One thing that nearly all commercial real estate properties have in common is tenants with leases. These leases, and the contractually mandated income that they produce, are the lifeblood of a commercial asset. But, the structure for each individual lease can vary by tenant and property type so it is critically important to understand the specifics as part of the pre-purchase due diligence process. Awareness of this information goes a long way towards creating a more accurate proforma and projecting more realistic investment returns.
Broadly, commercial leases fall into one of two lease structure categories, Gross or Net.
Lease Structure Differences: Gross vs. Net
In both the Gross and Net lease structures, the tenant is required to pay a base monthly amount of rent to the property owner. However, the key difference between the two lies in whether or not the tenant has to pay an additional expense (on top of their base rent) to cover their share of the cost associated with operating the property and maintaining its common spaces like hallways, parking areas, and elevators.
In a Gross lease structure, the tenant pays one base rental amount and nothing more. The property owner uses the rental income to pay for the operating costs associated with common area maintenance and managing the property on a day to day basis. For this reason, the base rental amount in a Gross lease structure is higher because the property owner knows that they will have to use some portion of the rent for operating expenses. Tenants like gross leases for their simplicity (they just make one payment every month), but don’t always appreciate the higher rental amounts. Property owners like Gross leases for the higher rental income that they produce, but they don’t enjoy the fact that they bear the responsibility for rising operating costs over time.
Under a Net lease structure, the tenant pays a base rental rate plus some portion of the property’s operating expenses. The exact amount of the extra portion is defined in the lease itself and is typically dependent upon the percentage of total space leased. For example, if a tenant leases 25% of the space in a property, they will likely be responsible for ~25% of certain operating expenses in a Net lease structure. Tenants like the Net lease structure for the additional control that it gives them over property maintenance, but don’t like the added risk that comes with potentially rising operational costs. Property owners like the Net lease structure because they are able to shift the risk of rising expenses to the tenant, but it comes at a cost because Net lease rental income can be lower than the Gross alternative.
Even within the Net lease structure, there are a number of variations that potential investors should be aware of.
Types of Net Leases
To understand the difference between the different types of Net leases, it is first important to understand a key concept behind the expenses required to operate a commercial property.
Generally, there are three major property expense categories that are directly related to the day to day operations of a property:
- Real Estate Taxes: Money charged by a city, state, or other tax entity that is used to pay for services like roads and sewers.
- Building Insurance: Money paid to an insurance company to protect against the financial liability of owning a commercial property. Property insurance typically protects against things like damage to the property, theft, or injury to a visitor.
- Property Maintenance: Cost associated with routine repairs to the property like paint, carpet, cleaning, and landscaping.
Knowing that these are the three main operational expense categories, it is easy to distinguish between the different types of Net leases:
- In a Single Net Lease, the tenant pays their base rent plus their portion of the property taxes.
- In a Double Net Lease, the tenant pays for their base rent plus their portion of the property taxes and property insurance.
- In a Triple Net Lease, the tenant pays a base rental amount plus their portion of the property taxes, property insurance, and building maintenance.
- In an Absolute Net Lease, the tenant pays a base rental amount plus their portion of all of the property’s operating expenses.
If a tenant is the sole occupant of a freestanding building, which is common in a Net lease structure, they are responsible for the entirety of the expense categories mandated by their lease agreement. While single and double net leases are used on occasion, they aren’t nearly as common as the Triple Net Lease (NNN Lease), which is a preferred structure for a certain subset of commercial real estate investors.
Why Certain Investors Like Triple-Net Leases Properties
Triple-Net leased properties, especially those that contain a single tenant (like CVS or Walgreens), are particularly popular with investors who are looking for an option that produces stable income with relatively low risk and has minimal management responsibilities. Often these are high net worth individuals that are at or near retirement age or corporate real estate investors who like them as core portfolio holdings. These investors like triple-net leased properties for the following reasons:
- Lower Operating Expenses: Because the tenant is responsible for the bulk of the property’s operating and maintenance expenses, the amount the owner has to pay is lower.
- Risk: Again, because the tenant is responsible for paying the property’s operating expenses, the owner is able to shift the risk of rising operational costs from themselves to the tenant.
- Management: In a Triple Net Lease, the tenant is responsible for basic repairs and maintenance to the property, which reduces both the time commitment needed to manage it and the amount of property management fees that the owner has to pay.
- Financing: Triple-net leased properties, especially those with national tenants, are usually able to secure long-term financing with favorable terms. These lower interest rates and lower debt service coverage requirements, and higher Loan-to-Value ratios can result in lower interest expense, boosting the long term cash flow of the asset.
- Tenants: Again, triple-net leased properties tend to be popular with large, national companies that have investment grade credit ratings. As a result, there is a lower risk of tenant default, which makes the rental payments akin to a long term bond.
- Rent Increases: Often, triple-net leases contain contractually mandated rent increases at regular intervals over the lease term. For example, it could say that the rent goes up 2.5% every year or 10% every five years. These increases result in improved Net Operating Income over time.
- Term: While the exact lease term can vary from one property to another, triple-net leased properties tend to have long-term leases that provide stable, long-term cash flow for their owners.
Triple-Net Lease Risks to Be Aware Of
Because the tenant is responsible for the rent and operational expenses in a triple-net lease, a default can be particularly impactful, especially if there is only one tenant, the property’s income could be reduced to $0 quickly. For this reason, analyzing the tenant’s credit worthiness is critically important when considering a triple-net leased investment. We like to collect multiple years of financial statements (including the income statement and balance sheet) to review the following key items:
- Liquidity: How much cash does the tenant have on hand and how does it relate to their short term debt obligations?
- Debt: What short and long term debt obligations does the tenant have and do they produce enough income to cover them, plus the lease payment, with a comfortable margin?
- Stress Test: A tenant’s income and expenses are not linear and they can change significantly in an economic contraction. As such, a stress test seeks to determine if the tenant can continue to pay their contractual rent if they are affected by sudden declines in sales or increases in expenses (or both).
- Credit Rating: If the tenant is a large company, they may have a published credit rating by an independent agency. If they are smaller, it can be possible to pull the business equivalent of a credit report to ensure they have a history of paying their obligations as agreed.
If a tenant is deemed to be an acceptable credit risk, a triple-net leased property can provide a stable, reliable, long-term income stream for the individuals who choose to invest in them.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, 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 Investor and would like to learn more about our triple-net leased investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.