The Deal Anatomy - The Off Market Trap

A client of ours owns a single-tenant, triple-net building leased to a national credit tenant. The lease is heading toward its back end. The tenant wants to stay, but wants improvements — roof, parking, a TI package. Clean trade: TIs for new term, then bring a freshly leased asset to market.

But credit tenants are the tortoise, not the hare. In this case they still had some term, so there just wasn't a sense of urgency. In net lease, the tenant and the term are the value. You're really on their clock.

Rather than wait, our owner was interested in another option: sell now, off market, at a slight discount, to a buyer willing to take the lease negotiation on themselves. Speed, in exchange for the buyer owning the lease risk.

A word on off market, because it matters to everything that follows. Off market rarely works out. It does when the market is making new highs every day, but in a flat market the odds are low. It can give you a good real-time basis for valuation, almost like a live BPO. But structurally it isn't conducive to us doing our job, which is sourcing the highest and best buyer. We rarely work these deals anymore. For key clients we're willing to put in the work — clear-eyed with them about the likelihood of success, and in a manner that won't hinder the process when we do actually go to market.

The buyer in this case was a well-known firm who shall remain anonymous. From the first conversation we were clear on the one point that mattered: we'd facilitate a tenant interview, but the deal was not contingent on a new lease being signed before closing. You close, then you negotiate. Multiple officers confirmed, verbally and in writing.

Then the PSA, and weeks of attorney billing. Signing day — and the buyer couldn't post the deposit for another two weeks. You don't have $250K in the operating account? They gave us a reason, it just didn't make much sense. Ultimately the seller decided to let it slide, as the buyer was a reputable firm and we were only talking about two weeks of time.

The tenant interview went exactly as expected: they intend to stay, they want the roof and parking addressed, they see themselves there for years.

Then darkness. The call finally came, not from the partner, from the analyst. Their capital partner had “concerns,” and could only proceed if a new lease were signed before closing.

A complete re-trade on the key business point, which could not have been clearer from the onset.

We sent it back plainly: the seller isn't budging, the whole reason for the discount was speed, go talk to your capital partner or terminate. A few days later, a simple email with the termination letter.

What I think actually happened.

In this case I think there were bigger factors at play than the lease renewal.

First, these past couple of years have been a bear for programmatic investors. Most of them don't want to admit it out loud, but it is just very challenging for them to hit their returns. The post-COVID property rally was an equity boom — trillions in stimulus pumped into the system, with a data center capex wave now working its way through behind it. Very little distressed debt out there, isolated mostly to a few corners of the market. When that happens, prices go up and stay up. Owners have no reason to discount and there is no forcing function to reset values. Hence tight inventory on the sales market. I expect that rents will need to grow into values, and that values generally will not reset downward.

Why does this matter?

Because a famine changes how people behave, and it changes what a handshake means.

In the programmatic famine the animal instinct with some is taking over. Their word just doesn't mean as much as it used to. If it's a choice between telling you — or themselves — the truth, or fibbing to see if they can re-trade for a better deal at a later date, some will opt for that route. Not all players are bad, and I don't even think most have ill intention, but the incentive structure they're on bends their actions in a way which ends up leading to a re-trade of sorts. Sellers become an abstraction and the numbers game idea takes over. The ones playing that game will carry multiple deals, sometimes dozens, under contract at once, knowing full well they'll drop most of them and only move on the ones where they've got the leverage at the end.

Which brings me to the part I keep turning over, which is what we could have done differently. The reinforcement lesson here is that pressing the managing partners in writing and verbally prior to going into contract simply wasn't sufficient. Could we have done more? I suppose we could have asked for written communication from the capital partner. Or maybe we could have gotten in the weeds with their underwriting to pressure test their assumptions. But beyond a certain point it's not practical or realistic.

Know Thy Buy Box

There's a related problem underneath all of this, and it has less to do with honesty than with organization.

In the programmatic famine, one other trend I've noticed is that organizationally some of these firms don't even know their own buy box. I mean, the individual at the firm probably has a legitimate opinion. But when you follow the game of telephone from analyst, to associate, to managing partner, to capital partner, and account for emotions and influences changing the opinion of that ultimate decision maker, you get this effect where those closest to the deal with the most accurate read on the risk/ reward paradigm have the least influence on the actual moment of truth where a deal gets funded or dropped.

Playing a Different Game

Which raises the obvious question. What does get funded, and why did this particular group drop this?

In this case, I don't think it was ever about the lease on its own. I think it has to do with an inherent incentive for some programmatic capital to gravitate toward lower cap rate deals and cap rate compression to drive IRR. Put plainly: high cap rate deals put much more of a burden on the operator to drive NOI growth in order to meet their IRR target.

Private investors buying on their own account in a portfolio aggregation strategy are playing a vastly different game. For them, positive leverage, yield, basis, location and durability of rental pricing power are the main variables. Plus they get to plan for all of the long term tax incentives baked into real estate, since they’re not on a short exit horizon. If you have no intention of selling within three to five years, you're more focused on cash flow, NOI growth, and the potential for rents to compound over a longer time horizon. You're also more focused on lender underwriting than buyer underwriting. That's how some of our veteran clients have used one property, refinanced over and over again, to go out and grow the portfolio. They also don't take credit (as in credit tenant) for credit's sake, and will typically formulate their own view of the stickiness of the tenancy. The exit cap rate is a consideration, but since they’re looking at longer time horizons, it’s really anyone’s guess where exit cap rates will be - NOI and cash flow are the game.

Programmatic capital by contrast is structurally more reliant on cap rate compression. Factor in deal fees on both entry and exit, and the required NOI increase to match even 100 basis points of compression on the exit is substantial.

And if the cap rate has to do the work, then the only thing that really matters at the end is who's standing there to buy it from you. Which is where a consensus view on property characteristics enters the picture.

Programmatic capital has largely decided that block construction is superior to metal. It's not even about the PPSF, as in this case the acquisition represented a reasonable PPSF value for a metal building. It has more to do with the perceived, or predicted, impact on cap rates. Since programmatic has decided to prioritize block, block by definition should have a deeper, more liquid buyer pool, or at the very least be more of a candidate for a roll-up strategy in which a larger buyer pays a tighter cap rate to acquire a portfolio at scale. The impact is that they feel trading in block makes it easier to hit their numbers on the exit, especially in a model with a relatively short investment horizon.

It doesn't necessarily have anything to do with actual tenant demand. The tenants don't really care. For tenants it's more about location, functionality, power, clear height. Whether or not the building serves the business needs.

I think what happened here is that this deal sort of fit into the programmatic bucket — it had the location, the tenancy, the story — but at the end of the day it was not a block construction deal. It’s either that the organization as a whole couldn’t articulate its reservations to us (despite serious repeated attempts before going under contract), or they were simply just trying to play the re-trade game on an option contract.

Onward and upward

Despite a couple of weeks wasted, all is not for naught. This is something we suspected from the beginning, but the experience validates the thesis.

And the thesis, stated plainly, is this. There is a real gap between what this building is worth and what it's worth to a programmatic buyer — and that gap is not a defect in the building. It's a defect in the match. Metal construction narrows the exit for someone who has to sell into a deep pool inside of five years. It narrows nothing at all for someone who intends to hold for twenty, collect the yield, refinance into the next one, and never test the exit cap rate in the first place.

Which means the discount is real, and it transfers. Whoever ends up owning this building gets paid for a risk they aren't actually taking.

So this deal requires a nuanced buyer in order to value the asset at its fullest potential. The odds of it trading to a programmatic buyer are not high. It's likely going to require a private investor buying on their own account, a 1031, a tax motivated deal, or perhaps a cash flow and NOI focused investor who sees the same gap in the market with metal which we've identified.

And for anyone else sitting on the sell side of something like this, the moral of the story is NOT that programmatic buyers are bad actors. Most of them aren't. It's that “we like it” and “we can fund it” are two entirely different sentences, and only one of them really matters. Ask what specifically about the asset gives their capital partner pause. Ask who signs off, and whether that person has actually seen it. If nobody can name a single thing they don't like about your building, they probably have never done a property tour in their lives. There is no such thing as a perfect property - this is a risk asset class after all. The key is the right set of characteristics for the right group at the right time.

Which brings it back to where we started. The trap in an off market deal isn't that you get one bid instead of ten. It's that a single buyer's stated intent is untestable. In a competitive process you don't have to divine whether a group truly knows its own buy box, because the other bidders do that work for you. Motivation and intent rise to the surface the moment somebody else is willing to take the asset away.

Off market, you're left pressing for confirmations that cost the other side nothing to give. There is no substitute for broad exposure to a wide variety of players with different incentives. That's what drives price discovery — and price discovery is really just intent discovery with a number attached.

We will simply continue with the business plan and re-negotiate the lease extension with the tenant, and once consummated, bring the property to market and give it the exposure required to source the right buyer.