In many ways, the COVID-19 pandemic brought the economy to a crashing halt. Commercial real estate investors faced real fears that tenants would stop paying their rents. However, there were bright spots even during those uncertain economic times. Namely, “essential businesses” and quick-service restaurants (QSRs) continued to outperform their industry peers.
Today, we look at the basics of essential businesses and QSRs (or “drive-thru” restaurants) and explain why these properties make such great NNN investments. As you’ll see, shifting consumer preferences and growth among these industries will make NNN properties even more attractive in the years to come.
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The types of commercial real estate leases
In commercial real estate, there are generally four types of lease options: a gross lease, single net, double net, or triple net lease. The main difference between each of these lies in how property expenses are allocated between the landlord (owner) and the tenant. Each lease type shifts different levels of financial responsibility for operating expenses from one party to the other. Here’s an overview of each of these lease types:
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Gross Lease:
In a gross lease (also known as a full-service lease), the tenant pays a fixed rental amount, and the landlord is responsible for covering all operating expenses related to the property. Operating expenses typically include property taxes, insurance, utilities, maintenance, and common area expenses. With a gross lease, the tenant's rental payment remains consistent throughout the lease term, and the landlord bears the risk of any increases in operating costs.
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Single Net Lease (N Lease):
In a single net lease, the tenant pays a base rent amount, as well as a portion of the property taxes on the leased space. The landlord is responsible for other operating expenses, such as insurance, utilities, and maintenance. The single net lease offers a partial transfer of expenses to the tenant, but the landlord remains responsible for most operating costs.
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Double Net Lease (NN Lease):
In a double net lease, the tenant assumes responsibility for two of the three "nets" - property taxes and insurance. The tenant pays a base rent amount, property taxes, and insurance costs, while the landlord is responsible for maintenance and other common area expenses. The double net lease represents a higher level of expense transfer to the tenant compared to a single net lease.
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Triple Net Lease (NNN Lease):
In a triple net lease, the tenant is responsible for all three "nets" - property taxes, insurance, and maintenance expenses. The tenant pays a base rent amount, as well as the additional costs associated with property taxes, insurance premiums, and ongoing maintenance of the leased space. The landlord's financial responsibility is limited to structural repairs and major capital improvements. Triple net leases offer the highest level of expense transfer to the tenant, making it a more hands-off investment for the landlord.
The choice of lease type depends on the negotiation between the landlord and tenant and prevailing market conditions. In general, gross leases are more common for residential properties and some retail spaces. Net leases, on the other hand, are more prevalent in commercial real estate. NNN leases are especially common and utilized for single-tenant properties leased to creditworthy tenants like large corporations, national retailers, or drive-thru food establishments.
Pros of NNN leases
The primary benefit of investing in NNN properties is that it generates a passive income stream for the property owner since the tenant handles most of the property-related costs. Additionally, NNN properties are often sought after by investors looking for relatively stable and predictable income, as the lease terms are typically long and the tenant is responsible for the property's maintenance.
Here are more specific benefits associated with investing in NNN properties:
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Passive Income:
NNN leases generate passive income for investors as tenants are responsible for paying operating expenses, including property taxes, insurance, and maintenance costs. This can provide a steady stream of rental income without the need for active involvement in property management.
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Stable Cash Flow:
NNN leases often have long-term lease agreements, typically spanning 10 to 20 years or more. The stability of these leases can provide investors with predictable cash flow and reduce the risk of tenant turnover.
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Reduced Management Responsibilities:
NNN properties shift the burden of property management to the tenant. Investors are typically not responsible for day-to-day management tasks or expenses, reducing their involvement and freeing up time for other pursuits.
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Lower Risk of Expense Fluctuations:
In a NNN lease, the landlord is insulated from varying costs such as escalating property tax rates, insurance premiums, and maintenance costs during the duration of the lease term.
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Tenant Quality and Stability:
NNN properties often attract creditworthy tenants with established brands or strong financials. These tenants tend to have a lower risk of default and provide stability to the investment, as they are committed to long-term leases.
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Potential Appreciation:
NNN properties located in desirable areas with strong market conditions have the potential for property value appreciation over time. Any owner or tenant improvements to the property can also enhance its value through “forced” appreciation. Both natural and forced appreciation can increase potential profit upon sale or refinancing.
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Hedge Against Inflation:
Most NNN leases contain set rent escalations (e.g., 2 to 4% per year). They might also contain an additional rent escalation tied to inflation. For example, a further escalation tied to the Consumer Price Index could boost the rent by another 4 to 6% per year during periods of rampant inflation. Those who invest in NNN leases will therefore find them to be a strong inflation hedge.
Cons of NNN leases
Of course, there are also reasons to be wary of investing in NNN leases. Here are some additional considerations for prospective NNN investors:
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Lack of Control:
With NNN investments, investors have limited control over property management decisions and operations. The tenant assumes most responsibilities, which means the investor may have limited say in property improvements, maintenance, or lease renewals.
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Property Condition and Repairs:
Investors in NNN properties may still be responsible for significant capital repairs and replacements over time, depending on the lease terms. For example, some NNN leases are structured where the tenant is responsible for all “walls in” maintenance whereas the landlords is responsible for “walls out” – such as the building’s façade, roof, and landscaping.
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Lease Renewal Risk:
When a lease term expires, there is a risk that the tenant may not renew the lease or may negotiate less favorable terms. This can lead to vacancy and the need to find a new tenant, potentially disrupting cash flow. Single-tenant NNN properties can be difficult to re-lease if that property is at all customized for the prior tenant.
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Lease Structuring Challenges:
Creating attractive lease terms in NNN agreements can prove to be challenging for some. Negotiating rent increases, escalations, or lease extensions can be complex and require careful review with real estate advisors.
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Tenant Credit Risk:
While NNN properties often attract creditworthy tenants, there is still a risk of tenant default or bankruptcy. If a tenant fails to meet lease obligations, it may result in loss of rental income, additional expenses to find a new tenant, and potential legal proceedings—however, this risk applies to all commercial properties, and not those specific to NNN leased buildings.
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Less Liquidity:
NNN properties are generally less liquid than other types of real estate investments. Selling a NNN property may take longer and involve more complexities, especially if the property has a long-term lease in place or a specific tenant tied to it.
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Lower Potential Returns:
Compared to riskier and more actively managed real estate investments, NNN investing generally offers lower potential returns. The passive nature of NNN properties may limit the opportunity for significant capital appreciation or high cash-on-cash returns.
Examples of “essential” business NNN investment properties
While the COVID-19 pandemic certainly had adverse impacts on some commercial real estate market segments, many NNN investments continued to hold strong. This is true even during the depths of the pandemic. The reason is that many “essential” businesses utilize NNN leases for their operations.
Examples of “essential” NNN businesses include:
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Pharmacies and Drugstores:
Tenants operating pharmacies and drugstores are considered essential, as they provide critical medications and healthcare products to the community.
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Grocery Stores:
Grocery stores are also essential businesses, as they supply food and household essentials to the public.
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Healthcare Facilities:
Properties leased to healthcare providers, such as medical offices and urgent care centers, are essential as they deliver medical services to patients.
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Auto Parts Stores:
Tenants operating auto parts stores are considered essential because they provide automotive products and essential repair services.
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Gas Stations:
Gas stations are also essential businesses as they supply fuel to motorists and are considered critical for transportation needs.
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Banks:
Properties leased to banks and other financial institutions are also considered essential and are needed to keep the economy afloat.
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Postal Services:
Properties leased to the US Postal Service, FedEx, UPS and other shipping companies are essential for the movement of mail and packages.
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Utility Companies:
Properties that lease space to power, water, telecommunications, or other utility providers are considered essential as they provide critical infrastructure to businesses and homeowners alike.
The definition of “essential” business may vary based on local and regional interpretations or the specific circumstances. Additionally, while essential businesses may offer some stability during periods of economic uncertainty, other factors – such as tenant creditworthiness and lease terms – are equally important when evaluating NNN investment opportunities.
Benefits of “Drive-Thrus” or QSR
By some estimates, there are more than 200,000 drive-thru or “quick-service restaurants” operating in the U.S. The top brands include McDonald’s, Burger King, Panera Bread, Starbucks, and Subway. According to Zion Market Research, drive-thru establishments are poised to increase their market share in the years to come.
This makes drive-thrus, or QSRs, a great NNN investment option for CRE investors. The continued growth of the fast-food industry opens the door to abundant NNN lease opportunities.
Here are some of the benefits to investing in QSR properties:
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Established Brands:
Many QSRs are well-known national or international brands with a strong market presence, which can attract customers and provide stability to the investment.
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Long-Term Leases:
QSR tenants often sign long-term leases, providing the investor with a stable income stream and reducing the risk of tenant turnover. It’s not uncommon for QSR tenants to sign leases of 10-15+ years with built-in annual rent escalations.
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Stable Cash Flow:
NNN leases with QSR tenants offer consistent rental income, as the tenant is responsible for most property expenses.
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Operational Simplicity:
QSRs typically have streamlined operations, which can result in efficient property management and lower landlord responsibilities. Many franchisees also have the support and backing of their parent company that can provide guidance if the business shows signs of weakening.
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Recession Resilience:
Fast-food chains are generally considered recession-resilient, as they tend to maintain customer demand during economic downturns.
What to look for in your QSR investment
Not all QSR investments are created equally. Consider the following when analyzing specific QSR investments, as these factors can impact the deal’s success:
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Tenant Quality:
The success of a QSR investment often hinges on the creditworthiness and stability of the tenant. Investing in a QSR with a well-established and reputable brand can reduce the risk of tenant default and provide confidence in the tenant’s ability to meet lease obligations.
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Location:
The location of the QSR property is critical for its success. Look for drive-thru properties located in high-traffic areas with excellent visibility, easy accessibility, and a strong customer base. Consider factors such as demographics, nearby businesses, and competition in the area.
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Long-Term Lease:
Look for QSR tenants willing to commit to long-term leases, as this provides stability and will reduce the risk of tenant turnover.
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Tenant Industry and Performance:
Evaluate the QSR tenant’s industry performance and operational track record. Research the tenant’s revenue growth, profitability, and overall performance in the QSR market to assess their ability to sustain and grow their business.
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Professional Property Management:
Be sure the business owner has engaged a competent property manager to ensure the building is well-maintained and any necessary repairs are properly addressed.
Why QSRs and essential businesses are a great NNN investment
Both QSRs and essential businesses can be great NNN investments for a variety of reasons.
The biggest reason to invest in these properties is that they prove to be recession resilient. During a downturn, people still need to spend money at essential businesses like grocery stores and pharmacies. Most still need to visit health facilities for route and specialized care. People still need to replace auto parts and fill up on gasoline.
This is especially true as people’s spending patterns change during a recession. For example, someone who would have taken a vacation overseas might now gas up for a more local road trip, instead. People who frequently eat out might shift to cooking more at home.
QSRs perform equally well during an economic downturn. The average fast-food meal costs around $6 compared to “fast casual” meals that are closer to $10-12 each. People who need a quick meal on the go will often turn to fast-food instead of spending at pricier establishments. National brands, like McDonald’s, also have the bandwidth and capacity to weather recessions better than independently-owned establishments.
Portfolio diversification is another reason to invest in NNN properties like QSRs and essential businesses. Including NNN properties in your investment portfolio can spread risk across different types of assets and industries.
Conclusion
QSRs and essential businesses are often overlooked among commercial real estate investors. Most start by investing in multifamily, office, industrial, or traditional retail centers without giving much thought to QSRs and essential businesses. As we’ve shown here, there are many reasons to invest in these NNN properties – most notably, they are a great way to mitigate the risk of a downturn, they are a great hedge against inflation, and they provide tremendous portfolio diversification.
If you’re interested in learning more about NNN investments, contact us today. It’s always worth reviewing your options with an experience real estate professional and/or a financial advisor ensure your next investment is aligned with your broader financial goals.
