Smith Commercial Real Estate
This column is offered to help educate agents new to commercial and investment brokerage and serve as a review of basics for existing practitioners.
In triple net (NNN) leases the tenant is responsible to pay all the expenses of the property including taxes, insurance, utilities, repairs and all maintenance. They may or may not also include tenants responsibility for structural items such as the roof, bearing walls and floors. Triple net investments are most commonly occupied by a single retail tenant with excellent credit; that has signed a long term lease. They can also be other types of properties or a complex like a shopping center. Buyers are purchasing the land, the building and most importantly the lease. Due diligence in reading and understanding the lease terms and conditions is essential as the buyer does not have an opportunity to change it.
These triple net deals can offer many benefits: A long term lease to a quality tenant; typically new or nearly new construction; stable cash flow; easy to finance; tenant pays all or most of the expenses; no management responsibilities; tax advantages of real estate ownership: depreciation and appreciation; and generally a 5% to 10% Return on Investment (ROI).
The lower returns on investments are typically for the longer leases and are priced higher. When NNN investments come on the market, where there is a relatively short-term remaining on the lease, they pose a greater risk that the lease will not be renewed, consequently they are worth less in value and offer the largest ROI.
However in considering a Triple Net Investment, there are other risks; real estate fundamentals must not be overlooked, especially location and market trends. The tenant may be a household name but what if the unthinkable happens and they close or go bankrupt.
What is the buyer’s worst case scenario strategy? Upon vacancy the rent goes to zero, the property owner now has to pay the taxes, insurance and maintenance. They now have a vacant, certain sized building; zoned for what type of use; that can be rented for how much? This is known as the “dark value”. In determining what one would pay to buy this investment, this must also be considered.
Obviously a building in a declining market area or a secondary location can be difficult to re-rent. The investment property was a casual restaurant. They have gone out of business, who are you going to rent to – another restaurant. But there may be no one interested, as the location or changes in the market are why the initial tenant failed.
The tenants declining business may not be their fault. The NNN investment was a fast food business on the outskirts of a mid-size shopping center anchored by a Sears store, which basically was the draw for people to come to the center and the restaurant. Sears closed their store, with the ripple effect of the NNN investment tenant going out of business.
Many triple net investment buildings are unique structures especially the fast food restaurants, banks and oil change businesses. They present a special risk if they go “dark;” as it can be difficult to adapt them to other uses and may even have to be demolished for redevelopment. To modify the current building for another tenant may be required to make the next deal; the owner may have to bear considerable costs for tenant improvements. This construction could be even more challenging if the absentee investor lives far away from the property.
Technology is great and ever changing, but what is “hot” today may not be here tomorrow. Buyers are expecting their NNN tenants businesses to be successful for the next twenty years or more. In the 1990’s and early 2000’s renting video tapes was the rage, BLOCKBUSTER had over 9,000 stores was considered a good NNN investment. Then the industry changed, they went bankrupt in 2010 and now the company and video store businesses are history.
Let’s take another look at the lease, who is the actual lessee? The business is a Dunkin Donut, Burger King, Exxon gas station or other national chain; but the franchisee is the signer of the lease and there is no corporate guarantee from the parent company. The franchisee may even be a Limited Liability Company (LLC), so if they fail, the landlord will virtually have no recourse. Buyers of triple net investments need to carefully examine the tenant’s financials to be sure they have the wherewithal to make all the required rent payments.
Many people think of triple net investments like fixed income, a stress free check arriving every month and it can be! But when purchasing these types of investments consider the worst case scenario. Never buy without visiting the location and understanding the demographics of that market. Plan ahead, if something goes wrong what can you do with the property. Read the lease carefully or have an attorney analyze it for you. Focus on who the tenant really is and their financial strength.
Edward Smith, Jr., CREI, ITI, CIC, GREEN, MICP, CNE, is a commercial real estate consultant, instructor and broker at Smith Commercial Real Estate, Sandy Hook, CT.
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