The Client's Story
This small investor group was selling a high value asset in the Bakken oil field in North Dakota and would face a very large income tax bill on the sale. They decided to complete a Section 1031 exchange into commercial real estate, and defer the tax. As successful, sophisticated investors and developers, they already owned a substantial portfolio of investment real estate. However, their existing investments required significant management and represented a fair amount of risk. They were now seeking to reduce the risk of their overall investment portfolio, and wanted to invest these sale proceeds into conservative real estate that would require no management and would provide them long-term, stable income.
After visiting with several commercial brokers, they chose Top Hand to represent them in their property quest. They gave us specific instructions: find them properties in the Sunbelt states, with strong locations in solid markets, backed by sound lease guarantors, and offering a minimum cap rate of at least 6%. We discussed that this was a very tall order in the current market – quality properties like this were generally offering lower cap rates – and we went to work for them.
Rolling Up Our Sleeves
We immediately began searching nationally, focusing on the Sunbelt states, for suitable properties. After assessing and presenting many potential properties to the group, identifying the strengths and weaknesses of each, they focused on their first deal: a franchisee-guaranteed triple-net leased Kneaders Bakery and Café located in a rapidly growing suburb of Phoenix. Kneaders is a regional casual dining chain that started in 1997 in Utah, and was now operating 42 restaurants in the western U.S. It is known for its healthy, made-to-order meals that focus on fresh, nutritious, high-quality ingredients and its loyal customer base. Their buildings are constructed with great attention to design and detail, and offer a high level of curb appeal. Going direct to the franchisee and developer, we were able to negotiate a favorable below-market price and cap rate for this property. The location is strong, sited in a Walmart-anchored shopping center. This was a brand-new restaurant under construction, so there was no operating history for this location. In reviewing the tenant’s financial statements for their other locations, we noted impressive average sales and net profits, providing our client comfort that the lease guarantor was on solid ground.
As we moved forward on the Kneaders transaction, we continued searching for other suitable properties. We soon presented a second property to our client, which immediately caught their interest: a corporate-guaranteed Arby’s ground lease in a growing market in Florida. Arby’s is the second largest quick-service sandwich chain in the U.S., operating more than 3,400 units system-wide. This property is located on an out parcel to a Walmart Supercenter and at a hard, signalized corner on a high-traffic commercial corridor. In addition to the exceptional location, the lease called for a 21% rent increase in year 10, roughly 3.5 years from our client’s purchase date. This amount of rent increase is extremely rare, and would effectively increase the cap rate on this property to 6.78%, unheard of for a corporate-guaranteed triple-net ground lease. As a ground lease, our client would be purchasing only the land. Arby’s owned the building upon that land, and paid monthly rent to lease the land. Throughout the lease term, Arby’s would be responsible for all costs and management responsibilities associated with the property – this is known as a “triple-net” or “NNN” lease. At the end of the lease – or earlier, in the event that Arby’s defaulted on the lease – ownership of the building would transfer to our client, at no cost to them. This provided significant additional security, as Arby’s had substantial money invested in the building and improvements.
Continually searching and analyzing additional properties for their portfolio, and with two strong properties under contract and moving toward closing, we presented a third property which we believed would satisfy our client’s investment parameters. This was an urgent care medical clinic located in an affluent and rapidly growing part of the Dallas, TX market. Established in 1993, this urgent care company dominates the market with 24 locations in the Dallas/Fort Worth area. The area presents strong demographics, highlighted by 75% growth over the past 10 years, high median household incomes, low unemployment and low poverty rates. The brand-new building sits on a high-traffic commercial corridor in an area of numerous national retailers, dense residential development and within a short distance of three major hospitals and medical facilities. The lease comes with attractive 2% annual rent increases. Annual increases are rare, as most increases for these types of commercial properties go into effect on five-year intervals.
With three triple-net properties either closed or under contract, and most of their investment capital now committed, our client directed us to find them a solid strip shopping center. We refocused our search and after reviewing multiple properties, presented them with a brand-new, four-unit strip center in the Albuquerque, NM marketplace. With a mix of three national tenants and one regional tenant, this property helped further diversify our client’s investment property portfolio, and offered an attractive cap rate as well. All leases were new and though they were triple-net in nature, due to the inherent operating structure of strip centers, this property still required some property management by the landlord. Conveniently, the developer of the property also had its own in-house property management company, so turnkey management was already in place. The location was strong, sited on a busy commercial thoroughfare and on an out parcel to a Lowe’s building center and next door to Home Depot, with significant other national retail in the immediate area.
Through all of the transactions, we completed comprehensive due diligence, examining the lease documents, property surveys, environmental reports, building inspection reports, title commitments, market demographics, locations, conditions, covenants and restrictions (CCRs) which govern the properties, and more. We vetted the tenants, examining their abilities to fulfill their lease obligations. Through it all, we reviewed our findings with our client and their attorneys. We effectively managed our client’s 1031 exchange to ensure all time limits were complied with, and had suitable backup properties identified in case the subject properties fell through.
Our client used the Section 1031 exchange to transition from their North Dakota investment property into a portfolio of four high-quality commercial properties offering long-term, stable income, with only one property requiring minimal property management. In so doing, they were able to avoid paying a tremendous amount of income tax on their property sale, and now enjoy annual income from the properties of more than $750,000. Their goal of purchasing a portfolio of properties located in strong markets in the Sunbelt and diversified by property type and geographic area was accomplished.
We've provided this information for general educational purposes. It is not intended as specific tax or legal advice. Please consult a professional for specific advice regarding your particular situation.
© 2016 Jack Sauther & Diana Sauther