Retail Real Estate Transaction

CVS PLAZA Route 6 Seekonk Ma. (fictitious)

The Financial Deal

Professor D. U. Moore is unhappy with the returns from his retirement fund, which have averaged 5%. He decides to investigate entering into a limited partnership with his brother-in-law Jack Vacant, who is a real estate sales broker in the Boston area. They plan on buying a 20,000 square foot triple net leased property worth 1 million dollars now occupied by CVS Drugs. The property is currently “free and clear” meaning there are no mortgages currently encumbering the land or building. D.U. needs to decide if the deal is a good one, in light of the agreement Jack is proposing.

Under the terms of the agreement, Jack plans to act as the General Partner with Moore as his limited partner. He has structured the deal so that while he only puts up 5 percent of the equity required (50,000.00) as the General Partner he receives 25% of the overall partnership returns (this is his sweat equity). Thus the remaining 75% of limited partnership interests must fund 95% of the equity required. It would be Moore who puts up the remaining 95% of the equity.

Also under the terms of the agreement, Jack agrees that his brother in law will receive a preferential 6% return on his investment from his share of the available cash flow. To the extent that the cash available for his 75% share is less than a 6% return, Jack agrees that Moore will receive the difference as deferred interest from the income of the partnership once it exceeds the 6% distributions to the partnership. Jack has told his brother in law that Jack’s sweat equity will not be subordinate to Moore’s 6% return but that he will defer further distribution until at least Moore has received in hand the 6%.

[Question: what does the deal need to generate in order to pay Moore his 6% return?

Moore puts up 950,000.00 for 75% of the deal. 6% of 950K is 57,000.00. Divide 57K by .75 (75%) and you get 76K. Divide 76K by the purchase price of 1M and the return needs to be 7.6% for Moore to see 6%.]

The Real Estate Transaction

Moore needs to determine whether or not the transaction is worthy of his doing. In order to come to an intelligent conclusion, Moore figures he needs to assess several items:

1. Value of the Property and Building. Value exists in relation to its market. This will be determined by location of the property. Route 6 is a high traffic area with easy off and on access to Rte 195. Also its size and usability, meaning how specialized is the building. So too, the age of the building, its type of construction (certain properties are worth more than others, wood frame versus brick or block) including ceiling heights (higher better than lower, column spacing (large spacing better than small), sprinkler systems, alarm systems, roofing materials (three ply better than poured). The building in question is block construction with a built up roof, 3 years old, had 20-foot ceilings and had been tenanted by Rite Aid Drug before they went bankrupt and closed this location. The size of the land is important as it indicates if additional plot coverage (adding to the size of the building) is possible. The amount of parking now and for future expansion also needs to be calculated (each jurisdiction has a code for number of parking spaces for each 100 sq. ft of building). The site was 4 acres (172,000 sq. ft. with 120 parking spaces covering 34,000 sq. ft.) Last, the way the property is situated on its site will in part determine its value as well as its accessibility (near major roads), ease of egress and ingress (at a stop light) and overall appearance. The building was situated two thirds back on the site closer to one side with parking in front, and 3 loading docks in the rear. In the back there was approximately one acre of land with a small stream running through it and was wooded. Both sides of the property were also wooded with one showing a “For Sale Sign: 3 acres zoned commercial A-4 (meaning lot coverage of 1 sq. ft of building for each 4 sq. ft. of land was possible provided parking was created for 6 cars per 1000 sq. ft. of coverage. Each car including egress and ingress consumed 240 sq. ft. The listing price on the sign was $200,000.00)

2. Demographics. Moore knows that the higher the potential traffic the more a retail tenant will be willing to pay for the space. He knows that CVS is a destination tenant in one sense but also an impulse tenant. Route 6 had a lot of transient traffic but also was surrounded by high-density residential neighborhoods. Being a blue collar area, the typical house was on ¼ acre which resulted in good population counts in a one mile, three and five mile radius. Average family income was 52,000.00, which put it on the higher side of normal, and the census reports from 1990 and 2000 showed that the population was middle aged but growing.

3. Environmental concerns. D.U. was a professor of chemical engineering and was an expert on environmental toxic waste. He had heard stories of land with buried tires, former factory sites, or even old farms where gasoline tanks had existed. He was also worried about PCB’s, which were contained in many of the old electrical transformers that dotted the landscape. Jack had assured him that it had a clean bill of health and that the tenant would not have entered into the transaction without a positive indemnification from the present owner. The indemnification was a personal guarantee for protection costs or expenses resulting from any loss, lawsuit or cost of clean up to do with the environment. Jack also knew that financing would not be possible without an environmental indemnification in the banks favor. And more importantly, environmental issues were able to pierce any corporate structure in certain circumstances.

4. The Economics of the Transaction. The lease had twenty years still to go, expiring November 30, 2021. The current rental was 65,000.00 per annum net to the owner. The tenant paid all taxes and operating of the building including roof repair and replacement. The tenant had a right to cancel the lease after the 10th year provided he gave the landlord 9 months prior notice. The rent increased every 5 years by the greater of either the increase in the Consumer Price index as of each 5th anniversary over the index in the year 2001 (the base year) or the 2 percent per annum (10% every 5 years). Thus in year 2006 the rent would be a minimum of 71,500.00 per annum.

5. Financing. The current market for financing on retail single tenant rated tenancies was 70-75% of appraised value, based on a free and clear income to debt service ratio of 1.2 to 1. The property appraised at 1 Million Dollars. Current interest rates were as follows: 200 basis points over 5 year treasuries; 210 basis points over 10 year treasuries and 225 basis points over 15 year treasuries. Current treasury rates were:

U.S. Treasury Bonds
Maturity / Yield / Yesterday / LastWeek / LastMonth
3 Month / 1.77 / 1.76 / 1.93 / 2.14
6 Month / 1.74 / 1.73 / 1.86 / 2.12
2 Year / 2.42 / 2.38 / 2.47 / 2.74
5 Year / 3.61 / 3.54 / 3.61 / 3.80
10 Year / 4.30 / 4.29 / 4.36 / 4.59
30 Year / 4.87 / 4.86 / 4.94 / 5.36
Maximum term being offered was 15 years. Loan amortization on a 10-year loan with a 30-year payout added approximately 1 percent to the loan rate. In addition, Moore would be responsible for a 1-point broker fee and a 1-point loan origination fee. These were one-time charges. Moore would also have to pay his attorney’s fees and those of the lender. These were usually 1 percent or point. There was also a mortgage recording tax of $2.50/thousand.
Last, Moore knew there would be title insurance and other costs of closing the transaction which could add up to another 1.5 percent of the purchase price.
6. Comparables. Sales in the area would have to be checked again but Jack had tracked two on Route 6 as follows: 3,000,000 for a 50,000 sq. foot Linens and More store, and 3,800,000.00 for a 62,000 sq. ft. Hope and Ann’s which had just closed last month, even though the tenant had declared bankruptcy the month before.
D.U. Moore knew he had a lot to think about and was hoping his economics class students might be able to help him with the calculations. In the end, though, he knew he would have to make the decision on his own.