When performing due diligence on a potential commercial real estate investment, it is common to focus on the major aspects of the property like the: location, condition, price, sub-market, and tenants. While these are important and they should be analyzed, they tend to overshadow another aspect of due diligence that is arguably more important, analyzing the in place leases and current leasing activity.
A commercial lease is a contractual agreement between a property owner and a tenant whereby the owner agrees to provide the tenant with access to a specific space in which to operate a business and, in return, the tenant agrees to pay a monthly (or yearly) rental amount for the privilege of doing so. While this is the general idea behind a lease, the specifics of the structure can vary by tenant and property type and understanding them is a critical ingredient in being able to create an accurate financial projection and business plan for each property. One of the most important distinctions is whether the lease has a “Gross” or “Net” payment structure.
Understanding the Differences Between a Gross and Net Lease Structure
Whether the lease has a Gross or Net lease structure, the tenant is required to pay a base monthly amount of rent to the property owner. However, the key difference lies in how the payment is calculated with regard to the additional expenses associated with operating the property and maintaining common areas.
In a Gross lease structure, the tenant pays one base rental amount and nothing more while the property owner is responsible for using this rental income to pay for the operating costs associated with managing the property on a day to day basis. For this reason, the required rental amount is higher because the property owner knows that they will have to use some portion of the rent for operating expenses.
In a Net lease agreement, the tenant pays a base rental rate 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. The exact portion of operating expenses depends on the specific type of net lease and there are four.
Net Lease Types
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 Investors Like Net Leases
From an owner/investor perspective, there is a lot to like about net lease properties, particularly if they include a single-tenant property:
- 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 the property and the amount of property management fees that the owner has to pay. For this reason, Triple Net Leased properties are particularly popular with investors seeking a passive income stream.
- Financing: When it comes to financing net leased properties, especially those with national tenants, are usually able to secure long-term and favorable terms. These lower interest rates result in lower interest expense, which can boost the long term cash flow of the asset.
- Tenants: Again, 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, 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 term can vary from one property to another, many Net leased properties have long-term leases that provide stable cash flow for their owners.
For all of the reasons listed above, Net leased properties are very popular with investors who are somewhat risk averse and prioritize income and stability over growth. They are also a popular option for individuals who are seeking replacement properties in a 1031 Exchange.
Net Lease Risks to Be Aware Of
Whenever a lease is being contemplated, the tenant’s ability to make the monthly payments through all phases of the economic cycle is important. But, because a Net lease structure shifts some or all of the burden of the property’s operating expenses onto the tenant, it is especially important to review their financial statements and to understand potential risks to their business.
Typically, this type of due diligence is performed by analyzing a multi-year trend of the tenant’s profit and loss statements and balance sheet. In doing so, it is a best practice 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 the tenant has a strong balance sheet and a track record of performing on their financial obligations, they may be a good candidate for a Net lease structure.
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 info@fnrpusa.com for more information.
