The principle of the "Three-Legged Stool" has been viewed for some time as the cornerstone of how net lease deals are valued. While the market has changed over the last two years, the axiom of the three-legged stool and its driving influence on net lease transactions is more important than ever. 

To appreciate what is happening in the net lease world today, you must understand the concepts behind the "Three Legged Stool." In our industry, the three legs (critical components) of a net lease transaction are:

1. credit worthiness of the tenant
2. lease terms/structure
3. real estate fundamentals

Historically, most net lease investors were leveraged buyers. Lenders underwrote all three of these components to determine the overall availability of debt. Capital markets were often referred to as the fourth leg of the stool and ultimately drove the value of most net lease assets. 

During the market peak of 2005 to 2007, we saw aggressive underwriting from lenders that were willing to place debt on assets where one of these three components wasn't necessarily strong. As a result, investors were willing to close on these same deals and often with insignificant pricing delta compared to deals where all three components were strong. Ultimately, because the debt terms were comparable, investors were willing to accept similar cash-on-cash returns and there wasn't a corresponding discount on the value of the asset.

Today that is no longer the case. Lenders are again scrutinizing deals on all three legs of the stool. Tenant credit remains a key component to the value of a net lease property. Lenders are unwilling to loan on deals where the credit of the tenant is weak. In addition to strong tenant credit, investors and lenders are also demanding primary market properties where they see less risk than smaller markets. This is not to say that secondary markets are without a future, but secondary and tertiary markets may experience a lull in investor activity largely driven by a lack of available debt, which ultimately drives a commensurate pricing delta. 

We are also seeing this trend play out in the structure of the lease. Eighteen months ago it was common to see deals getting done with terms of ten years or less. Today's market requires less risk and prefers 15-20 year terms with built-in escalations of a minimum of 1.5%-2% annually or the equivalent thereof. Initial rents are also closer to market rents as opposed to inflated rates evidenced in the recent past. Investors and lenders are also seeking to restrict other lease provisions that favored the tenant thereby limiting their risk such as the removal of cancellations clauses or "outs," first rights of refusal and shifting the responsibility of operating and capital expenses to the tenant. Options including shorter lease terms, property substitutions, buybacks, and assigning responsibility for maintaining physical improvements are becoming a thing of the past and leases in general are more landlord centric with tighter terms.

Tenant credit, real estate fundaments and a solid landlord friendly lease all remain critical in today's market. As capital markets remain constrained, lenders will pick and choose only the highest quality assets. Investors will often pay a premium to secure debt for lesser quality assets or find no financing available. As lenders charge this premium, we're seeing a significant pricing discount associated with those assets if they trade at all.