Deals like this are all about:
1. How quickly you can get your money out
2. How "secure" the cashflow is
We'll go through both of these in order
A 10% cap rate on $1.3MM is $130k of NOI. Since this is a retail deal, I probably won't leverage above 60%
60% * $1.3MM = $780k. Assuming a 5% interest rate (interest-only debt, your debt payment would be ~$40k, leaving you ~$90k of cashflow
Initial equity in the deal is:
$1.3MM PP + $50k deal costs = $1.35MM
$1.35MM - $780k debt = $570k of initial equity
So over the 5 years of the lease, you would be able to pull out $450k of $570k (~80%) in cashflow alone
Assuming 0 appreciation (selling for $1.3MM) you'd still have your $570k worth of equity in the building
So if you sold year 5, you'd net $450k + $570k = ~$1MM
That's 1.8x your initial $570k
Now what you need to do is stress your returns.
What happens if the building value drops year 5? At what point do you still get all of your money back (a 1x)? How far can lease rates fall for that to happen? How far can lease rates fall for you to still make 1.5x? Etc
If the lease is just a piece of paper, the answer is "not at all"
You want to make sure that you're going to get this cashflow no matter what happens
So how can you defend against this?
- security deposits
- personal guarantees
- escrow reserves
SDs are pretty simple. The tenant gives you money (usually a certain amount of months rent, say 5 months) that you keep in a bank account. If the tenant pays their rent and does not destroy their property they get this money back at the end of the lease
This makes the tenant more cautious of skipping rent (since they'll lose their SD) and it allows you to have 5 months backstop on your expenses if they leave
So if the tenant skips out after mth 3 of the lease you only end up with 8 mths of contractual cashflow instead of 5 yrs (60 mths)
Not good
While there are many types of guarantees, typically it means that the tenant signs a doc that obligates him to pay you back and if he doesn't, he is personally liable
While this sounds great (and it is), the drawback is that it's dischargeable in bankruptcy
Escrowed reserves are typically used by lenders, not by buyers
But in this deal, here's how it would work:
You pay the seller $1.3MM. The seller then leases back the building for a 10% cap rate. You and the seller agree to escrow 3 years of rent payments
With the first 3 years in an escrow account, you're nearly guaranteed to get that money
You've essentially locked in your first 3 yrs of income ($270k of cashflow to you)
But you can't utilize all three in one deal
So which ones are most applicable to this deal?
The first 3 years are essentially guaranteed since they'll be paid through escrow. The last 2 yrs will only be lost if the seller goes bankrupt
The good thing is I have 5 years to plan for that
The entire risk of the deal is essentially neutralized aside from the re-lease-up after year 5
Unless rents/prices plummet, you're "guaranteed" a 1.8x return. If rents increase, you make a killing