Negative Covenant
A type of restrictive property covenant that prohibits the landowner from certain acts. This type of covenant also runs with the land, remaining with any subsequent landowners. An example of a negative covenant may prohibit the landowner from expanding the physical building and increasing its square footage beyond a certain limit.
Putting ‘Negative Covenant’ in Context
Bluegrass Capital Partners, a real estate investment manager based in Lexington, Kentucky, has recently acquired Meadowview Industrial Storage Yard, a 15-acre industrial outdoor storage (IOS) property located near a major logistics hub in the city. The property caters to regional trucking companies, construction firms, and equipment rental businesses, offering secured outdoor storage for heavy equipment, shipping containers, and vehicles.
As part of the acquisition due diligence, the investment team discovered a negative covenant tied to the property deed. This restrictive covenant, established by the original landowner decades ago, prohibits the construction of permanent buildings exceeding 20,000 square feet on the site. The intent of this covenant was to preserve the property’s utility as an open storage facility, ensuring its alignment with the area’s industrial zoning and demand for outdoor storage.
How the Negative Covenant Impacts the Investment
- Preserving the Property’s Current Use: Meadowview Industrial Storage Yard currently has a small, 10,000-square-foot administrative building that houses leasing offices and maintenance facilities. While the negative covenant limits the possibility of future vertical development (e.g., a large warehouse or multi-story facility), it aligns with the investment’s current use and strategy as an IOS property. This ensures continuity for tenants who rely on the expansive open yard.
- Limiting Expansion Opportunities: The covenant could present challenges if Bluegrass Capital Partners wanted to pivot the property’s use to include additional storage buildings or change its use altogether. For example, a potential redevelopment into a logistics center or manufacturing facility would be constrained by the building size limitation.
- Market Demand: Given the growing demand for IOS properties, especially in the logistics-heavy Lexington market, Bluegrass Capital views this restriction as minimal risk. The covenant supports the firm’s core investment strategy by securing steady rental income from existing tenants, while the limited development scope minimizes CapEx requirements.
Financial Impact of the Covenant
The restriction also influenced the property’s valuation. The seller and Bluegrass Capital agreed on a cap rate of 6.5 percent, slightly higher than comparable properties without restrictive covenants. The acquisition price was $12 million, and the property generates an annual NOI of $780,000.
Example Calculation:
- NOI: $780,000
- Cap Rate: 6.5 percent
- Valuation: NOI ÷ Cap Rate = $780,000 ÷ 0.065 = $12,000,000
By understanding the implications of the negative covenant, Bluegrass Capital was able to mitigate risk while leveraging the property’s existing use and strong demand in the IOS market.
Frequently Asked Questions about Negative Covenants in Real Estate
What is a Negative Covenant in real estate?
A Negative Covenant is “a type of restrictive property covenant that prohibits the landowner from certain acts.” It runs with the land, meaning it applies to all future landowners as well.
What is an example of a Negative Covenant?
An example would be a restriction that “prohibits the landowner from expanding the physical building and increasing its square footage beyond a certain limit.”
How did a Negative Covenant affect the Meadowview Industrial Storage Yard acquisition?
The covenant “prohibits the construction of permanent buildings exceeding 20,000 square feet,” which preserves the property’s use as an industrial outdoor storage facility.
What are the pros and cons of this covenant for Bluegrass Capital Partners?
Pros: Aligns with current IOS use, ensures tenant continuity, and limits CapEx.
Cons: Restricts future redevelopment options such as building larger facilities.
How did the Negative Covenant influence the property’s valuation?
It resulted in a slightly higher cap rate (6.5%) compared to similar properties without such restrictions. The property was valued at $12 million based on an NOI of $780,000.
Does the covenant limit future development of the site?
Yes. The restriction “limits the possibility of future vertical development,” such as converting the site into a logistics center or warehouse exceeding the 20,000 square foot limit.
Is the Negative Covenant viewed as a major risk in this case?
No. Due to strong demand for IOS in Lexington, Bluegrass Capital considered the restriction a minimal risk and consistent with their investment strategy.
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