (high credit quality) and “A” and “BBB” (medium credit quality) are considered investment-grade bonds (Source: investopedia.com, March 5, 2020). An investment-grade bond signifies a municipal or corporate bond, which presents a relatively low risk of default. Bonds rated below BBB or A (below medium credit quality), are classified as non-investment bonds and are high-risk investments with a greater chance of default. Many investors seek to invest in investment-grade property assets which are tenanted by corporations and are rated at least BBB- or higher by Fitch and Standard & Poor or Baa3 or higher by Moody’s. Likewise, certain institutional investors such as pension funds, foundations, and banks can only invest in investment-grade bonds and properties leased to investment-grade tenants.
The investment-grade credit rating definition below shows the different rating types from Moody’s, Standard & Poor’s, Fitch, and AM Best.
Investment Grade Credit Rating Signifies A High Likelihood Of Payment
Many Single-Tenant Net-Leased Triple Net Retail properties are leased to publicly-traded companies such as CVS, Walgreens, Autozone, 7-11, Dollar General, McDonald’s, Chick-Fil-A, Starbucks, Walmart, Whole Foods, Hobby Lobby, or Kroger. In the case of medical and dental properties, the guarantor might be a large hospital system or Dental Services Organization backed by significant private equity firms or hedge funds. These companies are investment grade tenants because of their excellent financial reputation and high creditworthiness.
To check a company’s reputation, sites such as https://retail-index.emarketer.com can provide great investment information from reputable online stock analysis sources for the number of stores in a chain, sales growth trends, and same-store sales.
Non-Investment Grade Credit Rating Implies a High Investment Risk
Bonds rated below Baa3/BBB-/bbb- are considered to be non-investment grade bonds or speculative grade “junk” bonds, which means they have a greater chance of default. Due to this credit risk, investors are typically compensated with a higher yield/interest rate to offset the risk premium associated with lower credit ratings. A non-investment grade bond rated below B3/B-/b- is very risky and at an even higher risk of default, further increasing the yield/interest rate. Investors should pay particular attention to Credit Rating Downgrades (for example, when a credit rating drops from an AAA to an AA designation). Downgrades are a signal that the corporation/government entity is over-leveraged or the earning ability/revenues are decreasing.
When investing in single-tenant net leases, it would be wise to invest in investment-grade retailers or medical groups. These investments have lower yields than, for instance, the low-rated BBB “junk” bonds, but are associated with a lower risk of default and are consequently a less volatile investment option.
To illustrate the investment-grade credit rating definition, Jason Ricks has developed the following breakdown:
Benefits of Net Lease Properties Versus Municipal Bonds
Net leases are Main Street (independent small business) investments. When it comes to net leased properties, particularly with investment-grade credit rate tenants (also known as a Credit Tenant Lease or CTL), the rental income is backed by financially secure entities and the value of the underlying real estate. Additionally, the investor has all or a portion of the income sheltered from taxes because most governments want to encourage investment and development.
In contrast, Municipal or “muni” bonds are Wall Street (big business and high finance) investments. Wall Street pushes conservative investors towards municipal bonds because of their supposed security and often tax-free treatment by the US government. Many municipal bonds are extremely risky because of out-of-control public pensions and faulty revenue projections. Most notably, they barely keep up with inflation and can lose value due to debased money. In some recent years, total returns for municipal bonds were negative.
Closing Thoughts: Real Estate Has Intrinsic Value Along With Cash Flow
Real estate is a tangible, physical asset (hence the name “real” estate). Whereas bonds, stocks, and derivatives are financial products backed by the issuing counterparty, a net lease is a contractual financial agreement with the benefit of also being a physical property. Both kinds of investments are a mix of debt and equity. The performance on the income portion of the net lease is related to the financial health of the tenant and the location of the property. The performance of the equity portion is related to the location and the brand image of the tenant. Net Lease investments combine a reliable income stream (cash flow) backed by the stability of strong, financially secure tenants and the hard “physical” asset value of real estate.
Are you looking to make stable and secure investments with a steady flow of income but don’t know where to start?
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*Note: Liberty Fund/Concordia Equity Partners (Concordia) have made every attempt to ensure the accuracy and reliability of the information provided. Concordia cannot not accept any responsibility or liability for the accuracy, content, completeness, legality, or reliability of the information contained herein. The information herein considered legally-binding legal advice, tax guidance, or financial counsel.
Jason Ricks, CCIM is a Principal and the COO of Liberty Real Estate Fund LLC, the World’s First Net Lease Security Token FundTM, as well as a Concordia Equity Partners principal whose primary focus is on acquisitions, leasing, and development.
Jason is a native Texan, professional real estate investor and certified commercial investment member (CCIM). Jason’s background in retail leasing and asset management make him an invaluable member of Concordia’s team for developing strategies to unlock the value of a property. Jason also has extensive experience and familiarity with south and southwestern US markets. Jason’s most recent experience is with AMLI Residential as the Vice President for Retail Asset Management where he established and has led the mixed-used Retail Asset Management team working on premier properties worth hundreds of millions across the country.
Prior to that, he served as an Asset Manager for BH Properties where he oversaw a 2.2 million square foot value-add retail portfolio throughout Texas and Oklahoma. Jason broke into the commercial real estate business as a Shopping Center broker for Tarantino Properties. He received his BS in Business Management from Oklahoma State University, where he was a Team Captain for the Oklahoma State Football Team (The Cowboys).
Jason is an active member of the International Shopping Counsel of Centers (ICSC). Most recently, he was featured in the #1 Amazon bestselling book: DESIRE, DISCIPLINE & DETERMINATION (2019).
Jason has also been featured as a guest on NPR, the Nothing But Net Show podcast, Simple Passive CashflowPodcast, and Commercial Real Estate Investing from A-Z podcast.