Commercial real estate is a great way for individual investors to earn passive, tax-advantaged income. And yet, some people shy away from investing in commercial property due to their fear of property management.
For those who are intrigued but otherwise apprehensive, triple net properties are worth a close look. Triple net properties, often referred to as “NNN” properties, are a type of commercial real estate asset where the tenant is responsible for paying all (or most of) the property’s operating expenses, including all property taxes, insurance, and maintenance costs. The term “triple net” refers to the three main expenses typically passed on to the tenant.
In a NNN lease agreement, the tenant not only pays the base rent, but also assumes the financial responsibility for the property’s ongoing expenses. This arrangement is commonly seen in long-term leases involving commercial properties, such as retail stores, office buildings, industrial facilities, and even some single-tenant properties like pharmacies and banks.
In this article, we examine some of the reasons to invest in NNN properties and what specifically to look for as an investor.
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Why invest in triple net properties?
Investing in triple net (NNN) properties can offer several advantages to investors. Here are some of the reasons why people choose to invest in NNN properties:
Rewards without the risks.
NNN properties can be a strong source of passive income. NNN leases are often long-term and typically have rent escalations built into the agreement, providing investors with a stable and predictable cash flow over an extended period. This stability is attractive to investors seeking reliable income.
Free from the managerial obligations.
In a NNN lease, the tenant is responsible for property taxes, insurance, and maintenance costs. This relieves the investor from day-to-day property management tasks and associated expenses, reducing their involvement and allowing for a more hands-off investment approach.
Moreover, because the tenant is responsible for paying the operating expenses, the investor receives a consistent stream of rental income without the need for active involvement in property management. If operational costs rise, for example, these higher costs do not come out of the investor’s pocket.
NNN properties are commonly leased to well-established and creditworthy tenants, such as national retailers, large corporations, or government entities. This can provide a level of tenant stability and it lowers the risk of lease defaults, thereby enhancing the investment’s security. Once a property is leased up to credit-worthy, stable tenants, the property becomes particularly attractive for resale.
Potential for appreciation.
NNN properties can offer the potential for property value appreciation over time, depending on various factors such as location, market conditions, and lease terms. NNN properties generally benefit from “natural” appreciation – something that occurs given local area and macro-level economic conditions. “Forced” appreciation can be more difficult to realize when a long-term tenant is in place. Those who invest in a value-add strategy will often do so by making the property improvements prior to re-leasing the property to a new long-term tenant.
In either case, if the property value increases, it can lead to capital appreciation and the opportunity for an even more profitable exit strategy.
Hedge against inflation.
NNN leased properties often include rent escalations tied to inflation, or otherwise predetermined increases. This provides a valuable hedge against inflation. For example, if the Consumer Price Index rises 4% year-over-year, the base lease rent may also automatically rise by 4% with the new lease term. This can help protect the investor’s purchasing power and ensure that rental income keeps pace with the rising cost of living.
Investors are often looking for ways to diversify their portfolios away from more traditional stocks and bonds. NNN properties offer an opportunity to diversify one’s investment portfolio. By including commercial real estate with stable tenants and long-term leases, investors can reduce their exposure to stock market volatility and potentially enhance their overall portfolio performance.
NNN properties, like all commercial real estate, are highly tax advantaged. Many seasoned real estate investors will use what’s known as a “1031 exchange” when they sell a property. As long as the investor rolls the proceeds from that sale into another “like kind” property (e.g., any other commercial real estate), they can defer paying capital gains taxes on their profits.
Many real estate investors will use 1031 exchanges to grow their real estate portfolios. Rather than cutting a six- or seven-figure check to Uncle Sam, they use that money to invest in a more expensive (and potentially more lucrative) real estate asset. It’s a way of retaining more of your hard-earned money. Some investors will use 1031 exchanges in perpetuity. When they die, they can pass on their portfolios to their heirs at a stepped-up basis, which resets the property’s value and essentially eliminates the need to pay capital gains.
What investors look for before investing
Lease terms and remaining lease term.
Examine the lease terms, including the length of the lease and remaining lease term. Longer leases provide more stability and predictable income. Consider the expiration date, renewal options, rent escalations, and any clauses that may affect the property’s value and cash flow.
Regarding lease term: the most common NNN lease term is typically between 5 and 10 years. This duration strikes a balance between providing a stable income stream for the landlord and offering a reasonable commitment for the tenant. For landlords, a lease term of 5 to 10 years reduces the need for frequent tenant turnover. If a tenant only has one or two years remaining on a lease, it is important for investors to gauge how likely that tenant is to renew and how quickly they will be able to re-lease the property if it becomes vacant.
In a single-tenant NNN leased property, if that tenant vacates the building, an owner can find themselves sitting on an empty building for an extended period of time. Some owners may prefer to look for multi-tenant NNN leased property as a way to mitigate this risk; however, single-tenant NNN buildings tend to be the most common.
Tenant Quality and Creditworthiness.
Assess the current tenant’s financial strength, stability, and creditworthiness. Look for established and reputable tenants with strong financials and a track record of successful operations. National or well-known companies are often the first choice due to their stability and ability to fulfill lease obligations. For example, some retail owners would argue that a Walmart or Target is the gold standard for NNN retail tenanting.
Investors will also want to look for tenants willing to commit to long-term leases. While 5 to 10 years is standard, many companies will be willing to sign leases of up to 20 years or more. A longer lease term provides greater stability and reduces the risk of tenant turnover.
Lastly, be sure to evaluate the tenant’s industry and market position. It’s generally favorable to have a tenant operating in a stable or growing industry with positive long-term prospects.
Evaluate the property’s location and its potential for long-term growth and stability. Consider factors such as population demographics, economic trends, market demand, proximity to amenities, transportation access, and visibility. A desirable location can contribute to tenant retention and potential appreciation.
Property Condition and Maintenance.
Assess a property’s physical condition and its current and projected maintenance requirements. Just as you’d conduct an inspection prior to purchasing a home, do the same for a NNN lease commercial property. A thorough inspection, guided by a licensed professional, will be essential when evaluating the building, infrastructure, and potential repair or renovation needs. Understanding the maintenance responsibilities defined in the NNN lease is crucial when trying to anticipate future expenses—whether those are ultimately incurred by the owner or the tenant.
Net Operating Income.
A property’s net operating income, or NOI, is an indication of how profitable an investment will be. NOI is calculated as rental income minus operating expenses. Consider the stability and sustainability of the NOI, as it directly affects the investor’s cash flow and return on investment. Evaluate both the historical performance and projected growth potential, before and after planned renovations.
Study the local real estate market and analyze the property’s capitalization rate, or “cap rate”. The cap rate helps to measure a potential return on investment by comparing its NOI to its market value. Investors will always want to compare a specific property’s cap rate to the cap rate of other properties in the area to gauge the property’s true value.
Evaluate the financing options available for acquiring the property, including interest rates, loan terms, and down payment requirements. Often, a lender will give better rates and term to someone buying a NNN property that has a long-term lease with a credit-worthy tenant already in place (with substantial time remaining on that lease)—another reason why the lease terms and tenant profile are so important to NNN properties! Consider working with lenders who are experienced in financing NNN properties to ensure the most favorable terms and any potential loan restrictions specific to NNN investments.
The ownership structure for NNN properties can vary based on the investor’s preferences and specific circumstances of the investment. Individual ownership is one of the most common structures, in which an individual directly owns the NNN property. They have full control over the property and are responsible for managing it, collecting rent, and handling any associated responsibilities. Many people who own a property individually will do so through a limited liability company, or LLC.
Another way to own NNN property is through a partnership or joint venture. Investors can form either with as few as two people. Those who invest in a partnership or JV typically pool their resources, skills, and capital to acquire and manage the property. Partnership agreements should also define ownership percentages, responsibilities, and decision-making processes. Joint ventures operate similarly but are usually formed for a specific project or property.
Consider the potential for a profitable exit strategy. This includes assessing the market’s liquidity, demand for similar properties, and potential appreciation. These will all influence what an appropriate exit strategy might look like, which may vary depending on an investor’s anticipated hold period.
Ultimately, most commercial real estate investors are looking for the same thing: to create stable, passive income that can lead to intergenerational wealth. Investing in NNN leased properties is a great way to achieve that, especially for those looking to take a rather hands-off approach to property management. This lease structure allows them to free themselves from the day-to-day activities, while still reaping the benefits of ownership.
As always, we recommend seeking the guidance of real estate professionals – such as brokers, appraisers, and attorneys – who specialize in NNN properties to thorough evaluate each investment opportunity and to ensure it aligns with your investment goals and risk tolerance.
Are you ready to invest in NNN properties? Contact us today to learn more.