The Myth of the Triple Net Lease
Demand for triple net lease investment opportunities has been rising consistently over the last two decades. Triple Net Leased Properties (“NNN”) are properties leased to tenants, typically a single tenant, who is responsible for all of the operating expenses of the property including maintenance, insurance, and property taxes, on top of their monthly rent payment. The most desirable properties are leased for a long term (10 to 15 years) to Class A tenants and often contain options for the tenant to renew.
Investors flock to these properties due to the perception that they are low-risk, low maintenance, require little labor from the landlord and provide consistent cash flow for a long period.
The largest myth of triple net leases is that the tenant doesn’t always renew or exercise their lease option. Many investors go in thinking the tenant will stay in the property indefinitely. There are several reasons a tenant might ultimately vacate a property — business models change, the store does not perform well, or they decide to relocate to a newer property.
When considering an investment in a triple net lease property, it is important to figure into the mix the implication of a tenant vacating the property. Here are a few things to think about when looking at a triple net lease property to ensure you are buying only the highest quality properties with the best downside risk.
Location is Key
In real estate investing, never overlook the location of the asset. Even with a long-term lease in place, it is important to consider location since that factor alone can determine if a business will survive and/or whether the landlord will be able to re-lease the building if the tenant vacates. It is vital to analyze the long-term population size and economic conditions within the immediate area and consider the area’s potential to experience positive growth. In the case of retail buildings, assure that it has good frontage on a well-trafficked street. As well, know how many pieces of vacant land and new commercial development are near the property, since tenants will consider moving to a newer building at the end of the lease. If you can find a well-located property in an infill location with high barriers to entry, the risk of inability to re-lease the space will be much lower.
Credit of the tenant/signatory on the lease
Just because a tenant has signed a long-term lease does not mean they will be able to make their lease payments over time. Be wary of leases that are signed by a franchisee whose only credit backing is their personal balance sheet. It is very hard to collect from individuals who vacate the space in the middle of the lease term. Make sure the lease includes a guarantee from the corporate entity operating at the location and request the financials of that entity. An accountant will be able to run through the company’s balance sheet and determine their financial viability.
Often single tenant NNN buildings are built very specifically for the tenant’s needs. Buildings with high tenant-specific build-outs can be problematic. Why? If the tenant ever vacates, it can be very costly to bring the building back to a standard condition in order to lease it to a tenant who may have significantly different needs.
Capital needs over time
NNN lease landlords often think there will be no long-term capital needs. Unfortunately, that’s wishful thinking. Wise landlords plan ahead knowing that over time a significant capital investment will be required to maintain the property; the roof of the building will need to be replaced, the HVAC units upgraded, and the parking lot will require resurfacing. It is important to create a reserve for those items since, if a tenant does vacate, those costs will all hit at once.
A novice mistake investors make with NNN leases is assuming that the tenant will maintain the property to the original standards. That is often not the case. Landlords need ongoing oversight to ensure the tenant is meeting their lease obligations to keep the property in good shape. In the worst of cases, the tenant can leave the property without fulfilling any of their capital expenditures responsibility to the property, betting that the cost to litigate versus the cost to repair is prohibitive for the landlord to pursue. This can leave the landlord with significant rehabilitation costs that otherwise would have been addressed and paid by the tenant during the lease period.
While the list of considerations may sound daunting, Triple Net Leased Properties can be a great long-term investment. Our advice? Be wise. Before jumping in, perform due diligence upfront and fully understand the risk/reward proposition to help assure a successful investment.