The most common way real estate investors generate revenue is by leasing out their property. Although there are various kinds of leases, the “triple net” (NNN) lease has become popular for its simplicity. In a triple net lease, the tenant is responsible for property taxes, insurance, and maintenance. This places the burden and unpredictability that can attend all three of those expenses squarely on the tenant rather than the owner. Double net (NN) leases are similar. They typically leave repairs or maintenance to ownership, although the specific details may vary from lease to lease. Investors sometimes prefer NN leases for newer properties, as the risk of repair may be low, or maintenance may be minimal, while rental incomes are typically higher.
Investors should think about the risks of investing in triple net property and how to mitigate them. Here’s what this article covers:
- What are the primary risks of triple net property?
- What are the primary benefits of triple net property?
- What should an investor look for in a triple net tenant?
What are the biggest risks of triple net property?
Dependence on a Single Tenant
The biggest risk with a net lease is that if the main tenant default or declare bankruptcy, it can be incredibly difficult to find a new tenant to replace the original tenant. This is especially important in a property that is encumbered with a loan. If a tenant leaves the property, the lender still requires the payment of their debt service and without a tenant paying rent this may have to come out of the pocket of the investor or from a reserve account that is set aside for these situations. When a new tenant is found, it is common for them to request or require improvements in order to set up the location for the new tenant. The risk associated with being overly dependent on a single tenant can be mitigated in two ways. First, investors should look for good tenants (see below). Second, investors should consider acquiring fractional interests in portfolios of net-leased real estate. Instead of one investor holding one property, multiple investors may own multiple properties together to achieve diversification and other benefits.
Dependence on a Single Location
When it all boils down, real estate is highly dependent on location. This holds true in net-leased real estate. Real estate is driven by an income stream that comes from the tenants at the properties and having a favorable location allows a landlord to charge a higher rental rate. Tenants profit due to a strong area that is well trafficked and has a large population with relatively high incomes. In addition, a strong location offers the ability to re-lease the property if anything happens to the original tenant. In general, the cost of a great location will be higher, but it provides downside protection and the added bonus of potential value increase when you go to sell the property.
Limited Upside Potential
Since there is a large amount of downside protection that built into a net-leased property, there is also a limit to the upside that can be obtained. For example, if you sign a tenant to a 10-year lease with rent increasing 1% per year, you are protected against a market that has slower growth or even negative growth. However, if the local market is getting rent growth of 3% per year, you are losing out of 2% each year due to the contracted rent. This is something that investors should recognize and weigh against the potential reward for using a contracted net lease.
If the market is in a downturn, some sellers may need to dispose of their properties at a discounted price, which is an opportunity for investors. However, in an upmarket, prices run high. Purchasing property at such a time may end up hurting an investor. Purchasing an asset at a premium not only reduces the potential for appreciation, but also makes it difficult to achieve a conservative debt service coverage ratio (DSCR).
What are the biggest benefits of triple net property?
The structure of a net lease is known upon signing the lease. When two entities enter the agreement, they know the terms of the lease for the entire term. This makes it simple to know what the rental income or payment will be in year 1 through the end of the term. All rent increases are contracted and known by both parties. This provides a stable and reliable income stream for investors that is guaranteed to occur barring a default or bankruptcy of the tenant.
When using an investment grade tenant in a long-term net lease, there is less likelihood of default on the lease payments as well as a contracted rent for the entire lease term. This makes it easier to determine the profitability of the lease as well as the ability to sell for an amount that returns capital and profit. With a smaller tenant, there may be missed payments or late payments whereas with a national tenant with a corporate backed lease will be paid on time and will have their obligations fulfilled. In a downward market, a strong tenant on a long-term lease can provide downside protection that a local or regional tenant cannot.
In a net lease the simplicity of management is a great benefit. The landlord is generally not required to complete many services other than structural property maintenance under a NN lease. Under a NNN lease the landlord is not responsible for any operating obligations and therefore makes the ownership very simple. Both structures provide the ability to benefit from real estate ownership without the stress of day to day management
What should an investor look for in a triple net tenant?
Investment Grade Credit
An investment grade tenant is one with a rating of “BBB-” or higher from Standard and Poor’s, Moody’s or Fitch. This represents the ability of the company to repay their outstanding debt obligations. “BBB-” represents a good credit rating according to the ratings agencies. An investment grade rating is normally held by larger, national companies.
It is possible for nationally known tenants and corporations to have regional franchises. If this is the case, an investor should review the lease and see if the regional franchise or the national corporation backs the rent payments on the lease. The corporate parents may guarantee rent payments and therefore an investor should feel secure that the lease obligations will be satisfied. This is important as the price and value of an asset is tied to the income that is produced at the property and a rent payment from a national corporation is more certain than from a local tenant.
Balance Sheet Strength
When analyzing a potential tenant, the credit rating is an important factor, however it should not be the only piece of information that you look at. It is important to take a deeper look into the financial statements of a potential tenant. Any company that has a credit rating will have their financial statements (balance sheet, income statement, and cash flow statement) available to the public. An investor should look to these statements to provide themselves a more thorough look into the financial position of the company. Some questions to consider are: do they have sufficient cash or liquid assets in hand to satisfy their current liabilities and debt obligations, what liabilities will be coming due in the future, what is their overall debt to assets ratio, how has their revenue, expense, and income growth or decline faired for the past years or quarters? All of these questions are important and there are more that could be asked to gain a better understanding of the financial health of a potential tenant. If an investor is not comfortable completing this type of analysis, it is best to have a CPA review the financial information and advise the investor accordingly.
Business Strength Overall
In addition to reviewing the financial statements and strength of a company it is important to consider the line of business that the tenant will be in. It is possible that market trends, competition, or government legislature could hinder the success of the business that the tenant operates in. A good rule of thumb is to look for tenants that provide a necessity product that is still in high demand during a recession. These tenants provide groceries, gas, healthcare, pharmacy, discount retail, automobile supplies, and necessity retail such as farming, home improvement, and infrastructure. For example, in a recession it would be common for someone to skip their morning trip to Starbucks to save a few dollars, however they will most likely continue to fill their prescriptions. Although there are companies that can thrive during strong markets, it is always best to try to mitigate as much downside as possible and choosing a necessity retail tenant is one way to do that.
Willingness to Sign a Long-Term Lease Contract
A long-term lease is one which lasts for at least 10 years during the primary term. It is important to distinguish between the primary term and the options terms as option terms are not guaranteed to be executed by the tenant and should not be relied upon by the landlord. When considering the length of the lease it is important to factor in the ability to finance the property as well as exit in a profitable manner and therefore a term that allows you flexibility to execute on a sale is important.