For many commercial real estate investors, one of the primary challenges to getting a deal across the finish line is obtaining the necessary financing. Lenders have different approval criteria, different loan programs, and require different documentation. It can be confusing, and the resulting delays can be costly.
In this article, we are going to discuss the financing criteria for “net leased” properties. We will start by describing what a net lease is, why investors like them, and the general criteria that lenders require for loan approval. By the end, readers will have greater awareness of the quirks associated with financing a net leased property versus one with a different type of lease arrangement.
At First National Realty Partners, we occasionally acquire a net leased property and we leverage long standing lending relationships to do so. We have found this structure to be very beneficial for investors and like to utilize it when we can. To learn more about our current investment opportunities, click here.
What is a Net Lease?
In commercial real estate, there are two common lease structures, gross and net. The difference between the two has to do with who is responsible for paying the property’s operating expenses.
In a gross lease, a tenant pays one monthly rental amount and the landlord/property owner pays for all operating expenses. Tenants like this arrangement for its simplicity and landlords like it because it allows them to charge higher rent. However, it also exposes the property owner to the liability of rising operational costs, which they are unable to pass on to the tenant. For this reason, some landlords prefer a net lease structure.
In a net lease, the tenant pays a base monthly rental amount plus their share of the property’s operating expenses. There are four types of net leases:
- Single Net Lease: In a single net lease, the tenant pays base monthly rent plus their share of one of the major operating expense categories, usually property taxes.
- Double Net Lease: In a double net lease, the tenant pays base monthly rent plus their share of two of the major operating expense categories, usually real estate taxes and insurance.
- Triple Net Lease (NNN Lease): In a triple net lease, the tenant pays base monthly rent plus their share of three of the major operating expense categories, usually property taxes, insurance and maintenance.
- Absolute Net Lease: In an absolute net lease, the tenant pays base monthly rent plus all of the operating expenses.
Of the four types, the triple net lease is particularly common and there are benefits to this structure for tenants, landlords, and real estate investors.
Why Net Leases Are Attractive
Tenants like the net lease structure because it gives them more control over the property’s maintenance schedule and because their base rent is lower.
Landlords like net leases because it shifts the liability of rising costs to the tenant. In addition, it takes some of the administrative burden of organizing and performing maintenance off of their shoulders.
Real estate investors like the net lease structure because it allows them to take a passive approach to managing their investment – the tenant is responsible for this. In particular, investors like triple net lease properties (NNN properties) with “credit tenants” like Walgreens, CVS, and Dollar General because they have excellent credit ratings and tend to sign long term leases. As a result, these same properties tend to produce a lengthy, reliable, stable, income stream which is always welcomed by investors.
When it comes to obtaining debt financing for NNN properties, there are a few quirks that potential borrowers should be aware of.
Why the Lease Type Matters For Financing
When a lender evaluates a commercial real estate loan request, there is one key difference between their process for net leased properties versus those that have a gross lease.
In a property with a gross lease, the lender’s analysis tends to focus on the property owner/landlord and their experience operating and managing commercial real estate assets. This is because they are responsible for using the tenant’s rental income to fund the day to day operations of the property, which includes repaying the loan.
In net leased properties, the focus is on the tenant and their ability to pay the rent and their share of the operating expenses. If a net leased property has just a single tenant – which is common – the lender also wants to be comfortable with their ability to operate the property on a day to day basis since they are the one primarily responsible for doing so.
What a Lender Looks For In a Net Leased Property
Every lender has their own unique real estate loan underwriting criteria, but they all focus on the “five Cs of credit:”
- Character: Does the borrower have a strong reputation for paying their debts on time and as agreed? This is usually analyzed by looking at the borrower’s credit report for evidence to the contrary such as late payments, foreclosures, or legal judgments.
- Capacity: Does the borrower have the financial resources to make the necessary equity contribution and/or support the loan from their own pocket if necessary?
- Conditions: What are the prevailing economic conditions at the time of the loan request? Are they favorable for the tenant’s business? Or, do they potentially threaten the tenant’s continued ability to pay rent?
- Capital: How much of their own capital is the borrower contributing to the deal? Most lenders have certain loan to value (LTV) thresholds that must be met – usually in the 80% range – which means that the borrower must have the resources to contribute the remainder of the purchase price out of their own pocket.
- Collateral: This is the most important aspect of a net lease loan request. The lender wants to look at the property, the location, the market, and most importantly the tenant(s) to ensure they have the ability to pay rent for the entirety of their lease term. As part of their collateral analysis, the lender will pay special attention to the lease agreement for the property. They will look for key clauses like prepayment, rent increases, term, events of default, and exactly which operating expenses they are responsible for.
For the deals that meet the necessary criteria, the loans usually come with favorable terms.
Net Lease Loan Terms
One of the major benefits of investing in net leased real estate is that lenders typically provide generous loan terms. Among the key provisions:
- Amount: For investment grade tenants, the lender may advance up to 100% of the property’s purchase price. Typically, it is closer to 80% – 85%. In either case, the borrower’s down payment is minimal.
- Interest Rate: Triple net lease properties typically get lower interest rates. In most cases they are fixed for the life of the loan.
- Payments: Triple net leased properties usually require amortizing principal and interest payments.
- Term: In many cases, the lender likes to structure the term of the loan to match the term of the lease. For example, if the lease has a term of 15 years, the lender will likely provide a 15 year loan.
- Recourse: Triple net lease loans can be either non-recourse or full recourse depending on the property type, tenant, and financial strength of the borrower.
Again, these terms can vary widely by lender so it is important to review the lender’s term sheet carefully to determine if they are acceptable.
Summary & Conclusion
A net lease is one where the tenant is responsible for a base monthly rental payment plus their proportionate share of the property’s operating expenses.
There are four types of net leases, of which the triple net lease is particularly common in commercial real estate investment.
Investors like triple net leases because they can be truly passive investments where the tenant is responsible for day to day upkeep and the owner collects the monthly rent.
In addition, triple net leased real estate tends to be eligible for some of the most favorable commercial property loan terms including low interest rates, high loan to value ratios, and terms that match the length of the lease.
When evaluating a triple net leased loan request, lenders pay particular attention to the tenant to ensure they have the financial resources to pay rent for the term of the lease and the operational expertise needed to manage the property on a day to day basis.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.