Triple net properties present numerous opportunities for investors interested in earning a steady stream of passive income.
Even if you prefer high-risk investment properties, triple nets are an essential addition to any portfolio; their low-risk, management-free profile are a great way to diversify your holdings and provide a stable source of income you can count on.
As with any investment, due diligence is essential, but since the strength of a triple net is largely dependent on the quality of the tenant and the lease, these are two areas that warrant special consideration.
Evaluate Tenants’ Creditworthiness
The value of commercial properties is strongly influenced by the strength of the tenant. Tenants need to be able to cover rent and utilities, and in the case of office and some retail tenants, share in the cost of maintaining public spaces.
Triple net lease tenants are responsible for covering nearly all of the expenses associated with the property. This includes utilities, property taxes, insurance, repair and maintenance costs on top of the monthly cost of leasing the property. That’s why it’s especially important you ensure any tenants you consider are able to meet their financial obligations.
The best way to do this is to evaluate tenants creditworthiness using a standard rating system such as Standard and Poor’s (S&P), Moody’s, and Fitch. Standard and Poor is generally the most trusted rating when evaluating commercial investment properties.
Types of Credit Ratings
Standard and Poor assigns credit ratings ranging from AAA to D. Ratings reflect a candidate’s ability to meet their financial commitments and use a combination of letters, pluses or minuses to indicate strength.
AAA is the highest rating; signifying “extremely strong capacity to meet financial commitments,” and the lowest is “D” which indicates the candidate has already defaulted. A BBB rating means the company has “adequate capacity to meet financial commitments, but is more subject to adverse economic conditions.”
For triple net lease properties, tenants with a minimum of BBB (with any combination of pluses or minuses) provide the least risk of default and are the preferred tenant. These investment grade tenants provide greater stability of income and value, and can reduce your exposure to risk in a volatile market.
Determine the Strength of the Lease Agreement
As hinted to earlier, when you buy a triple net lease property you’re really buying the lease rather than the property or the land. If the property were empty it would have less value, and as the quality of the tenant increases so does the value of the property.
Occasionally an investor will buy a net lease property with the assumption that it is a pure triple net lease, when really it’s a modified triple net or even a double net. That’s why it’s critical you examine the lease carefully before you start inspections, market research, or any other due diligence activities.
One particular area of concern is whether or not the lease specifies periodic rent increases, and if so, if these are connected to fair market rate.
This is important since triple net leases can range anywhere from 15 to 25 years, but if there is no accommodation made for inflation, you as the owner could end up losing a great deal of money.
The second area you’ll want to investigate is the taxation burden.
In triple net leases, the burden of paying property taxes and insurance, common area maintenance fees, and any other fees decided between the tenant and the owner. Even those there may be a specified amount in terms of fees, these are tentative and can change after reconciled.
This can become a big problem for tenants when a property is sold, as the tax basis can suddenly jump dramatically higher. As the new owner, this could mean your tenant who was otherwise financially stable could suddenly find themselves unable to pay.
Watch Out For Inflated Lease Rates
At first glance, many investors would be thrilled to have a tenant that pays more than market rate for their lease. After all, who doesn’t want to make more money?
Believe it or not, this is actually a problem you want to avoid, for two important reasons.
Number one, if a tenant is paying more than the real market price for rent, that means the sale price will also be higher than what it should be. The sale price of a triple net property is based on how much cash flow the property brings in, and if this number is inflated, then you’ll end up paying way more money than you should.
Second, what will happen when the lease ends for this tenant?
They may very well decide to move to a different property. Even worse, they may go out of business, and then you’ll be stuck with a property that can only be solvent when the tenant pays a higher than normal market rate.
This doesn’t even include all the expenses that come with a vacant building, since in addition to the costs you’d incur marketing the property, you now have to pay all the expenses that were previously your tenant’s responsibility.
That’s a lose-lose proposition that could force you to sell the property at a loss.
The best way to avoid this is to investigate standard market rates, but if you’re unable to get hold of that data, you can also compare the replacement value to the purchase price.
Simply break down the price per square foot for each, and evaluate the difference between them. There is a correlation between what it costs to rebuild a property and the market price, and although they won’t be exactly the same, if it’s too high, then the tenant is likely paying rent that is wildly out of line with market prices.
Don’t let these factors warn you off of buying triple net properties, however. Triple nets are known as steady investments for a reason. But like any commercial real estate investment, you need to do your due diligence before you jump in with two feet.