The single most important principle of wealth management is to preserve one’s capital and protect it from loss. Investing in property that is leased to credit tenants on a long-term, triple-net basis is an intelligent way to preserve capital, while receiving steady cash flows and achieving potential appreciation in the long-run. Although “double-net” and “triple-net” leases generally place all or most of the structural and operational responsibilities on the tenant, the specific terms that are actually spelled out in the lease agreement determine the obligations of all parties involved. This makes the lease agreement one of the single most important documents for investors to analyze in order to minimize their risks, protect their capital, and safeguard their potential for appreciation. Lease agreements should not be examined in isolation, but understood in the context of the investment as a whole.
For example, if an asset or property manager does understand, or simply fails to respect, a requirement to provide written notice to a tenant about a reimbursement for services provided, the reimbursement period may expire, leaving the manager, and possibly the owner, with unwarranted costs. Investors should understand the lease terms themselves, but go beyond them by looking into each tenant’s understanding and ability to fulfill their obligations, as well as any manager’s understanding and ability to enforce the tenant’s obligations and carry out their own responsibilities in light of the lease agreement.
This article addresses the following elements of a lease contract:
- Relationship (between the tenant and ownership)
- Responsibilities (tenant, insurance company, ownership)
- Rents, Rent Bumps, & Term Lengths
- Renewal Options
- Red Flags (such as co-tenancy and early termination)
An investment property’s lease agreement should require the ownership (or their manager) and the tenants to clearly communicate in writing when it comes to renewal options, lease termination, buyout, sublease, expenses, maintenance, permissions, and other mutually involving issues, and maintain good records of the correspondence for reference.
In the case of renewal options, tenants should be required to give ownership written notice six to eighteen months in advance of the end of their lease in order to allow the manager to plan accordingly. As with any obligation, penalties should be attached to any violations. The agreement should specify a fine to be paid by the tenant if this notice is not given in time in order to compensate the owner for potential costs or devaluation that could result from non-renewal. There may also be benefits provided in response to providing notice on time or agreeing to renewal terms earlier than the required.
In the case of a tenant buyout or sublease, the tenant should be required to receive written permission from ownership. It is important to specify this, even in the case of a triple-net lease. Although the tenant would remain obligated to continue to pay rent, protecting the owners’ cash flow, material changes to the space or operation of a property may greatly impact its value and long-term potential for appreciation and resale.
In any lease, it is important to specify that any space that is used by a tenant, or harm caused by the tenant’s operations, is their responsibility. Risks that should be the responsibility of the tenant include, but are not limited to, the use of physically or environmentally hazardous materials, business-related lawsuits, damage to tenant fixtures and furniture, and work-related injuries. By clarifying the responsibilities of the tenant, the potential risk of a tenant vacating unexpectedly or without fair penalty can be minimized. Note that only certain “absolute” triple-net leases place all responsibilities on the tenants. Many leases still require ownership (or management) to shoulder some obligations and liabilities.
Ownership may choose, or be required, to maintain certain insurance policies to protect against criminal activity, physical damage, lost rent due to natural disaster, and more. If ownership fails to maintain such insurances, it is possible the tenants may be able to stop rental payments or even terminate their leases. Even in the case of absolute triple-net leases, certain limited liability insurance may be required. Investors should confirm that any and all insurances necessary are included and maintained in the lease to ensure the property does not suffer from liability issues during the holding period. Investors should also identify what the insurance covers and think about what may not be covered so they can look for these to be covered in the operating budget. Potential expenses that are not planned for in advance can pose a significant threat to one’s investment.
Investors, although they should not be responsible for the operations of a tenant, may still be often liable for the structural risks of a property. This may include, but may not be limited to, the roof, walls, exterior, surrounding signage, sidewalks, and parking lots. Certain communal area maintenance may also fall under ownership’s responsibility, and failure to maintain any of these things may mean that ownership is liable for an injury related to one of these areas. It is therefore crucial for investors to understand the terms of the lease and make sure that management is prepared to handle their responsibilities faithfully.
Rents, Rent Bumps, & Term Lengths
Long-term leases can provide an investment with incredible stability, but doing so without the proper lease bumps to counteract inflation over the course of many years may mean investors’ expenses cut into, or eventually rise above, the rental income. As the dollar’s value decreases over time, a tenant’s first year of rent will not be equal in value to their tenth year of rent if the dollar amount remains the same. Instead, adding “lease bumps” or “rent bumps”, with an average annual increase of 1–2% in rent will not only help pay for the costs of ownership, but also keep a property’s rent from contracting to below-market value. Not only does this result in diminishing returns, it can severely a property’s resale value.
There is an important difference between renewal options and lease length. A lease is an obligation, while a renewal is an option. A five-year lease with a five-year option is different than a ten-year lease. The lease agreement’s treatment of renewal options can work to the advantage of both the ownership and the tenant. The tenant should be required to provide notice of intent before the lease is up, to give ownership time to find a new tenant if necessary. Ownership should be required to provide clear renewal terms long before the lease is up to give the tenant time to consider. These terms should reflect appropriately-paced increases in rent to maintain the pace of the rent bumps built into the original lease. If renewal terms are fair and favorable to investors, options as long as five to fifteen years are recommended.
There are various types of clauses found in lease agreements that favor tenants but put investor capital at risk. Two such clauses address co-tenancy and early termination.
In a co-tenancy clause, a tenant may be allowed to stop operations should an anchoring neighbor tenant cease operation for any reason (e.g. bankruptcy, lease termination). For example, should a Best Buy go out of business that is anchoring a retail center, other tenants in the retail center may be allowed to stop operations or even back out of their own lease if a co-tenancy clause was agreed upon in their lease terms.
Another form of a co-tenancy clause may provide a tenant the ability to stop operations should a competing business move adjacent or near enough to the tenant. For example, should a McDonalds move adjacent to a preestablished Burger King, the Burger King may be allowed to stop operations or terminate their lease.
Another dangerous “out” condition is a pre-agreed option for early termination. Investors should beware of these, as they allow a tenant to terminate their lease before the lease term is complete. A tenant may want to jump ship should better lease terms become available elsewhere, leaving the landlord and property with an undesired vacancy.
Should the early termination occur, typically six to eighteen months of advanced notice is required from the tenant, along with a lump sum payment. This lump sum, however, is smaller than the full lease term payment would have been, so while it may offset some of the ownership costs, it does not entirely mitigate the risk of cash flow lost to vacancy.
Both types of clauses can result in the need to re-lease a property, devaluation of the property, failure to meet projected cash flows or loss of investor capital.