Investors now looking differently at long-lease buildings

09-11-2006

The spread between leaseback and non-leaseback capitalization rates has narrowed noticeably in recent years, according to data surveyed by Rode & Associates’ team of property economists and valuers

A leaseback capitalization rate is the income yield that investors require to induce them to buy a property that is occupied by a tenant with a long lease – normally 10 years or more. A non-leaseback situation refers to a building with multiple tenants and leases of less than 10 years − normally 3 to 5 years.

Historically, the spread between leaseback and non-leaseback capitalization rates was between 0,5 and 1,5 percentage points, with the better nodes presenting the smallest margins. A long lease with a AAA tenant is of course less risky than shorter leases − hence leasebacks command lower capitalization rates. But recently this spread has become negligible in some top nodes.

A possible explanation for the decreased margin of late, is the expectation of robust market-rental growth, says Erwin Rode, CEO of Rode & Associates.

“It seems that investors are reconsidering the wisdom of having a tenant tied into a 10-year lease escalating at, say, 8% per annum, in a market where vacancies are already low and market rentals could be growing by more than 15% p.a.”

Rode sees this as the likely reason why investors are now requiring similar minimum income returns (cap rates); regardless of whether they’re faced with the traditionally less risky option of having a tenant tied into a leaseback agreement or with the possibility of signing shorter agreements with multiple tenants, but with a greater upside.

The accompanying graph shows that the spread in Rosebank has been deteriorating relative to that of the Cape Town CBD during the last few years.

“This could be an indication that the market increasingly perceives Rosebank as a risk compared to Cape Town CBD.

“The planned Gautrain station in Rosebank could be the reason for investors’ caution. That is, the station is a double-edged sword in that it could on the one hand lead to an increase in crime, whereas on the other hand it could be positive for the office and residential markets as it is in developed countries - because of improved access.”

Rode said that without more research, no further conclusions could, however, be drawn.