In a given month or year, FNRP may evaluate dozens of commercial properties as potential acquisition targets. In doing so, we look at important physical features like location and condition, but we also spend a significant amount of time analyzing things that aren’t seen. One of these is the leases for the property’s existing tenants.
For each lease, understanding the structure, monthly payments, expiration dates, and lease type, among other things, are critical to creating a financial projection for the property and estimating potential returns.
There are two types of leases for commercial properties, and understanding the difference plays an important role in the accuracy of the projection. In this article, we will first discuss gross leases vs. net leases before looking more closely at net leases in real estate.
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Gross Lease vs. Net Lease in Real Estate
The two types of leases in commercial real estate are gross leases and net leases. The difference between these two types of leases is subtle, but significant.
What is a Gross Lease?
In a gross lease, the tenant pays one base rental amount and nothing more, while the property owner is responsible for paying all of the operating costs associated with managing the property on a day to day basis. For this reason, the base rental amount is higher with a gross lease because the property owner knows that they will have to use some portion of the rent for operating expenses. This is an important distinction when modeling income and expenses in the financial projection.
What is a Net Lease?
In a net lease, the tenant pays a base rental amount plus some portion of the property’s operating expenses that is typically proportionate to the percentage of space that the tenant leases in the property. For this reason, the base rental amount tends to be lower because the property owner knows that the tenant is paying for their portion of operating expenses.
Types of Net Leases
There are multiple types of net leases in real estate, and these are most commonly found in office, industrial, and retail properties.
- Single Net Lease: In a Single Net Lease, the tenant pays their base rent plus property taxes.
- Double Net Lease: In a “Double” net lease, the tenant pays for their base rent plus property taxes and insurance.
- Triple Net Lease: The Triple Net Lease, sometimes referred to as an NNN lease, may be the most common type of net lease. In this structure, the tenant pays a base rental amount plus property taxes, insurance, and maintenance.
- Absolute Triple Net Lease / Bonded Lease: In an absolute net lease, the tenant pays a base rent plus all operating expenses.
Given the uniqueness of the net lease structure, there are a number of benefits and risks to be aware of.
Benefits of Net Leases
The major benefit to the net lease real estate structure is the tenant(s). They are often widely known companies with a strong balance sheet like Walmart, McDonalds, or CVS. As a result, there is a great deal of confidence that the lease payments will arrive on time every month. But, that isn’t the only benefit. Others include:
Because the tenant is responsible for maintenance in an NNN property, the burden of property maintenance on the owner is decreased.
Periodic Rent Increases
Many net leases include “escalators” that call for periodic increases in the rental rate at different intervals in the lease term. These escalators increase a property’s Net Operating Income (and value) over time. In addition, they help the returns keep up with, or beat, inflation.
Net lease property tenants tend to sign long term leases that can go up to 25 years in duration. Thus, they create a long term cash flow stream that investors enjoy. But it is also important to understand that the remaining term on the lease at the time of purchase has a direct impact on the asking price for the property. The less time remaining, the more risk and the lower the price.
Because the tenant is responsible for the property’s operating expenses in a net lease real estate structure, the risk of those expenses rising is borne by the tenant, not the property owner.
Favorable Debt Terms
Because net leased properties tend to have long term leases and strong tenants, lenders are more likely to offer debt on favorable terms.
Risks of Net Leases
Like any investment, net lease real estate also have potential risks:
Credit tenants like Walmart or Walgreens with a high credit rating – and the stability that comes with them – can be expensive. The high up front cost can limit potential upside as the property becomes more of a cash flow play with less of an opportunity for capital appreciation.
Often, the value of the property is not determined by the fundamentals of the real estate, rather the strength of the tenant. For example, Dollar General is a strong tenant, but they tend to operate in rural locations. If they leave, the backfill options can be limited.
Regarding tenant concentration, single-tenant properties are either 100% occupied or, if the tenant leaves, 0% occupied with no cash flow. Because retail spaces are often purpose-built for the tenants, it may take months – and many thousands of dollars – to repurpose the property for a new tenant.
As part of our investment strategy, we actively work to mitigate these risks as part of the business plan and due diligence research for each property.
Net Lease Real Estate Investing: Meet the Players
For the reasons listed above, net leased real estate is particularly popular with four groups of real estate investors:
1. Institutional Investors
Real estate investment trusts (REITs) and private equity firms may allocate a portion of their capital to net leased properties.
2. Merchant Builders
Individuals or firms that have a relationship with a tenant may work with the tenant to select a site, construct a building, and execute a long term lease. In some cases, these merchant builders may keep the property as an investment for themselves. In other cases, they flip them to investors.
3. Single Tenant Users
If a business owns their real estate, but needs capital, they can execute a “sale/leaseback” transaction where they sell the property to an investor and simultaneously lease it back from them. The result is that the business gets their needed capital and the investor gets a long term lease with a strong tenant.
4. 1031 Exchange Buyers
Property owners with significant capital appreciation can face a big tax bill upon sale. But, those taxes can be deferred indefinitely through a process known as a “1031 Exchange,” which allows them to use a property’s sale proceeds to invest in another property that is of “like kind.” Net leased properties are a popular choice for a replacement property because of their relative stability, low management responsibilities, and long term leases.
For each of these investors, close attention must be paid to the lease to ensure that it is a good fit for the investor’s risk tolerance and time horizon.
Net Lease Investment Strategies
When evaluating a net lease real estate investment opportunity, we drop the deal into one of two buckets: Core or Value Add.
The Core bucket is very straightforward. There are deals with long-term leases, strong tenants, stable cash flows, and periodic rent escalations. As such, core deals tend to be relatively low risk. While we like core deals, we don’t always want to pay core prices. Because FNRP has significant, long-standing relationships in the brokerage community, and they know that we can close a deal, we are often able to negotiate discounts of 50 or 100 basis points on the cap rate.
The other bucket is “value add,” and these deals are less straightforward and may come with an elevated risk/return profile. Often they involve a motivated seller looking to divest the property because of the uncertainty around the tenant renewing their lease. In cases such as these, we can leverage our existing relationships and operational expertise to acquire the property at a discount to intrinsic value and renegotiate or renew the lease to add significant, immediate value.
Net Lease Returns
Because of their stability, returns for net leased properties tend to be lower than other investment types. But, one of the strategies FNRP uses to maximize return potential is to position the property as a turnkey investment so a core buyer can step in and pay full market price.
The actual rate of the return for a net leased property is a function of two key lease elements:
- the number of years remaining and
- how much the rent will rise over the remaining term.
To position the property for a core buyer, we actively work to maximize both of these lease elements. For example, we may give the tenant cash for building improvements in return for a lease extension, or we could offer flat rent or smaller rental increases in return for a new, long-term lease. Either way, the goal is to position the property to extract maximum value upon sale.
Summary & Conclusion
Net leased real estate is a popular option for investors looking for stable cash flow and relatively passive involvement in the day to day management of the property. But, that doesn’t mean that investing in net leased properties is “easy.” Buyers need to invest a significant amount of time up front to evaluate the deal from all angles to ensure it meets their risk tolerance and time horizon. Best practices for net leased property investment include:
- Analyze the tenant: Do they have good credit and a strong balance sheet?
- Analyze the real estate fundamentals: Is the property in a strong market with good visibility from the road and high traffic counts?
- Analyze the lease term: How many years are remaining on the lease and what can be done to increase the term?
- Look for rental escalations: Leases should include periodic rent escalations to ensure that returns keep up with inflation.
- Avoid high rents that are irreplaceable: Should a tenant leave, you’ll want to be able to replace them at a rental rate that is the same or higher than the existing rent. Properties with high rents relative to the market should be avoided unless there is a significant amount of time left on the lease.
- Look at stability vs. other asset classes: Evaluate the stability of the property’s cash flows against other income producing assets, like bonds, to ensure that the return is commensurate with the risk.
With the proper amount of due diligence and proactive risk mitigation strategies, net leased properties can be a rewarding addition to any real estate investment portfolio.
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.
Whether you’re just getting started or searching for ways to diversify your portfolio, we’re here to help. If you’d like to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.