Investment Secrets - How To Generate Outsized Returns On NNN Investments
A key is to understand how financial leverage, passive income, property appreciation and long-term upside all work together to build generational wealth.
In an environment where there are plenty of “get rich quick” schemes, commercial real estate is a proven asset class that has generated wealth and financial independence for investors for centuries.
There are many different entry points and investment strategies that fall under that broad commercial real estate umbrella ranging from buying land to investing in triple net lease (NNN) properties. So, how can investors choose a real estate that will not only generate benefits, such as portfolio diversification and a hedge against inflation, but also deliver outsized returns? One key is to understand how financial leverage, passive income, property appreciation and long-term upside all work together to help create outsized returns.
Applying Financial Leverage
Using leverage (debt financing) to boost returns is one of the fundamental components of real estate investing. Interest rates have remained historically low since the Great Financial Crisis. The 10-year treasury – the benchmark for setting long-term financing rates – has been hovering below 3% for the past decade and has even dipped below 1% in the past year. Although the low rates have resulted in paltry yields for fixed-rate investment products, such as bank deposits, bonds and treasuries, it has been a windfall for investors who are able to use cheap debt to acquire commercial real estate assets.
The low interest rate environment is one of the factors contributing to a feverish pace of sales in residential real estate market. On the commercial side, low-cost loans are a strong incentive to use financial leverage in acquisitions. Investors are finding a favorable spread between the interest rate they can get on a loan in the current market (typically 3% -4%) and yields they are finding on assets (5% - 7% or more depending on the individual property).
Example: An investor buys a net lease Dollar Tree store for $1.5 million with a cap rate of 7%. The investor puts down $500,000 in cash and obtains a $1 million bank loan to finance the balance at 3.5%. The individual pays 3.5% in interest on the loan and receives a cash-on-cash return of 10.22%, a significant boost in yields pocketed by leveraging other people’s money. Leverage is a very effective way to allow your money to work for you and enjoy higher cash-on-cash returns. It comes with some added perks, such as being able to deduct the mortgage interest on the loan, more buying power and the ability to access higher priced assets.
Generating (Passive) Income
Commercial real estate assets produce income from the rent paid by a single tenant or multiple tenants at a property. Those rents, less any operating expenses, translate to net income for a property and revenue for the property owner. Single tenant net lease assets in particular are attractive, and widely sought after, by investors who are looking for passive investments that deliver steady, predictable income.
NNN assets can be either single or multi-tenant with occupants that typically sign a long-term lease, often for 10-20 years. Some national tenants might occupy the same property for decades, with several lease renewal and automatic rent increases built into the terms of the lease. The long-term nature means no incidental leasing expenses for the owner that often arise in multi-tenant properties when a tenant vacates and a replacement must be found. Likewise, the NNN structure puts all additional costs for maintaining the property – from changing light bulbs to building repairs – squarely on the tenant. NNN owners simply sit back and wait for monthly rent checks to roll in.
Realizing Property Appreciation
The universal rule of thumb for any investment is to buy low and sell high to take advantage of value gains, and real estate is no exception. Investors can greatly capitalize on real estate appreciation and higher property values on a sale. The catalysts can be a high rate of population and economic growth in the area, major renovation to the building, or an existing short-term tenant that subsequently signs a new long-term lease. The Return on Investment (ROI) can be up to 2X – 5X or more of the amount invested over time.
Leverage + Income + Appreciation = Total Return
The merits of commercial real estate can get overshadowed by the stock market, especially during a strong bull run. Yet real estate is an attractive strategy for diversifying and stabilizing investment portfolios. Real estate is backed by tangible assets that are less volatile than buying stock such as Tesla or Bitcoin. Another paramount differentiator between the stock market and real estate is that real estate allows investors to generate significant passive income immediately. Most people buy stocks for the upside in rising share prices. Certainly, you can buy dividend stocks. However, most dividend stocks are delivering low yields, generally in the 2% -4%. In comparison, cash-on-cash returns for real estate assets can range between 6%-12% or even higher in some cases. Importantly, that passive income is valuable income for those who are looking for added cashflow, such as investors who are retired or semi-retired.
In addition, commercial real estate investors can apply different strategies to raise that overall total return. For example, shopping a loan to multiple lenders might allow that Dollar Tree investor to secure a loan at 3.5% versus 4%. Investors also can buy assets that have more upside potential, such as a NNN property with a local tenant that may present an opportunity to lease the property to a national credit tenant in the future. This can result in greater income stability and significantly boost the valuation of your property.
Commercial real estate also has a unique advantage in being able to sell assets and defer capital gains taxes inevitably by executing a 1031 Exchange. The IRS approved 1031 Exchange allows an investor to sell a property and roll proceeds into a new “like kind” property with zero tax penalty. What this means for investors is that they don’t have to worry about getting stuck in an investment they are afraid to sell because of a high tax bill. Perhaps even more compelling is that there is no limit how many times you can do 1031 exchanges. For example you can start out with 4-unit apartment building worth $400K and over 25+ years participated in 15+ rounds of 1031 Exchanges and end up with a portfolio of $12M. Investors who hold assets over their lifetime and then transfer property to heirs upon their death pass on real estate at a stepped up basis, meaning that the accumulated capital gains resets to $0 for your heirs. This provides huge tax savings and an added boost to that total return that helps build a legacy of generational wealth.
If you are interested in learning more about triple net lease assets and whether NNN aligns with your investment objectives and lifestyle goals, contact Andrew Vu at 415-539-1120 for a free, no-obligation NNN consultation.