Net Lease Underwriting: A Field Guide to Rent Steps, Options, and Credit

Single-tenant net lease looks like the simplest asset class in commercial real estate to underwrite. One tenant, one lease, little or no operating expense. The model fits on a page. That simplicity is real, but it moves the risk rather than removing it. In a net lease deal, almost all of the outcome depends on four things: the exact rent schedule, what happens at the end of the firm term, the strength of the party obligated to pay, and what the real estate is worth if that party leaves.

This field guide covers each of those, then works through one illustrative deal to show why going-in cap rate, average yield, and unlevered IRR give three different answers, and when each one misleads.

1. Build the rent schedule from the lease, not the OM

The OM’s rent table is a summary. The lease is the contract. Build the schedule from the lease and its amendments, then reconcile it to the OM and, later, to the tenant estoppel.

Dates first

Rent increases key off a specific date: the commencement date, the rent commencement date, or a lease-year anniversary that may not line up with the calendar or with your closing date. Model by month, at least for the first few years, so that a bump falling in month 7 of your first year is captured as five months of higher rent, not twelve. If there was an abatement period at the start of the lease, confirm whether lease years run from commencement or from rent commencement. The difference can shift every increase by several months.

Escalation types

• Fixed periodic increases (for example, 10% every five years) produce a step-shaped schedule. Average yield depends heavily on where in the cycle you buy.

• Fixed annual increases (for example, 1.5% or 2% per year) compound smoothly and are easy to model, but check whether the increase applies to the original base rent or to the prior year’s rent.

• CPI-linked increases usually carry a floor and a cap, and sometimes a lookback period. Model the floor as your base case. Treat any assumption above the floor as a forecast, and label it as one.

• Flat rent is common in long leases with strong tenants. The nominal income does not change; its real value declines every year.

Reconcile and record

When the lease, the OM, and the estoppel disagree, the executed lease and amendments control, and the discrepancy goes on the diligence list. Record the page and section for every rent figure in the model, so that a reviewer can check it without rebuilding your work.

2. Treat renewal options as the tenant’s decision

A lease with four five-year options is sometimes described as having “35 years of term.” It has the firm term. The options are rights held by the tenant, exercised when they benefit the tenant.

A practical framework:

• Do not assume exercise in your base case beyond the firm term. If your hold extends past expiration, underwrite a renewal probability and a downside in which the tenant leaves.

• Compare option rent to market rent. If option rent is fixed and below what the space would command, exercise is more likely. If it is above market, a rational tenant will either leave or use the renewal date to negotiate a lower rent.

• Read the notice mechanics. Most options must be exercised within a window before expiration. That date determines when you will know, and when a buyer will know if you are selling.

• Price options into your exit, not your going-in yield. Options affect what the next buyer will pay, especially when little firm term remains at sale.

3. Underwrite the obligor, not the brand

Credit analysis in net lease starts with identifying the entity that is legally obligated: the tenant named in the lease and any guarantor. A national brand can stand behind a lease, or it can sit above a subsidiary or a franchisee that signed it. Underwrite the entity that signed.

What to collect

• The executed guaranty, including any cap on amount, any burn-off after a period of time, and whether it extends into renewal terms.

• A public credit rating if one exists, and the most recent financial statements of the obligor (public filings, or private statements under NDA).

• Store-level performance where the tenant reports it: sales, and rent as a share of sales.

Why the store matters even with strong credit

In a U.S. bankruptcy, a tenant can choose which of its leases to keep and which to reject. Under Section 365(d)(4) of the Bankruptcy Code, an unexpired lease of nonresidential real property is deemed rejected unless assumed within 120 days of the order for relief (or by plan confirmation, if earlier), subject to one 90-day extension for cause; further extensions require the landlord’s written consent. Tenants generally keep their profitable locations and reject the rest. Corporate credit protects you most when your store is one the tenant wants to keep.

If a lease is rejected, the landlord’s claim for future rent is capped by Section 502(b)(6): broadly, the rent reserved for the greater of one year or 15% of the remaining term (not to exceed three years), plus unpaid rent already due. That claim is typically an unsecured claim and may be paid at a fraction of face value. An illustrative case: with 11 years remaining on a $240,000 lease, the claim for future rent would be limited to a period of one to three years’ rent, not eleven. Courts have differed on how the 15% is measured, so confirm the treatment with counsel for any deal where it matters.

The practical lesson is that a strong guarantor reduces the probability of default but does not make the real estate irrelevant. Store performance and re-leasing value determine what you keep if things go wrong.

4. Value the building as if it were dark

Dark-store risk covers two different situations. In the first, the tenant leaves at expiration or after a rejection. In the second, the tenant stops operating but keeps paying rent, which many retail leases permit unless they contain a continuous operation covenant. The second case protects your income in the short term but can hurt the property: a dark box can trigger co-tenancy clauses in nearby leases, reduce traffic, and make the building harder to sell before expiration.

The disciplined test is to estimate value with no tenant. An illustrative calculation for a 9,000 SF freestanding retail building bought at $4.0M ($444 per SF):

Here, roughly two-thirds of the purchase price depends on the current lease. That is not a reason to pass. It is the number the investment committee should see next to the credit analysis, because it measures how much the deal relies on the tenant. Land value and replacement cost are useful cross-checks.

5. Choose an exit cap that reflects the lease at sale

Exit cap rate is not a market forecast alone. In net lease, buyers price remaining term heavily. A building sold with 14 years left on a corporate lease and the same building sold with 4 years left are different assets, and the second will usually trade at a higher cap rate.

• Set the exit cap with reference to the remaining term at the assumed sale date, not the term at purchase.

• Apply the exit cap to the forward NOI the next buyer will receive, and say so in the model.

• Deduct sale costs.

• If the hold runs close to expiration, consider modeling a sale after a renewal and a sale with the tenant’s departure, rather than a single blended exit.

A worked example

The following deal is illustrative. Numbers are rounded, cash flows are annual and received at year end, and there is no debt.

Rent runs $240,000 in years 1–5, $264,000 in years 6–10, and $290,400 in year 11. At sale, the buyer receives a lease with five years remaining. Gross sale price is $290,400 ÷ 6.5% = $4,467,692; net of 2% costs, $4,378,338.

Three measures, three answers

Going-in cap rate describes year one only. It is the market’s pricing convention and the figure most often quoted, but it ignores escalations, timing, costs, and exit.

Average yield captures the escalations over the hold. It is a better income measure for a buyer who intends to hold, but it treats a dollar in year 10 like a dollar in year 1 and ignores the exit entirely.

Unlevered IRR includes timing, costs, and the residual value. Here it exceeds average yield because the net sale proceeds ($4.38M) exceed total cost ($4.06M), even though the exit cap is 50 basis points higher than the going-in cap. The step-up in rent carries the exit value. That also means a large share of the return depends on one assumption made ten years out.

Note also what the example assumes away: no capital costs, no vacancy, no credit event. In an absolute net lease with a strong tenant, that is a defensible base case. It is not a complete one, which is why the dark-value calculation above belongs beside it.

Sensitivity: rent structure against exit cap

The same $4.0M price and $240,000 starting rent, with three different escalation structures. All other assumptions are unchanged. Every row has a 6.00% going-in cap rate.

Three points stand out. First, identical going-in cap rates conceal a spread of more than three percentage points in IRR across plausible structures and exits. Second, the 1.5% annual lease produces higher average income over the hold, but the periodic-step lease produces the higher IRR here, because its year-11 step lands just before the sale and lifts the exit value. Move the sale date by one year and the ranking can change. Third, on the flat lease, each 50 basis points of exit cap expansion costs roughly 50 to 60 basis points of IRR. Flat leases put almost all of the return on the exit.

A useful sensitivity table for an investment committee shows the exit cap and one other variable that matters for the specific deal: renewal probability for a lease expiring near the end of the hold, downtime and re-leasing rent for a tenant with weaker credit, or purchase price for a competitive process.

Common modeling mistakes

• Escalations modeled on calendar years when the lease runs on lease years.

• Renewal options treated as firm term.

• Exit cap set equal to the going-in cap, regardless of the term remaining at sale.

• Exit value calculated on trailing rather than forward NOI, without saying which.

• Landlord obligations under an “NNN” lease (roof, structure, parking) left out of the cash flow.

• Credit described by brand rather than by the obligated entity and the terms of the guaranty.

• No downside case in which the tenant leaves.

• Rent figures in the model without a reference to the lease section they came from.

Where Rets fits

Rets builds the rent schedule and returns from the lease itself, with each rent figure cited to its page, so escalation dates and option terms come from the contract rather than the OM. It extracts price, NOI and lease terms from inbound OMs, abstracts leases with citations, and compares tenant estoppels to the lease during diligence. Chat answers questions about the deal from your documents, with sources.