When Tenant Credit Matters (and When Location Matters More)

TL;DR

The net lease industry's pricing convention treats tenant credit as the primary driver of cap rate. A Walgreens deal trades tighter than a same-sized regional pharmacy chain because Walgreens is a publicly-traded, rated tenant and the regional chain isn't.

This is mostly right for long-term leases on tenant-specific buildings. It's less right — and sometimes wrong — for shorter-term leases or generic buildings, where the residual value depends primarily on location and re-leasability rather than the original tenant's continued occupancy.

This post lays out a framework for knowing which factor dominates your specific deal: tenant credit or location quality.

The Two Drivers, Defined

Tenant Credit Driver

The deal's value depends primarily on the probability the original tenant continues to pay rent for the lease term. The asset value comes from the contractual cash flows; the residual value at lease expiration is secondary.

This driver dominates when:

• Lease term is long (15-20+ years remaining)
• The building is highly tenant-specific (Walgreens box, fast-food drive-through with specific kitchen layout, dialysis center, automotive service bay, etc.)
• Re-leasing the building to a different tenant would require significant capex
• The tenant credit is investment-grade (low probability of vacating)

Examples:

• A new 20-year Walgreens BTS in a stable submarket
• A 20-year FedEx Ground lease on a purpose-built sortation facility
• A 25-year corporate-guaranteed McDonald's

Location Driver

The deal's value depends primarily on what the property could be re-leased for if the original tenant vacated. The asset value is bounded by the income from any tenant, not just the current one.

This driver dominates when:

• Lease term is short (less than 7-10 years remaining)
• The building is generic or easily-converted (small-format retail box, office space, light industrial flex)
• Re-leasing the building to alternative tenants is realistic
• The location has high alternative demand (high-traffic intersection, dense submarket, growing demographics)

Examples:

• A 5-year-remaining corporate Subway lease on a hard-corner site in a growing market
• A 7-year-remaining bank branch lease on a freestanding building in a downtown core
• A 4-year-remaining urgent care lease on a generic 4,500 sq ft building in a high-traffic location

How the Drivers Interact

In reality, every deal has both drivers operating. The question is which dominates and by how much. A simplified mental model:

Total cap rate = (Tenant credit cap rate × tenant-stays weight) + (Location cap rate × tenant-leaves weight)

Where:

• Tenant-stays weight = probability the tenant occupies the building for the full lease term
• Tenant-leaves weight = 1 − tenant-stays weight
• Tenant credit cap rate = what the deal would price at if you knew the tenant would stay
• Location cap rate = what the deal would price at if you knew the tenant would leave (and you re-leased to alternatives)

For a long-term lease with strong credit on a specific building, the tenant-stays weight is near 1.0 and tenant credit dominates. For a short-term lease on a generic building, the tenant-leaves weight is meaningful and location starts to dominate.

Quantifying the Two Cap Rates

For a specific deal, calculate both inputs:

Tenant Credit Cap Rate

What would this deal price at if the tenant were known to stay for the full lease term and pay all contracted rent?

Use net lease cap rate comps for similar tenant credit + lease term:

• Investment-grade national tenant, 15+ year remaining lease: typically 5.0-6.5%
• Speculative-grade national tenant, 15+ year remaining lease: typically 6.5-8.0%
• Strong regional tenant, 15+ year remaining lease: typically 7.0-9.0%
• Local independent tenant, 15+ year remaining lease: typically 8.0-10.0%+

Location Cap Rate

What would this deal price at if you knew you'd be re-leasing the building to a different tenant after the current lease expires?

Approach:

1. Estimate market rent for general retail/office of this size + class in this submarket (CoStar, REIS, local broker data)
2. Calculate post-vacancy NOI = market rent × (1 - downtime allowance) - operating expenses landlord absorbs
3. Apply a market cap rate for general retail/office in this submarket (typically 50-150 bps wider than tenant-specific cap rates)
4. Subtract re-leasing capex (TI allowances, leasing commissions, vacancy carry costs)

This is the deal's floor value — what it's worth if the tenant vacates and you replace them.

The Spread

The spread between the two cap rates tells you how much pricing premium the tenant-stays scenario adds:

• Tight spread (50-100 bps): location and tenant credit are close substitutes; this is a location-driven deal
• Wide spread (200-400 bps): tenant credit adds significant value; this is a credit-driven deal

Three Deal Archetypes

Archetype 1: New Build-to-Suit, Investment-Grade Tenant, 20-Year Lease

Example: Brand-new Walgreens BTS, $5M asking, 5.5% cap rate, 20 years remaining, strong submarket.

• Tenant credit cap rate: ~5.5% (matches asking)
• Location cap rate: ~7.5% (general retail box at market rent)
• Spread: 200 bps

Verdict: credit-driven deal. The asking price is fair if Walgreens stays for 20 years. The downside is the 200-bp gap if they ever vacate.

Archetype 2: 6-Year-Remaining Sit-Down Restaurant, Local Operator, Hard-Corner Location

Example: Local restaurant tenant, $2M asking, 7.5% cap rate, 6 years remaining, prime intersection in growing suburb.

• Tenant credit cap rate: ~9.0% (local operator with short term)
• Location cap rate: ~7.0% (hard-corner site in growing market with strong replacement demand)
• Spread: -200 bps (location is better than the tenant credit)

Verdict: location-driven deal. The asking 7.5% cap rate doesn't reflect the tenant credit (which would warrant 9.0%) but does reflect the location quality (which would support 7.0%). This is a deal where the buyer is paying primarily for the underlying real estate, not the income stream.

Archetype 3: 12-Year-Remaining Office Building, Single Corporate Tenant, Non-Specialized Build-Out

Example: Corporate office tenant, $8M asking, 6.5% cap rate, 12 years remaining, suburban office park.

• Tenant credit cap rate: ~6.5% (matches asking; assumes investment-grade-equivalent corporate tenant)
• Location cap rate: ~8.5% (suburban office is a challenged asset class with weak re-leasing dynamics)
• Spread: 200 bps

Verdict: credit-driven deal that's more vulnerable than the same-spread Walgreens BTS because:

1. The asset class (suburban office) has structural challenges
2. Re-leasing risk is real (post-COVID office demand is reduced)
3. The 200-bp gap represents a larger relative haircut on a weaker asset class

When the Conventional Wisdom Goes Wrong

The "tenant credit is everything" mindset misprices deals in three common situations:

Situation 1: Short-Term Lease on Generic Building

A 4-year remaining lease on a generic 5,000 sq ft retail box might be marketed as a "credit deal" but is functionally a real estate play. Buyer should evaluate:

• What's the building worth re-leased?
• What's the trade area's demand absorption?
• What's the market rent vs the current contracted rent?

If the market rent is at or above the contracted rent, the deal can work even after the tenant vacates. If the market rent is materially below, the credit-driven asking price overstates value.

Situation 2: Tenant in a Contracting Industry

A long-term lease with an investment-grade tenant in a contracting industry (drug, certain retail categories, certain restaurant categories) is more vulnerable than the credit rating implies because:

• The industry trajectory means closure programs are likely
• Your specific store may be in the closure-target subset
• The credit rating doesn't fully reflect store-specific vacancy risk

For these deals, location is a meaningful tiebreaker. A strong location reduces the impact of any individual store closure decision.

Situation 3: Specialty Building in a Stable Industry

A long-term lease on a specialty building (medical, automotive service, fitness, etc.) where the tenant industry is stable but the building is hard to repurpose is all credit-driven. Location matters less because re-leasing requires either (a) finding another specialty tenant in the same category or (b) significant repositioning capex.

These deals reward credit-focused underwriting and are vulnerable when the credit story changes.

Practical Workflow

For any deal under offer:

1. Calculate the tenant credit cap rate — what should this deal price at given just the tenant + term?
2. Calculate the location cap rate — what's the deal worth if re-leased at market?
3. Calculate the spread — how much premium is being paid for the tenant-stays scenario?
4. Estimate the tenant-stays probability based on lease term, tenant credit, industry trajectory
5. Stress-test the residual — what's the deal worth in the tenant-vacates scenario?
6. Decide if the asking price is a fair blend of the two scenarios

When Brokers Add the Most Value

The conventional pitch is "this is a [tenant credit] deal at [cap rate]." More sophisticated positioning recognizes that every deal has both drivers and presents both:

• "Investment-grade tenant on a 17-year lease — the income story is strong. Plus this is a hard-corner location in a growing submarket — even in the long-term residual scenario, the asset is well-positioned."

This dual framing helps buyers see both upside scenarios and understands the asset's downside protection. It also helps differentiate genuinely strong deals (both drivers favorable) from credit-dependent deals (only credit favorable, location risk if tenant vacates).

Closing

Tenant credit matters most when the tenant is unlikely to vacate. Location matters most when re-leasing is the realistic baseline. Most deals sit somewhere in between, and accurate pricing requires evaluating both drivers explicitly.

The brokers and investors who do this consistently develop better instincts for deal pricing — and avoid the credit-rating trap where investment-grade tenants on bad locations get over-paid because the OM headline focuses on the credit story.