Don't buy the tenant; buy the box

It’s easy to look at a commercial real estate (CRE) property and think about all the money it’s bringing in.

At least that’s where my mind goes. I guess it’s a lingering byproduct from my development days.

But here’s another piece of conditioning I picked up during my three decades of building stores for retailers: The best CRE investments aren’t always determined by who’s paying rent right then…

It’s determined by who will want it after that tenant leaves.

I wish I could say I was born with that knowledge already firmly entrenched in my head. Truth be told though, I learned it the hard way. In fact, it was one of the most expensive lessons of my career.

Fortunately, once I did take to heart how important a store’s size and shape – its “box” – really is, I’ve never forgotten it. Which is why I get to share some valuable insights on the subject with you today.

Back in the early 1990s, when I was still developing CRE, one of my clients was EconoLube N' Tune. Founded in 1973, it was based in California (at the time) and expanding throughout the Southeast.

I looked into all of EconoLube’s facts and figures, of course, and it seemed like a strong and growing company. So I signed it on, only to find out that it didn’t want me to build ordinary retail buildings.

Nope. The “boxes” it wanted involved L-shaped floor plans to facilitate roll-up service bays and below-grade, oil-changing pits. Every square foot of those designs was tailored for one use by one tenant.

Not that this bothered me initially. I was only thinking about all the business I could do with the larger company. And so I built those shops as requested, one after another.

Everything went according to plan for months. I would scope out a place, get cleared by EconoLube, and build-to-suit. Then I’d sell the completed project, usually to a 1031 exchange investor (a topic I’ll discuss in future articles) who liked the idea of becoming a long-term landlord with dependable income.

At least it was supposed to be dependable.

About a year after I first began working for the company, it filed for bankruptcy. This was right after I completed two new stores that were supposed to have “reliable” 15-year leases – which EconoLube promptly rejected, as it had the right to do under Chapter 11 law.

That meant I was stuck with vacant specialty buildings that nobody else wanted. There simply aren’t many businesses out there that need L-shaped workspace like that.

After almost two years, I finally disposed of both properties. The experience left me with substantial financial losses… but also the valuable realization that I needed to start asking more questions before I signed on the dotted development line.

Instead of only asking how strong a potential tenant was, I needed to also know the building’s adaptability. If my client disappeared tomorrow, how quickly could a new one move in?

The more complicated the answer, the more reason I had to say no.

One of my favorite words in commercial real estate is fungibility. It’s not a common word, I know, but it simply means an asset that can be easily reused with minimal cost and disruption.

The more fungible a piece of property is, the more valuable it can become over time. This is especially true in the retail space.

Leases can and do expire. Shopping trends come and go. And companies can outright fail. But great real estate has a tendency to outlive even the best of its tenants.

Unlike those EconoLube shops I built, a well-located, well-maintained, fungible building can produce income for generations. This is why net-lease landlords such as real estate investment trusts (REITs) tend to be such stable investments.

It’s not just that they cater to companies that are strong enough to sign 15-year or longer rental contracts. (Although that’s quite the consideration in and of itself.) But their propensity to purchase free-standing, standard shaped properties gives them amazing flexibility in their tenant selection.

A fast-food structure can just as easily accommodate a Burger King, Wendy’s, Taco Bell or McDonald’s with a few modifications. Just like a simple, rectangular retail box can be transformed into a Tractor Supply, Five Below, or Burlington Coat Factory easily enough.

You can’t say the same for movie theaters with stadium seating, car washes with 120-foot tunnels, bowling alleys, or fitness centers with swimming pools. These properties can easily require millions of dollars in alterations to make them attractive for other tenants.

Which means that, should a specialty lessee leave, its landlord has to choose between forking over big money, knowing it will likely take years to recoup the investment… or letting the building lie dormant until a similar company maybe, possibly, hopefully wants to move in.

This philosophy is one reason why I admire companies like Agree Realty (NYSE: ADC), which I wrote about earlier this week. A few years back, it published a paper titled “Fungible boxes: all rectangles are not created equal” that does an excellent job explaining the topic.

Here’s how page 6 in particular reads:

In particular, the publication focuses on AutoZone (AZO) – one of its biggest tenants – with its 6,500+ stores that average 7,000 square feet. That company’s stores are typically located on main roads with easy access.

Agree goes on to note that:

In other words, the tenant is important. I don’t mean to imply otherwise – especially after seeing one fall into bankruptcy. But it’s not the only important consideration by far.

Even a strong tenant isn’t much good in a poorly placed building. Whereas a fungible property with broad leasing appeal is bound to attract ongoing business for decades to come.

Happy SWAN investing!

Brad Thomas
Editor, The Wide Moat Daily

P.S. Stay tuned for my article on Monday, where I’ll share another important lesson I’ve learned… how to avoid sucker yields!

In honor of the 250th anniversary of The United States of America’s Declaration of Independence, let’s talk about the real estate investment trusts (REITs) that came out of it.

That’s not a cheap gimmick to get you to watch the latest episode of The Wide Moat Show.

The economic opportunities our Founding Fathers opened when they committed to the self-evident truths “that all men are created equal… endowed by their Creator with certain unalienable Rights” including “Life, Liberty, and the Pursuit of Happiness”…?

They’re widespread and enormous.

So we’re more than happy to point even just a few of them out right here.