For investors looking to gain exposure to the commercial real estate asset class, there are a wide variety of options to meet each individual risk tolerance and time horizon. For example, an investor who prefers short term, highly liquid opportunities may prefer the publicly traded securities of a Real Estate Investment Trust. Or, on the other end of the spectrum, an investor with a high risk tolerance and a long term outlook may prefer ground up development opportunities.
Investors looking for a core portfolio holding with stable cash flow and relatively little involvement in the day to day operations of the property may find a lot to like in assets with a “triple-net” lease.
What is a Triple Net Lease?
Generally, there are two types of leases that are popular in commercial properties, gross and net.
In a Gross Lease, the property owner charges tenants one monthly amount for rent and uses that income to pay the property’s operating expenses. For the tenant, it is beneficial because it is a relatively simple structure and places the risk of rising costs on the property owner. But, to compensate for this risk, the rental rate is higher. For the owner, this structure is beneficial because they are able to collect higher rents, but bear the risk of rising costs. For this reason, some owners prefer a net lease structure.
A Net lease is the opposite. In this structure, the property owner charges a base monthly rental amount and the tenant is responsible for the property’s operating expenses. For the tenant, a net lease is beneficial because it allows them to pay a lower base rental amount, but they bear the risk of rising operating costs. For the owner, a net lease is beneficial because they are able to shift some risk to the tenant, but they must lower the base rent to do so. There are three types of Net leases and they are distinguished by the specific expenses that the tenant is responsible for:
- Single Net Lease: Tenant pays base rent; plus property taxes
- Double Net Lease: Tenant pays base rent; plus property taxes and insurance
- Triple Net Lease: Tenant pays base rent; plus property taxes, insurance, and and all common area maintenances
While all three types are used in commercial properties, the triple-net lease is particularly popular with investors.
Why Triple Net Leases are Popular With Investors
Triple-net leases are particularly popular with investors for a number of reasons:
- Tenant Strength: Triple-net leases are used with a wide variety of tenants, but they tend to be particularly common with companies that are known as “credit” tenants. This means that their size and financial strength is significant enough to be rated as “investment grade” by one of the three major credit rating agencies (Fitch, Moody’s, or Standard & Poor’s). As such, the risk of a credit tenant defaulting on their lease payments is low, even in times of economic distress. Examples of credit include CVS, Walgreens, and Dollar General.
- Lease Length: The value of an income producing property is derived from the length and stability of the income stream it produces. So, it follows that investors like triple-net leased properties because they tend to come with long term leases. For example, a Walgreens drug store could sign a lease with an initial term of 15 years and extension options that could increase the term to 30 years. Because Walgreens is a credit tenant and the lease length is significant, buying this property would be similar to buying a long term bond.
- Lease Escalations: Many triple-net leases include built in “lease escalations” which are contractually obligated rental increases at regular intervals in the lease term. For example, a lease could mandate 1% annual rental increases or 5% every five years. These escalations combined with the tenant’s payment of operating expenses ensure that the property becomes more profitable over time.
- Low Touch Management: Because triple-net leases require the tenant to be responsible for all property operating expenses, they require relatively little day to day management. This leaves the property owner free to pursue other interests or other investments.
- Financing Terms: Because they typically contain strong tenants and long term leases, triple-net leased properties can command favorable financing terms from lenders. Whereas a typical commercial property may require equity of 20% or greater, triple-net leases properties with credit tenants can be financed with a down payment as small as 5%. In some cases, when the strongest tenants are involved the property is relatively new, a triple-net leased property can command 100% financing.
- Liquidity: Because they are so popular with investors, triple-net leased properties tend to be received very favorably when the time comes to sell. It is not uncommon for there to be multiple bidders, especially for those properties with the strongest locations and the longest leases.
- Depreciation: Because triple-net leased properties tend to be highly leveraged, depreciation taken by the owner may produce a “loss” that can be used to offset other taxable income.
Although the benefits can be significant, triple-net leased properties are not risk free.
Triple-Net Lease Risks
Because a property has a triple-net lease with a credit tenant does not absolve the investor from the need to perform due diligence prior to purchase. There are number of risks that they should be aware of:
- Vacancy: Triple-net leased properties tend to be leased to single occupants, which means that they are either 100% occupied or 0% occupied. This risk can be particularly acute as the lease approaches the end of the initial lease term and there is some uncertainty as to whether the tenant intends to either renew it or vacate the property. Should the tenant vacate the property, the space would have to be re-leased at the then prevailing market rate which could be higher or lower than the lease rate.
- Reconfiguration: Because triple-net leased properties tend to have a single occupant, the space is likely configured for a very specific use. Should a tenant decide to vacate the property, it can be very difficult and/or expensive to reconfigure the property for another use. For example, a triple-net leased property whose tenant is a bank branch would be very difficult to convert for a non-bank business. This can limit the potential pool of tenants that will lease the space and result in periods of extended vacancy.
- Market Risk: Because triple-net leases tend to have long terms, the prevailing market rental rates at expiration could be significantly different than the original lease rate. Should a tenant vacate the property, it is possible that prevailing lease rates could be significantly lower than what was charged to the previous tenant, resulting in the prospect of a cash flow negative property.
- Default Risk: Not all triple-net leased properties have credit tenants. Some may have non-credit tenants, which means that owners need to be aware of the risk that the tenant will get to a point where they can’t or won’t pay their rent. In such a case, the eviction process can be expensive and the market risk associated with re-leasing the space can result in a loss.
The risks in owning a triple net leased property underscore the need to complete a significant amount of pre-investment due diligence and to actively mitigate identified risks.
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 email@example.com for more information.
There are different types of commercial leases you can learn about on our site. If you would like to learn more about triple net leases or if you have any questions regarding the real estate investing industry, the team at First National Realty Partners is here to help. We’re here to answer your questions and provide guidance about your investment opportunities. If you would like to know more about the benefits of private equity commercial real estate investing, please don’t hesitate to reach out. Our team is built with the best industry leaders, utilizing proven strategies that create great investment opportunities for you. Contact us any time when you are ready to learn more about the possibilities of investing in commercial real estate.
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