Triple-Net Leases: What the Three “N”s Mean to Investors
A triple-net lease refers to an arrangement between a tenant and a property operator whereby the tenant is responsible for all of the property’s major operating expenses. This article breaks down the triple-net lease concept, compares triple-net with other common lease types, and explains what to consider when evaluating a triple-net lease investment.
Commercial real estate lease structures may vary considerably depending on the property, tenant profile, and business model of both the tenant(s) and the property operator. Over the past several months, EquityMultiple has offered several triple-net lease investments, including an Amazon procurement center and an addiction treatment facility.
The Three “N”s
Triple-net lease—often abbreviated as NNN or Net-Net-Net—is a lease structure most often found with commercial buildings in the office, industrial, and retail sectors. The structure is most popular with single-tenant properties where one tenant occupies the entire leasable space of the property. Generally, the NNN structure leads to lower contractual rent payments as the tenant is generally reimbursing the landlord or paying directly for all operating expenses at the property. The three “N”s typically refer to common area maintenance (CAM), real estate taxes, and property insurance expenses. Some lease structures also require tenants to be responsible for roof and structural maintenance. These are often referred to as Absolute NNN Leases.
The more traditional lease is often referred to as a Gross Lease where the tenant simply pays an agreed-upon rent amount and the landlord is responsible for all operating expenses. Within the net lease space, modified structures can also include Single-Net (N) and Double-Net (NN) leases as well. Under these structures which are also referred to as Modified Gross Leases, operating expenses are split between the landlord and tenant.
Considering that the property owner is shifting the responsibility to pay for the three major operating expenses to the tenant, the triple-net lease generally entails the lowest rents of any lease structure, all else being equal. More importantly for the property owner and corresponding investors, it shifts the burden to maintain the property onto the tenant and offers a more passive asset management plan.
Single tenant net lease terms can range from short to long term (1-2 years to 15+ years, respectively), with 10-year terms being most common. The long term lease structure allows the property to produce bond-like cash flow over a long time period. When structuring a triple-net lease, the property owner will seek to include rent escalations annually or at a less frequent cadence (e.g every 5 years). The contractual rent escalation can also be linked to the Consumer Purchase Index (CPI) to keep up with inflation.
Considering the long-duration nature and the payment responsibilities of NNN leases, the structure is best suited for industrial, warehouse, self-storage, and retail properties, and for credit tenants who have demonstrated financial strength and sound business operations.
While property owners and tenants may prefer net leases for practical reasons, commercial real estate investors should also carefully consider the lease term’s merits in relation to the investment’s return and risk profile. Compared to other lease types, the triple-net lease can lower operating expenses but also temper the property’s revenue potential. While triple net lease may have a zero-sum effect on the net operating income, in transferring the responsibility to pay the operating expenses, the property owner also transfers the risks of increasing operating cost to the tenant. In the event that insurance premiums, property tax, or maintenance costs increase—due to unforeseen circumstances such as natural disaster, change in tax policy, or damages—the tenant will be liable to cover the increased cost on top of the rent. As previously noted in absolute NNN leases, the tenant is also solely responsible for maintenance and all necessary repairs and/or replacements to the property, including the roof, landscaping, exterior and structural portions, foundations, and parking lot. Because the tenant pays for their own maintenance, insurance, and taxes under the triple-net lease, the managerial responsibilities will be lessened for the property owner and investors can benefit from decreased property management-related fees.
When combined with a strong-credit tenant, the triple-net lease can help investors secure attractive long-term debt financing with low interest rates, further boosting bottomline returns to equity investors. NNN transactions are often levered conservatively with long-term debt in the 50-65% LTV range. The low debt service mitigates default risk and creates an opportunity for investors to capture enhanced current yield. NNN investments may be most appealing to investors who are relatively risk-averse but still seeking current yield.
Why Triple-Net Investments are Appealing Now
Following two drastic rate cuts in March, U.S. real interest rates have been trapped in negative territory. With the Federal Reserve indicating that the nominal rate will be kept near zero through 2022, investors may need to consider alternate income strategies beyond traditional fixed-income instruments. High-yield and current-income driven investors expecting consistent and stable income should strongly consider triple-net investments.
NNN lease investments backed by corporate guarantees may offer meaningful downside protection for investors who are wary of market conditions in the near term. These investments can generate attractive cash-on-cash yields that can outperform the high-yield bonds on an investment-grade credit. While the price of high-yield bonds fluctuate as market sentiment shifts and credit spread widens, triple-net investments can benefit from stable rent collection. Despite the COVID-19 pandemic disrupting tenants’ normal business operations, W.P. Carey (NYSE: WPC), a public REIT solely focused on triple-net leased single-tenant properties, reported a 97% quarterly rent collection rate in Q2 2020 and 98-99% monthly rent collection rates in Q3 2020.
Considerations for Triple-Net Lease Investment
When evaluating a NNN lease investment, creditworthiness of the tenant is one of the most crucial aspects in the due diligence process. Since the terms under triple-net lease can be long, investors looking to generate long-term, steady income must discern the tenant’s ability to meet the lease obligations throughout the investment hold period. Reviewing the tenant’s corporate credit rating is a good starting point in understanding the tenant’s credit quality. Credit rating agencies, such as Standard and Poors (S&P,) Fitch, and Moody’s assign letter grades to indicate the creditworthiness of public companies and reflect the tenant’s ability to meet financial obligations. Beyond credit ratings, investors can look into the tenant’s financial statements to ensure the tenant has sufficient liquidity to meet the lease obligations under distressed situations in the near term, and examine the capital structure to ensure conservative leverage and assess the tenant’s ability to meet financial obligations in the mid-to-long term.
When considering a triple-net lease investment with a single-tenant, the investor should consider the relationship between the property and the tenant’s business operations. Tenants are incentivized to continue the tenancy even amid a tough economic environment when the property is mission-critical to business operations, located in a valuable location, or in the case of retail, has demonstrated sales performance.
Finally, investors should consider the lease term and lease rate of the existing tenants. In order to avoid or minimize lease-up risks, the remaining lease terms on average should be longer than the investment hold period and lease rates should be in-line with the market.
EquityMultiple makes investing in triple-net properties simple and accessible through extensive in-house underwriting, low investment minimums, and a simple investing process. Please check back on our Invest page frequently and do not hesitate to bring any and all questions to our Investor Relations Team.
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