One thing that nearly all commercial properties have in common is leases.
A lease is a contractual agreement between a property owner and a tenant whereby the property owner agrees to lease a designated space to a tenant in return for a specified monthly rental payment.
At a high level, the basic premise of a commercial real estate investment is that the rental income generated from lease payments is used to pay for the property’s operating costs and anything left over is distributed to the property owner and/or investors.
But, not all commercial real estate leases are created equal. Broadly, there are two types of leases that are commonly used in a commercial property and they are known by their shorthand names, “Gross” and “Net.” In this article, these two lease types will be defined and the specific pros and cons of a triple net lease will be discussed. To learn more about why this lease structure can be beneficial for real estate investors seeking passive income, visit our website at www.fnrpusa.com.
Gross Lease vs. Net Lease
The key difference between a gross lease and a net lease is who has responsibility for the property’s operating expenses.
What are Gross Leases?
In a gross lease, the tenant pays one monthly rental amount and the property owner has the financial responsibility for all of the operating and maintenance costs. For this reason, the per square foot rental price is usually higher in a gross lease. For the tenant, the benefit of this structure is the simplicity of one monthly rental payment and the protection against rising operating costs. However, the rent is higher, which means that the total cost of the lease can also be higher in the long term. For the property owner, the benefit of this structure is that they are able to obtain higher rents, but they are exposed to the risk of rising operating costs.
What are Net Leases?
In a net lease, the tenant pays a base a base monthly rental amount plus some portion of the property’s operating expenses (usually prorated based on square footage occupied). For this reason, a net lease agreement typically has a lower base rental amount. There are three types of net leases:
Single Net Lease
In a single net lease, the tenant pays their base monthly rental amount plus one of the three major expense categories, usually property taxes.
Double Net Lease
In a double net lease, the tenant pays their base rent plus two of the three major expense categories, usually property taxes and insurance.
Triple Net Lease
In a triple net lease (NNN lease), the tenant pays their base monthly rent plus all three of the major expense categories, property taxes, insurance, and common area maintenance while the landlord is responsible for the rest of the expenses.
NOTE: There is a fourth type of net lease known as an “absolute net lease” or “absolute nnn” where the tenant is responsible for all property operating expenses. These are outside the scope of this article.
The last type, the triple-net lease is particularly popular with commercial real estate investors seeking a (mostly) passive income stream. The pros and cons of this structure are discussed in the next section.
Triple Net Lease Pros
The primary benefit of a triple net lease is that the tenant is responsible for the daily upkeep of the property. As a result, there are little or no management responsibilities for the property owner, which leaves them with plenty of time to pursue other interests or chase more deals. But, this isn’t the only benefit.
1. Long Term Occupancy
Each triple-net lease is unique, but they tend to have long term lease periods. In some cases, they can reach 25 years or more. As a result, property owners can have some level of comfort that the tenant is committed to a space for the long term.
2. High Quality Tenants / Reliable Stream of Income
Tenant quality can vary by lease, but triple-net leased properties tend to be occupied by high quality and/or credit grade tenants like Walgreens or Starbucks. This means that there is a lower risk of lease default, which results in a long-term reliable stream of income from the lease payments.
3. Build Equity
A portion of the triple-net lease payments are used to make the property’s mortgage payments, which consist of principal and interest monthly. With each payment, the loan’s principal balance is reduced, which builds equity for the property owner. This equity is realized upon sale and can result in a healthy profit for the investor.
4. Lease Transfers Upon Sale
Because triple-net leased properties are popular with real estate investors, they frequently bought and sold. Fortunately, the lease agreement survives a sale, which means that it can be transferred to the new owner who will realize the benefits of the lease payments.
5. Protection from Operating Expense Increases
Because operating expenses are passed through to the tenant in a triple net lease, owners are protected from increasing operating expenses. So, if there is an unexpected jump in property taxes or insurance premiums, the impact is not felt in the real estate investment performance.
6. Rental Income Stream is Separate From Expense Reimbursement Stream
The tenant’s base rent payment is made separately from the expense reimbursement payments. From an accounting standpoint, this arrangement makes it easy to track the income streams separately and to reconcile the expense reimbursement income against the actual costs paid. For example, if a property owner collects $100,000 in expense reimbursements for property insurance, but the actual insurance bill is $125,000, this becomes readily apparent and an effort can be made to recover the full cost.
7. Both Parties Have The Right To Audit
It is important to note that triple net lease tenants do not pay expenses directly to the vendors. They reimburse the property owner for them. As such, they rely on the property owner to communicate what each line item cost is. To ensure that the exact expenses are being paid, each party has the right to audit the actual expenses versus the money charged to the tenant.
8. Rental Increases
Finally, triple net lease terms often mandate periodic rent increases over time. For example, the lease could state that the rent will go up 3% annually. For investors, these increases mean that the rental income stream also increases over time, which can boost returns.
While these benefits are significant, there are downsides that real estate investors must consider as well.
Cons to Triple Net Lease Properties
There are downsides to a triple net lease for both the property owner and the tenant.
1. Limited Upside
Triple-net leased properties – especially those with credit tenants – are very popular commercial real estate investment vehicles and the competition for the best ones can be intense. This also makes them very expensive. As such, many of the benefits are priced in and the upside is somewhat limited.
2. Vacancy & Rollover Costs
Certain triple-net leased properties have just one tenant. If this tenant decides not to renew their lease, the property immediately goes from 100% occupied to 0% occupied once they move out. In addition, the interiors of these single tenant properties are often built for purpose and can be incredibly expensive to retrofit for a new tenant.
3. Liability
Triple-net leases are most commonly found in office and retail properties, both of which tend to have heavy foot and pedestrian traffic. This can expose the property owner to liability in the event of an injury or unexpected event. Insurance can be purchased to reduce this risk, but it doesn’t go to zero.
4. Price Gaps During Negotiation
Every real estate investor perceives risk differently and every market commands different prices. When these factors are combined with the competition for properties with these types of leases, they can be tricky to value. For this reason, it is common for there to be price gaps between what a buyer is willing to pay and what the seller wants, which can make negotiations difficult.
5. Costs of Maintaining a Triple Net Lease
There are some administrative costs to maintaining a triple-net leased property that come with the reconciliation of expense reimbursement income to actual expenses. These do not exist in a gross lease because it is one lump sum.
Given the pros and cons of a triple net leased property, it is only logical for real estate investors to ask, are they a good investment?
Is a Triple Net Lease Property a Good Investment?
Like many things in commercial real estate investing, the answer is…it depends. Every investor has a different risk tolerance, time horizon, and return requirement so a triple net leased property may be a good fit for some and not a fit for others.
For real estate investors seeking long term, stable cash flow with reduced risk of principal loss, a triple net leased investment can be a fantastic option. However, this relative safety comes at a price in the form of lower overall returns.
For commercial real estate investors who are seeking more risk and looking for higher overall returns from both income and price appreciation, a triple net leased investment property may not be a good fit because the high returns aren’t as likely.
So, it is recommended that potential triple net lease investors take the time to thoroughly understand the risk/return profile of each deal to see if it matches their desired objectives. If it does, it may indeed be a good commercial real estate investment.
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.
To learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
