Understanding Triple Net Lease: Answers To Frequently Asked Questions
Triple net lease (NNN) is an asset type that is embraced by both seasoned and newbie commercial real estate investors. Picture yourself owning quality real estate that yields good, stable returns that typically range between 5% -7%. That steady cash flow is generated by rental income from established investment-grade national tenants that guarantee their leases. The cherry on top is that there is little to no management responsibility required for the triple net property owner.
Given the attractive benefits of collecting steady income coupled with zero active management, it’s no surprise that nearly half of all 1031 Exchange buyers pursuing a NNN property are migrating from the multifamily sector. Apartment owners grow tired of dealing with hands-on apartment management headaches, and they view NNN assets as an attractive alternative to trash, tenants and toilets. NNN property owners can enjoy the fruits of their labor and live a lifestyle without the day-to-day burden of active management. In this blog we explore some core aspects of triple net leases, discuss benefits for investors and answer common FAQ.
What is a Triple Net Lease (NNN)?
Triple net lease assets get their name from the underlying lease structure. In a NNN lease (aka absolute triple net), the tenant is responsible for all property operating expenses including maintenance, property insurance and property taxes. Because of that lease structure, NNN properties provide stable cash flow and relatively little or no involvement in the day-to-day operations of the property. The tenants that typically occupy these NNN properties are well-known national brands that we see all around us, such as Walgreens, 7-Eleven, McDonalds, Taco Bell, Trader Joe’s, Home Depot and Dollar General amongst others. Triple net leases terms start at 10-20 years in the base term and can extend for another 15-30 years including lease renewal options.
Why is tenant credit such a big deal in NNN?
When a tenant signs a lease, they are entering into a contractual agreement. That lease is effectively a corporate guarantee to pay the landlord rent for the entire term of that contract. In a worst case scenario, if the tenant ever vacates the property before their lease expires, they are still contractually required to fulfill their rent obligation for the full length of the lease term. However, the strength of that guarantee is only as strong as the company standing behind it. For example, McDonald’s is an excellent credit tenant (S&P:BBB+, Moody’s: Baa1) that has staying power, whereas the same cannot be said of a Bill’s Burger Barn. Check out these “Magnificent 7” retailers that are in high demands among NNN investors.
How large is the NNN investment marketplace?
Per data from Real Capital Analytics, triple net lease properties generated $68.1 billion in sale transactions in 2019, which represented a healthy rate of year-over-year growth at 16%. Tens of thousands of triple net lease properties exchange hands every year in the U.S. However, the industry is still somewhat of a well-kept secret among real estate investors.
For those that are in the know, why are triple net lease properties so popular?
Individuals, family offices, REITs and other institutions are all active NNN property buyers. Investors across the spectrum are attracted to key attributes that include:
Predictable Cash Flow: NNN assets are known for their bond-like characteristics. They deliver predictable income with rent payments that are backed by the tenant’s corporate guarantee to pay the lease even in the case of a default. NNN assets also have been delivering very attractive yields for investors in the current low interest rate environment. The average yield, or cap rate, for net lease property sales has held relatively steady at about 6.2% for the last 5 years.
National Credit Tenants: Size does matter, and that is certainly true among national retailers that have built a sustained business model and have successfully withstood economic distress. NNN tenants frequently include public companies with current financial strength that has been vetted by premiere credit rating agencies such as Standard & Poor’s and Moody’s.
Long term leases: If you own an apartment building, you would typically have your tenants sign a 6-month or 1-year lease. In some cases, renters may even occupy on a month-to-month basis once a lease ends. The day-to-day active management can be overwhelming even in a 5-10 unit building. NNN leases are typically 15-20 years in base term with up to several renewal options that can stretch the overall tenancy to 30-50 years. Many NNN leases also have built-in rental increases, which helps investors keep up with inflation and retain long-term value.
Lower volatility than equities: Real estate investment is an ideal contributor to a well-diversified portfolio. It is not subject to wild market swings like what you see with the equity market. The long-term hold nature of real estate helps to protect you from day-to-day market fluctuations. At the same time, investors also benefit from the tax advantages of real estate ownership, such as mortgage payment write-offs, depreciation and property appreciation over time.
Does the landlord pay for common area maintenance?
NNN = hands-free management = zero landlord responsibility.
Do you prefer to sleep better at night, and spend your days pursing personal and other professional interests? This is exactly the lifestyle that NNN investors enjoy as tenants are fully responsible for all maintenance and building expenses. The check list of tenant responsibility includes parking lot cleaning and resurfacing, mowing the grass, trimming the trees, maintaining HVAC systems, fixing roof leaks and paying property taxes and insurance. The list can go on and on, but you get the idea. If you have ever owned residential or apartment properties, those days of hands-on management and headaches are now behind you with triple net properties.
What are some best practices for triple net lease acquisition strategy?
Three tips that you can take with you no matter what happens to the economy are:
1. One strategy that has been further reinforced by the economic impact of the global pandemic is that the best course is to stick with proven investment-grade tenants that guarantee their leases. It’s even better if the tenant is considered an “essential retailer”. In fact, many triple net lease essential retailers such as Dollar General, 7-Eleven, CVS and Firestone Complete Auto Care are thriving in the current pandemic and will continue to be well-positioned for the future.
2. No matter how bright and shiny an asset seems, make sure you are buying at or under market value. Always evaluate the rent per square foot (rent/sf) that the tenant is paying and know how that compares to current market levels. Are rents on par, above or below market peers? That is important, because the price you pay for the property is derived directly from rental income (price = net operation income/cap rate). If you have a tenant that pays above market rent and the tenant leaves, you may not be able to get another tenant to pay at the same high rent/psf level as the previous tenant. The result in that situation would likely be a decline in property valuation.
3. Stick to the basics. Always look to the real estate fundamentals to evaluate a deal. This includes key intrinsic factors such as location, potential parcel usage, demographics, retail synergy in the area, economic development initiatives and growth potential of the area among other factors. It also is important to take a 360-degree approach to NNN valuation.
The Invest Net Lease group at Touchstone Commercial Partners helps clients navigate the NNN marketplace and has completed thousands of transactions. If you are interested in learning more about triple net lease assets and whether NNN aligns with your lifestyle objectives and financial freedom goals, contact Andrew Vu at 415-539-1120 for a free, no-obligation NNN consultation.