Which deal would you take? Retail property scenario

Interesting case study. I think more information is needed and the analysis is more about risk assessment/mitigation and less about returns - obviously in both scenarios you stand to make a killing.

I have an offer from a private equity group to buy it for 3.25M but they need 18 months to go through permitting and will pay my taxes/insurance during that period.

Do you have any insight into the permitting process? What are they seeking? Expected return is irrelevant in this analysis and only plays a role if you have multiple tries. You only really have one shot at this and the outcome is binary - either you picked the right offer or you didn't...there's no going back. Also, I wouldn't say the expected return on the permitting is 50%, but much higher. There is no way a developer/REPE/sponsor will take a 50/50 risk. They must be familiar with the permitting process and feel confident that they will get some sort of entitlement. If the probability of permitting is truly 50%, then the sponsor sucks and likely doesn't know what they are doing. If this is a reputable sponsor with a track record, then I think the focus is more so on mitigating your risk if the permitting is unsuccessful. For example, you might ask them to escrow some money during the permitting process. Assuming you bought the property with 75% LTV @ 7%, then your monthly mortgage payments are ~$10k month. At a minimum they should escrow $180k plus maybe another $30k (3 months of mortgage payments), which will compensate you for your cost should they be unable to perform and 3 months of cost of carry to put another deal together.

The other offer I have on the table is from a national to lease the property for 300k NNN for 15 years with 10% escalations every 5 years. However, I have to shell out an additional 1.1M for landlord's work, tenant improvement allowance, and broker's commission. 

Now this is a more interesting analysis. Basically it comes down to more risk, but also more reward. It's very easy for users who don't put up their own money to tell you to do so in the hopes of making more money, but when it comes down to it, $1.1mm is a lot. Are you able to finance this? In the REPE scenario, if you can get them to escrow, you basically have nothing to lose financially, just 18months. In this scenario you not only lose time and cost of carry during renovation...but potentially $1.1mm on top. What happens if you are almost done with renovation and the national tenant backs out last minute? How unique are the tenant improvements you are making? Are they so unique, that they are only valuable to this national tenant or only a handful? Or are they more generic improvements that are applicable to many tenants? Can you negotiate a lower rent amount and in exchange they do the entire TI or at least go 50/50 so they have some skin in the game? You could also employ a similar approach to the REPE scenario and have them escrow some funds should they back out. Although this scenario has a lot more upside, there is also a lot more downside, so I really think your decision is more about risk mitigation. You may also consider spending a couple thousand dollars on a real estate attorney that does this. Attorneys have seen hundreds of similar scenarios and have come up with many solutions.

Unsure about which location in NJ but retail is a great asset class at the moment. It might not be in 18 years. $3.25m sales price vs a $2m purchase sounds attractive on the surface but in this environment, if they find one thing wrong in the DD process they'll re-trade you. Unless you have some great earnest money/hurdles built into the 18 month timeline, I'd go the other option. the cash on cash being 10%+ sounds good to me.

Do you have any insight into the permitting process? What are they seeking? 

They're seeking to do a car wash. They have car wash brands all over the united states and are private equity backed. I'm located in a prime signalized corner with lots of traffic. I do not have any insight into the entitlement process. I only know they're willing to pay me 100k over 18 months to cover my holding costs, and if successful, they'll pay 3.25M at closing. If not successful, they'll only lose 100k. I guess my homework is to find out what percentage chance they have of getting entitlements approved by city. If it's 80%+, then this is an attractive offer to me. If it's less than 50%, I'd definitely lean towards the lease offer.

 $1.1mm is a lot. Are you able to finance this? In the REPE scenario, if you can get them to escrow, you basically have nothing to lose financially, just 18months. In this scenario you not only lose time and cost of carry during renovation...but potentially $1.1mm on top. What happens if you are almost done with renovation and the national tenant backs out last minute? How unique are the tenant improvements you are making? 

I spoke to a local lender and they're able to give a loan of 65% of stabilized value once lease is signed, which I anticipate the stabilized value to be 4.6M. I would have no money into the deal at this point. I have very minimal landlord work (whitebox the space and remove flooring) - the majority of that 1.1M is cutting the tenant a check for high 6 figures for the tenant improvement work. The tenant is an auto use with over 1,000 locations nationwide. They're providing a corporate guarantee for the entire 15 year lease.  

1. If you go with the private equity buyer and they back out in Month 18, you've presumably been sitting on a vacant building for 1.5 years. (This assumes that you won't be able to lease the building for the 18 months that you're under contract, and that they won't pay your taxes/insurance if they back out.)

They're actually allowing me to sublease to any dry use for the 18 months, but I doubt I can find anyone willing to pay much for that short period of time. The problem is pinpointing the chance that they will pass entitlements.

. You could sell for $4.65M as soon as the lease is inked and collect your $500k profit (pretty good!). But you could also harvest $300k a year, less financing costs, and make that ~$4.5M a few years down the road. On equity multiple alone this sounds hard to beat. Run EM and IRR calcs on selling now vs. 3-5 years down the road (conservatively at a higher cap rate than today's due to loss of lease term) to find the optimal selling point.

In the lease scenario, I purchased for 2M and need additional 1.1M, so that's 3.1M total. My anticipated sale is 4.6M, so 1.5M profit. I bought the property all-cash in a 2-week closing to get that price (having a 1031 helped). I plan on placing debt on the property of about 50-60% of stabilized value (4.6M) if I sign the lease, which should cash me out entirely and leave me with no money in the deal. 

I wouldn’t let a car wash tie up my site for 18 months. They’re notorious for putting 3-4 sites u/c in a particular area, then backing out at the last minute.

Happened to us last summer; they even went so far as getting all entitlements and permits in hand, still ended up killing the deal and moving forward with another site one town over along the same road.

Definitely pass on the car wash - very different from PE coming to redevelop for resi and those guys are notorious for tying up sites then walking.

The lease scenario is better a better option IMO if you have the capital - if its a national your risk will be very minimal by the time you are putting the $1.1M into the deal, and when all is said and done you're at a 9.7% yield on cost with escalations, which is GREAT as is, and you have something that you should be able to sell quite easily (I say not knowing the site).

If it was sell without conditions beyond diligence it might be a more difficult question but the 18 month, permit-contingent nature of the PE deal is unappealing.

Both offers have their advantages and disadvantages, and the choice will depend on your investment goals, financial capabilities and risk tolerance.
Sale to private equity group:
Pros: Making significant profits in the short term.
Cons: Uncertainty about obtaining permits, risk of delay, possible costs for taxes and insurance in case of delay.
Renting to a national tenant:
Pros: Guaranteed income for 15 years, the opportunity to receive significant capital in the future.
Cons: The need for additional investments in the work of the landlord and improvement of living conditions, the risk of possible losses if the market situation changes.

Tough decision you've got on your hands, but it sounds like you've got some solid options to weigh. Personally, I'd be inclined to lean towards the leasing deal with the national tenant. Sure, it requires a bigger upfront investment, but the steady income stream over 15 years plus those escalations every 5 years could really pay off in the long run. Plus, there's something to be said for the stability that kind of arrangement offers.

Not sure I’ve seen anyone point this out: there is no exit market for car washes right now. The TPGs/SuperStars went out and bought land and created this massive platform to build and operate them, sell off the land on an extremely favorable (to the tenant: TPG) rates and hope there is a play for NNN ground leased properties with no upside in value/cap rate compression looming. Guess what? There isn’t and they are getting squeezed massively right now. The programming doesn’t work unless they refi the land, but at that point they are too pregnant on the site and don’t have all of their cash back in hand. 
 

just think about that when negotiating with the carwash team. There is no real end in site either, with a potential consumer recession looming it would be quite nuts to rely on them for your future livelihood at the moment. Also, you better know what the city thinks of your site and what they think of car washes. They aren’t the most sought after use cases since their residual uses are limited..