No matter the asset class or property type, the one thing that all commercial real estate assets have in common is tenants with commercial leases. But, all leases are not equal. Depending on the property, the tenant, and the wishes of the owner, there are a number of different lease structures that can be utilized to rent space to another business.
Broadly, there are two major types of commercial real estate lease structures, Gross and Net. In a Gross lease, the tenant is responsible for paying a base rental amount and the property owner is responsible for the expenses associated with operating it. As a result, the rental amount tends to be higher so that the owner can recoup some portion of their contribution to operating expenses. Two of the most common Gross lease structures are known as a Full Service Gross Lease or a Modified Gross Lease.
A Net lease is the opposite. Under this lease agreement structure, a tenant is responsible for a base rental amount and some portion of the property’s operating expenses, depending on the specifics of the net lease structure. In a single-net lease, the tenant pays for rent and property taxes. In a double-net lease, the tenant is responsible for base rent, property taxes, and insurance. Then, there is a third option, the triple-net lease (“nnn lease”), which is particularly popular with a certain type of investor.
What is a Triple Net Lease?
Following the pattern above, a triple-net lease is a type of lease where the tenant is responsible for paying a base rental amount; plus the actual real estate taxes, building insurance, and all required maintenance costs. These lease terms shift the burden of rising operating expenses onto the tenant so they tend to come with a lower base rental amount to compensate. As such, you should understand the triple net lease pros and cons before making a decision on your investment.
Benefits of the Triple-Net Lease Structure
There are benefits to the triple-net lease structure for both the property owner(s)/investor(s) and the tenant themselves.
Property Owner(s) / Investor(s)
Commercial property owners and investors like the triple-net lease structure for a variety of reasons:
- Expense Inflation: Because the tenant is responsible for paying the property’s operating expenses, property owners and investors are protected from expense inflation. For example, if a property’s insurance premium has a sharp increase, the burden for paying it falls on the tenant, not the owner.
- Stable Income: Because the property owner(s) / investor(s) are sheltered from the burden of rising operational expenses, the income produced by a property with a triple-net lease tends to be more stable. Some triple-net leases even have built in rent increases, which allows the income to grow over time.
- Low Touch Management: Because the tenant is responsible for the property’s maintenance, the owner does not have to be heavily involved in the day to day operations of the property. This provides them with time to pursue other projects.
- Credit Tenants: Often, tenants who prefer the triple-net lease structure have significant financial strength and have a strong “credit” rating from a nationally recognized firm. Examples include Walgreens or Dollar General.
- Long Term Leases: Triple-net lease tenants, especially those with a national footprint like to sign long term leases for their space. For example, it is not uncommon to see a Walgreens triple-net lease with an initial term of 25 years.
Tenants like triple-net leases for the following reasons:
- Control: With the responsibility for property maintenance, the tenant has the ability to control the day to day operations of the asset. This means that they can maintain it to their specific needs and specifications. This is particularly important for national tenants who place a high value on their brand identity.
- Low Base Rent: Because the tenant is responsible for the property’s operating expenses, their monthly rent payments are lower. This makes the property more affordable for a wider variety of businesses. This is particularly true for properties with a large number of tenants because the operating expenses can be divided amongst them, making it more affordable for everyone.
While the benefits can be significant, there are also a number of risks that are specific to properties with triple-net leases.
Risks of the Triple-Net Lease Structure
Again, there are a number of risks to the triple-net lease structure for both the property owner(s) / investor(s) and the tenant.
Property Owner(s) / Investor(s)
Triple-net lease risks for property owners are:
- Default: The primary risk for a property owner is a tenant default, particularly if there is only one of them. With a triple-net lease, the property owner loses not just the rental income, but they are now also responsible for paying for the property’s upkeep. As such, it is imperative that a significant amount of due diligence be performed prior to purchasing the property.
- Vacancy: It is common for triple-net lease properties to be occupied by a single tenant, which means that it is either 100% occupied or 0% occupied. If a tenant chooses not to renew their lease or vacate the property for some other reason, the property’s cash flow is reduced to $0 until it is re-leased.
- Buildout: It is common for single tenant, triple-net leased properties to require a sizable and customized buildout on the interior of the space. Should the tenant decide to vacate the property, it can be difficult and/or expensive to reconfigure the property for a new tenant.
- Neglect: Just because the tenant is responsible for the maintenance of the property doesn’t necessarily mean that they will keep it to a high standard. If a tenant chooses to skimp on property maintenance, an owner can be left with a significant bill to bring it back to market standards.
The primary risk for the tenant is a significant increase in the property’s operating expenses. They could increase as a result of inflation or, in a worst case scenario, there is some sort of significant damage to the property as a result of a storm or fire. In such cases, the tenant may be responsible for a significant rebuild that they did not plan for when they signed their lease.
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.
In all of our deals that involve a triple-net lease we spend a significant amount of time analyzing the financial capacity of the tenant to ensure that they have the capability to support both the rental payments and the property’s operational expenses. If you would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.