Net Lease CRE Investing: Understanding Credit Ratings in CTL Finance
Net lease investing — purchasing a commercial property that is net leased to a single, creditworthy tenant — is a unique way to profit from commercial real estate (CRE). It offers predictable cash flow and all the benefits of ownership yet requires a minimal level of landlord responsibilities that can vary depending on the type of net lease. When properties and tenants are selected carefully, net lease investing can be a relatively low-risk way to own income-producing properties and enjoy significant tax benefits.
How is Net Lease Investing Different from Conventional Real Estate Investing?
Net lease investing differs from conventional CRE investing in several significant ways. One of the most unique aspects is the financing. Net lease deals can be funded through a highly specialized finance method called credit tenant lease (CTL) finance. Unlike conventional CRE mortgages, which are backed primarily by the equity in the building being financed, CTL uses the lease that a tenant signs (the income the lease produces) as collateral. In other words, CTL finance depends on the tenant’s ability to pay the rent rather than on the value of the building. A tenant’s credit, therefore, is a critical aspect for success in net lease CRE investing.
Understanding the Importance of Credit Ratings
Companies and other corporate entities that lease real estate have credit ratings that are analogous to the individual credit score that most people are familiar with. Professional rating services such as S&P, Moody’s, and Fitch Ratings analyze companies and routinely assign corporate ratings. Each service has its own proprietary methods that differ somewhat, but ratings are typically assigned on a letter grade basis, with “A” being higher than “B” and “B” being higher than “C” and so on down the scale. They will also use capital letters or lowercase letters to emphasize relative strength and will add modifiers such as pluses (+) and minuses (-) or one-digit numbers.
The highest credit rating any entity can receive is “triple A” (AAA). A firm or other institution with a AAA rating can be trusted to meet its financial obligations on time and in full. The lowest ratings are “C” and “D.” Low-rated firms represent a high risk of default.
Investment Grade vs. Non-Investment Grade
While there are many gradations in credit ratings, there are only two main categories. They are “investment grade” and “non-investment grade.”
Companies, institutions, and governments with an investment grade rating are comparatively low risk. Non-investment grade entities carry more risk for investors, especially debt investors. Investors demand a higher yield from weaker companies. Thus, AAA-rated firms will pay less interest on bonds, and often less rent on real estate, than BBB-rated firms will.
How is CTL Finance Structured and Who Qualifies?
For accounting and investing purposes, a real estate lease is seen as a debt obligation. CTL finance looks at a lease very much as it would a corporate bond. CTL bankers collateralize the lease and make a loan to investors or purchasers based on the creditworthiness of the tenant.
It’s important to understand that only corporate tenants with an investment grade rating from a major rating agency can qualify for CTL financing. In practical terms, that means a BBB- or higher rating from S&P and Fitch Ratings of a Baa3 or better from Moody's.
The significance for net lease investors is clear. Non-investment grade and unrated tenants can be financed by other means but should be avoided by investors looking to use CTL finance. Investment grade tenants should be sought out, but with the realization that higher rated tenants, while offering a higher measure of safety, tend to pay somewhat less in rental income.
There is no need for CRE investors to be intimidated or confused by the technicalities behind credit ratings and CTL finance.
Each major rating agency has only 10 investment grade levels, and Fitch’s levels are the same as S&P’s, and they’re fairly straightforward and simple to understand. While CTL finance is a very sophisticated type of CRE investment banking, from the investor's perspective, the process is practically indistinguishable from conventional financing.
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