- By definition, commercial properties have tenants with leases. In the due diligence phase of the transaction, it is important to review the structure, payment, and expiration of each of them.
- Generally, there are two types of leases, Gross and Net.
- In a Gross Lease, the tenant is responsible for paying a base rental amount and nothing else. The property owner is responsible for paying the day to day operating costs. As a result, the base rental amount tends to be higher.
- In a Net Lease, the tenant is responsible for paying a base rental amount plus some portion of the property’s operating expenses, depending on the type of Net Lease.
- In a Triple Net Lease, the tenant pays a base rental amount plus the property’s taxes, insurance, and maintenance.
- Net Leased properties are popular with investors for their relatively low touch management, long term leases, high quality tenants, and availability of financing.
In a given month or year, we 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 things 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. With regard to the lease type, there are two options and understanding the difference plays an important role in the accuracy of the projection.
Gross Lease vs. Net Lease
The two types of leases are referred to in shorthand as “Gross” and “Net” and the difference is subtle, but significant.
In a Gross leasing structure, 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 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.
In a Net lease agreement, 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 they lease 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. There are multiple types of net lease structures 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: 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.
Net Lease Benefits and Risks
The major benefit to a net lease 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:
- Property Management: 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.
- Lease Term: Net lease 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.
- Operating Expenses: Because the tenant is responsible for the property’s operating expenses in a Net lease 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.
But, like any investment, net lease properties also have potential risks:
- Price: 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.
- Fundamentals: 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.
- 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.
CRE Net Lease Investing – The Players
For the reasons listed above, Net Leased properties are particularly popular with four groups of real estate investors:
- Institutional Investors: Real Estate Investment Trusts (REITs) and Private Equity firms may allocate a portion of their capital to net leased properties.
- Merchant Builders: Individuals or firms that have a relationship with a tenant may work with them 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.
- 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.
- 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 participants, close attention must be paid to the lease to ensure that it is a good fit for their risk tolerance and time horizon.
Net Lease Investment Strategies
When evaluating a net lease 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, they tend to be relatively low risk. While we like core deals, we don’t always want to pay core prices. Because we have 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 we use 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 them. 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 properties are 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 them 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 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 firstname.lastname@example.org for more information.
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