How Pad Sites Provide Value-Add Opportunities for Retail Property Investors
A pad site is a commercial space that is next to or adjacent to an already existing building, typically located in a retail shopping center. Pad sites are in contrast to the main retail space, which is sometimes called the “inline” space.
Pad sites are often part of the main parking lot, but are sometimes empty land, lightly landscaped areas, or unused “dark” buildings.” In most cases, pad sites are already owned by the landlord of the adjacent or nearby property, but sometimes, they belong to a separate owner and must be purchased.
In the past, pad sites were often seen as throwaway land, but in recent years, that perception has changed in recent years. Developing or redeveloping pad sites is growing increasingly popular as investors and retail tenants alike want to maximize the income produced by existing properties. Depending on their nature and the needs of landlords and tenants, pad sites can generally be used for one of three things:
Expanding a building for an existing tenant
Building a structure to be used for new tenants
Redeveloping an unused or “dark” building on-site
For example, many fast-food tenants may wish to utilize an adjacent pad site to create a drive-through or expand their property to add more seating.
How to Finance Pad Site Development
Pad site construction and acquisition can sometimes be difficult to finance, due to the fact that it can be difficult to demonstrate exactly how much additional income will be generated by the project. Therefore, bank construction loans are often available only to well-qualified borrowers, generally for properties that already have a high debt service coverage ratio (DSCR) and strong tenants. In cases where bank financing is not available, hard money or private money loans may also be used for pad site development.
In the case of owner-occupied properties, funding for pad site development can often be achieved with an SBA 7(a) or SBA 504 loan. SBA loans provide low-cost business financing to small businesses (generally those with revenues under $5 million/year) and have terms and amortizations of up to 25 years, These loans generally stipulate that at least 60% of the property is owner-occupied, which means that 40% of the property can be leased to other tenants.
What to Consider When Considering Developing a Pad Site
There are several major factors to consider when deciding to develop a commercial pad site.
Zoning and Construction Laws and Regulations: Even if a pad site development project looks like it could be a profitable endeavor, it could meet a dead end if the development violates local or state laws or zoning codes. For example, sometimes, properties must be set back a certain amount from a road, which could prevent a parking lot from being developed into a new building or an extension of the current building. Building size and height rules should also be taken into account.
Anchor Stores: While pad sites are typically used as spaces for new tenants or building extensions for smaller tenants (not anchor tenants), the anchor tenant in a shopping center should still be considered. Ideally, the pad site should be relatively close, but not too close, to the anchor store, and the businesses should complement each other (i.e. a small pharmacy next to a big pharmacy would not be ideal).
Visibility, Accessibility, and Traffic Count: Before putting funds into any retail pad site development, the state of the current shopping center should be evaluated. If the center is already not particularly profitable or popular, a pad site may not be a worthwhile investment. In addition, the pad site itself should be visible, and, if the pad site is currently part of the parking lot, a developer should be careful to make sure there is still enough parking in the shopping center to accommodate current and future traffic.
The Potential Benefits of Commercial Real Estate Pad Sites
In general, pad site development is considered a form of “value-add” investing, as it takes a property that is already functioning well and (ideally) makes it more profitable. Some of the specific benefits of pad sites include:
Increased Income/Profitability: Since, in most cases, the owner or developer already owns the land, developing a new portion of the land will not incur any additional land purchase expenses, and will increase the income of the property by providing more square footage that can be rented to tenants.
Increased Property Value: Since the development of a pad site can increase rental income, and property value is typically derived from NOI, the property will gain value as a result of the additional rental income.
Attracting Anchor Tenants: Many anchor tenants, national and regional retailers, and restaurants, such as pharmacies like CVS, Walgreens, and fast-food chains like Chipotle and McDonalds, may be more likely to gravitate toward leasing out properties in shopping centers with pad sites, as they allow for the shopping center to expand and accommodate new businesses, which could bring more business back to the anchor tenants. These anchor tenants are often referred to as credit tenants, as the corporation behind the business has a great credit score and a far lower lease default list than an average tenant. Credit tenants typically sign triple net (NNN), absolute net leases, or credit tenant leases, making it far easier to get financing at significantly lower interest rates and higher leverage.
Reduced Risk: Traditional real estate development, including retail development, is high risk due to the long construction period in which the property will not generate any income. However, this risk is offset in pad site development due to the fact that the property is already generating income.
Tenant Diversity: In a shopping center with only one tenant (or only a few tenants), one vacancy could leave the property struggling to pay its debt service. Therefore, if the pad site is leased to a new tenant (and not simply an expansion of a current tenant’s structure) it increases the number of separate tenants, reducing vacancy risk. In addition, a diversity of tenants could make the shopping center more attractive to customers. For instance, if a customer can both grocery shop, go to the pharmacy, and go to a coffee shop in the same shopping center, it could increase the profitability of all businesses involved, strengthening tenant profits, which also reduces vacancy risk. If there is a profit-sharing agreement between the tenant and the landlord, this can also increase the property’s profitability.
Ground Leases: Ground leases are long-term leases that provide a tenant significant ability to modify, develop, upgrade, and sublease a property. The owner of a pad site can sometimes offer a ground lease to a tenant who will invest themselves into developing the pad site, reducing the risk for the original owner.
Property Division and Sale: In some cases, a property owner may wish to subdivide the property and sell the pad site to another developer. This can increase the overall profitability of the property and is almost akin to a cash-out refinance (without actually having to refinance the property). However, if there is an existing loan on the property, selling part of the property may violate the terms of the loan agreement, and could actually necessitate a refinance.
Pad Sites vs. Pad-Ready Sites
A pad site may sometimes be referred to as a “pad-ready” site if it is ready for new construction. This may include land that has been compacted (sometimes referred to as subgrade), and ready for excavation for plumbing and the setting of the building foundation. A pad-ready site may or may not be a traditional retail pad site; instead, it could be undeveloped, but primed land next to an industrial building.
In Conclusion: Pad Sites Represent a Significant Value-Add for Retail Owners and Investors
As previously mentioned, pad sites are growing increasingly popular as a way to increase the value and generate more income from existing retail shopping centers. They have a wide variety of benefits, including making existing tenants more profitable, increasing tenant diversity, reducing lease default risk, and potentially providing a greater variety of stores in one shopping center, which can help keep customers around. With owners looking to squeeze every ounce of value and income out of their investments, it looks like pad site development will only become more popular in the future.