Sick of Being a Landlord? 3 Things to Know Before Ditching It for Triple Net Lease Investing
Triple net lease (NNN) properties require tenants to take care of the insurance, maintenance and taxes — ideal for landlords who just want passive rental income, as long as you have these basics covered.
Triple net lease (NNN) commercial real estate means that the tenant handles insurance, taxes and maintenance on the asset along with rent and utilities, leaving the landlord with minimal responsibilities.
For real estate investors who are sick of managing multifamily buildings or juggling a dozen different residential assets, they can be a great option if you want to 1031 exchange into something that's a little bit more hands-off (with the understanding that every asset will, at some point, require at least some of your attention).
With NNN, ongoing day-to-day maintenance is significantly lower than it is with other types of real estate that you directly own. No one will be calling you about a leak. No one will need you to fix a toilet. As long as the tenant keeps paying rent, your responsibilities are largely limited to filling out some paperwork here and there.
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Put a different way: On the passive-active continuum, NNN is somewhere between a REIT and a rental.
If you clicked on this article, you're likely already interested in investing in your own NNN asset. You might have even checked some of them out with a broker or an adviser.
But what should you be looking for before going under contract?
We're a private family office that specializes in triple (NNN) and double (NN) net lease commercial real estate, having facilitated over $470 million worth of transactions over the past few years.
Here's what our team looks at first.
1. Tenant creditworthiness
Imagine you're renting out a single family home and your renter pays the property taxes, insurance and takes care of the maintenance. You're ecstatic.
When you first hear about NNN commercial real estate, you might have a similar reaction.
There's only one problem: What happens if that tenant loses their job? Or, in the case of commercial real estate, what happens if the tenant goes bankrupt?
That's why tenant creditworthiness is the number one factor when evaluating single tenant net lease assets. Your tenant's ability to pay rent is essential, which is why it's prudent to invest in the highest quality tenant you can find. If that tenant stops making money, there's a chance that they'll default on the lease.
Look for national corporate tenants with an investment grade of BBB- or higher (depending on your risk tolerance), with the understanding that there's a close relationship between risk and return. If you're investing in McDonald's corporate-guaranteed ground leases, you're taking on very little risk, so you can expect very little reward.
If you invest in a regional quick service coffee operator, you can expect significantly higher reward while taking on more risk.
2. Corporate guarantee
A corporate guarantee is a legal promise by one company (often a parent company or affiliate) to cover the financial or contractual obligations of another business entity (such as a subsidiary) if it defaults.
For instance, let's say you purchase an oil change garage in what turned out to be a bad location, but your lease is corporately guaranteed by a national operator with 500+ locations across the country.
The beautiful thing about economies of scale is that even if that location underperforms, the operator might be willing to not turn a profit on it. Intelligent accounting might allow them to use the losses from that location to offset gains from another location.
Suffice it to say, it's important to have a corporate guarantee on your lease — and it's important for this guarantee to be backed by the corporate entity involved in the transaction, not just single LLC or franchisee.
This is a common pitfall for newbie commercial real estate investors: You might think you're getting a great deal on a property only to find out that the lease guarantor isn't necessarily connected to the actual tenant — or at least not in any way that would allow you to recoup significant losses.
If the Wendy's is "corporately guaranteed" by Wendy's 456 Lakewood Dr LLC, for instance, that LLC could be easily dissolved in the event of that location's underperformance.
Commercial real estate can get confusing fast, particularly when there are multiple LLCs involved in a single transaction. Always pay attention to who is actually guaranteeing the lease. If it's a franchise entity, you need to know that going in.
3. Long-term leases
Let's return to that residential metaphor and assume you have a tenant who's been diligently paying the taxes and insurance on your property, fixing up the roof, replacing the gutters and so on.
What if they decide to leave one day?
You'll be stuck trying to find a new tenant just like them, and if it's a location that's perfect for them (but not necessarily anyone else), you might have a difficult time finding a new tenant. That's when your low landlord responsibilities might become a little bit more intensive.
Take a dialysis clinic as an example. In a dialysis clinic, there will be 20 to 40 bays with mechanical, electrical and plumbing coordination. A water treatment room houses the reverse osmosis and bicarbonate distribution infrastructure. Usually, this is all purpose-built to be used as a dialysis clinic, since finding a new tenant for that space can be difficult.
That's why you'll want to secure a tenant with a long-term lease (anywhere from eight to 20 years or more). That way, you'll have plenty of room to plan accordingly if you ever run into any re-tenanting issues.
Know the difference between NN, NNN and absolute NNN
There's unfortunately no authoritative definition for these that everyone sticks to, and offering memorandums for net-lease assets tend to conflate NNN with what we would call NN. The three "Ns" typically refer to insurance, taxes and maintenance.
Some offering memorandums will say that it's an NNN lease with the tenant handling the roof and structure.
In our opinion, that's maintenance. Some might say that the "maintenance" in NNN only refers to "common area maintenance." We think that's confusing.
We only use two definitions: Absolute NNN (tenant handles all maintenance, insurance and taxes) and NN (tenant handles insurance, taxes and maybe some maintenance, but you're on the hook for roof and structure).
In conclusion
If you're interested in investing in NNN and NN assets, there are three specific things to look for:
1. Tenant creditworthiness (look for national tenants with credit ratings north of BBB-, depending on what you're looking for)
2) Corporate guarantees (from the parent company, not an individual franchisee or LLC)
3) Long-term leases (so you can plan your exit accordingly)
If managing an entire NNN acquisition all by yourself seems overwhelming, our private family office can help. We built out seven divisions to simplify the process of acquiring a commercial real estate property.
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