110 Tower at 10 SE Sixth St., Fort Lauderdale. (Courtesy photo)
It sounds easy when you are offered a real estate investment that states you are essentially going to sit back and receive checks monthly with very little responsibility. But beware of the details if an investment of this nature interests you.
The triple net lease, or NNN, is a common lease structure used in commercial real estate. And even though it has become widely popular, the most seasoned investors and their advisers do not always fully understand the details.
Triple net is a lease structure where the tenant is responsible for paying for all expenses for the property. This is a passive investment. These are typically new or almost new properties that have tenants with good or great credit, long-term leases, stable cash flow, attractive financing options, no management responsibilities and tax advantages. Sounds great! These can be good passive investments that are suited for diversification, 1031 exchanges and sleeping well at night.
Commercial lease structures range from gross leases where the landlord/owner pays for everything to absolute NNN Leases where the tenant pays for everything. NNN is often misunderstood. Most people think that refers to a lease that removes any and all responsibility of the owner for paying for any expenses. But very few leases are absolute NNN leases, also known as bondable leases. An absolute NNN lease requires the tenant to be responsible for all expenses including any repairs and replacement of the structure and roof.
And that absolute NNN structure also has clauses regarding casualties and condemnations that exempt the landlord from any responsibilities. A regular NNN lease, not absolute, requires the landlord/owner, not the tenant, to be responsible for the structure and roof. So there is a big difference between what someone says is a NNN lease and what that lease really offers.
And even if the deal is an absolute NNN structure, the buyer will have expenses that are not covered by the lease such as legal and accounting expenses necessary in drafting and reviewing documents.
Rule #1: Understand the owner’s responsibilities
Evaluating the risk: The higher the quality of the tenant, the lower the risk and the higher the price of the property (less risk, better sleep). The tenant quality is measured by a credit rating determined and published by one of the three ratings firms, Standard and Poor’s, Moody’s and Fitch. Those with a rating of BBB and higher are considered investment grade. Not all NNN opportunities are investment grade, and not all of them are with tenants that are even rated at all even though the industry often states an opportunity as a “credit-rated” tenant. So beware.
Rule #2: Understand the quality of the tenant and their financial condition
Pricing: The top-rated tenants demand the highest prices. For example: Home Depot and Wal-Mart are rated in the A category, so is JPMorgan Chase, and Dollar Tee is Ba2. Dollar General is BBB-. Prices for those that are the highest rated are in the 4.50-5.50 percent cap rate range. The cap rate is the return on investment to the buyer/invester when paying cash. Investors who use debt can achieve higher returns, and high- credit tenant deals are easily financed. It isn’t just the tenant’s rating that dictates the price. Supply and demand obviously is a huge factor. These types of investments are in high demand right now. So you will see 4.50-5.50 percent returns asked for NNN deals where the tenant is not rated at all. So then what do you do? You have to look at the financial statements to determine the condition of that tenant and determine your appetite for risk. That could require some professional advice.
As with all net lease structures, at the end of the term of the lease, if there are no options for renewal that are exercised and the tenant decides to leave, the owner/landlord is left with an empty building that has to be re-leased or sold. Consequently, the longer the lease term, the less the short-term risk. You can see that when these deals are offered for sale, it is the remaining lease term and any options that really matters. These deals become available during the spectrum of the lease term: developers sell them right when the lease begins (least amount of risk), owners sell after a period of time when they feel the price is at a maximum, and owners sell when they see that the value is eroding because this is a short lease term remaining (most risk). The goal for a NNN investor is not to “own” the tenant, it is to “own” the income stream.
Rule #3: Understand the remaining lease term and any options
The basics of real estate: Even though these are investments that are in a class by themselves, the basics of real estate still apply and must be examined during the due diligence period. You should always look at the market conditions assuming you might have to take back an empty building. Look at the demographics, study the lease rates for a variety of uses and attempt to come up with what is known as a “dark value” — what the building is worth if it was empty. One very important aspect is if the tenant was paying an inflated rate compared to the market. That is often the case since these deals are based upon income returns and not necessarily market lease rates. What about location and the traffic, both vehicular and pedestrian? A lot of NNN deals are adjacent to high-traffic generators. So the underlying value of the real estate is a huge factor in these transactions.
Rule #4: Understand the market
NNN investments are long-term, passive investments. The question the investor has to ask in evaluating an opportunity is whether or not the risk is worth the investment given an alternative that might be less risky. There are two direct comparisons that can be made in that evaluation. If the tenant has a credit rating, the option for the investor is to buy a debt instrument from a company with the same credit rating and compare the yield to the investment in the NNN real estate opportunity.
Let’s say you can purchase a JPMorgan bank branch for a 4.5 percent return unleveraged on a 20-year lease term. Florida Power & Light has a similar rating as JPMorgan Chase, and you can buy their corporate bond at 4.10 percent yield for 25 years. How do you wrestle with that decision? Everyone has a different risk profile and desire to diversify their investments. And the decision based upon those two options cannot be made without uncovering all the potential aspects to each of those opportunities. First of all, you can leverage your real estate purchase and increase your yield considerably. Second, it is not just about the yield, it is about the underlying real estate which has value
Going forward, the net lease market will continue to see strong demand and limited supply. Net lease development increased this year compared with 2015, and we expect that to keep going. It is yet to be seen what will happen to yields when interest rates go up. However, buyers will still pay premiums for solid net leased properties.