If you’re an experienced commercial real estate investor, then you already know how powerful a triple net lease is.
The steady income, freedom from management responsibilities, and no-hassle tenants make NNN’s a shoo-in for investors interested in diversifying their portfolio with a stable long-term investment.
Unfortunately, finding a great triple net isn’t always easy; competition is stiff, and finding a true triple net in just the right location can be difficult without the right connections.
As a result, many investors are choosing to skip to the head of the line by building their own net net net property and offering it to creditworthy tenants.
This type of property is called a build-to-suit, and although it always involves a developer building a property according to a particular tenant’s specifications, there are two different ways for investors to get started.
The first way is to work with a specific tenant, becoming familiar with their exact needs, only afterward looking for a specific property that suits their specifications.
The second method involves looking at a particular location – one that is particularly suited for a triple net lease – and then finding the best tenant for the spot. In this case the developer would offer the tenant to more than one tenant. If the location is an excellent one and the tenants well-chosen, the developer could end up with several national tenants vying for their property.
Build-to-suit NNN leases are a great profit opportunity. However investors who fail to set up the terms of the triple net properly risk investing a boatload of money on what could end up a standard commercial property – if they’re lucky.
How to Calculate the Base Rent
As an investor, your goal should be to charge as much rent as the market will allow. It’s reasonable to assume that since you took the risk of building on a vacant piece of land, any property you offer on that land should go for significantly more than the land-inclusive replacement cost.
Of course you should check with a local broker experienced in triple nets to ensure you have an idea of the range of prices for the area, but don’t assume you have to base your cap rate on the land and construction costs.
When you charge premium prices, tenants are paying for the potential of owning a property built especially for them in an excellent location, and a well-positioned franchise will realize that fact immediately.
Instead, make sure you negotiate for the highest possible rent you can, adding in a minimum of 10% increases every five years.
How to Handle Rent Escalation Clauses
Rent escalation clauses, also known as rent escalators or “lease bumps,” are clauses that increase the base rent over a set period of time.
Rent escalators can take several forms. Some increase just rent, while others increase operating costs. There are also rent escalators that increase both rent and operating costs.
Increases can be in the form of percentages, such as a 3% increase yearly, or a flat increase, where the rent goes up by a certain amount per square foot. If the increase is a variable increase, then it is tied to the Consumer Price Index, which tracks the prices paid by consumers for goods and services.
The Bureau of Labor Statistics publishes the CPI; however more than one CPI is published. There are several CPI’s, depending on location, the type of consumer, the type of goods and services, and the base index period.
Basically, there are two different CPI’s published: one for urban consumers, and one for urban wage earners. Though these account for 87% of the population, the remaining 13% (who are farmers, prisoners, long-term hospital patients, and those in the military) are not included, since their numbers tend to be distorted due to subsidies or self-sufficiency.
However, within these two categories – CPI-U and CPI-W, there are indices for metropolitan areas, urban areas, regions, and more. So you’ll need to specify on which CPI to base the rent escalator on.
Once you decide which CPI to base your rent escalator on, whether to use a fixed or variable increase, and how much it should be, it’s time to decide the percentage rent.
Determining the Percentage Rent
Percentage rent requires tenants to pay an additional amount of rent based on a percentage of gross sales. While base rent is usually based on square foot and is a fixed sum, percentage rents kick in after after a certain number of sales, termed the breakpoint.
The breakpoint can be natural, which means the percentage rent is calculated by dividing the base rent by the percentage decided upon by the owner and tenant. It can also be artificial, which means the percentage rate is determined by choosing the amount of sales in dollars at which the percentage rent will apply.
Again, it’s critical to consult with both an experienced broker and a lawyer when drafting the lease, as the terms of the lease will have a major impact on the value of the lease, and therefore the property.
Don’t Forget Option Terms
Option terms, or the terms for lease renewal, are nearly as important as the lease itself.
There are four parts to a renewal clause: Notice period, term, rental rate, and fair market value. The notice period ranges from anywhere to six to 12 months, and is the length of time a tenant has to notify you that they plan to leave.
The term is the amount of time the tenant can renew the lease for; some owners and tenants prefer to give more flexibility by providing more than time period for the tenant to chose from, for example four or six years. And lastly, the rental rate is the amount of rent to be charged, which will usually be determined by fair market rate.
Of course, what counts as fair market value depends on how it is defined. It may include tenant improvements and concessions, or it may include a maximum percentage of FMV. Whatever you decide, it is critical not only that the language be clear, but that an option to allow a third party arbiter should be included in case of disagreement between the owner and tenant.
Build to suits offer plenty of opportunity for investors willing to go the extra mile. Despite the risk involved, they offer the potential of as much as 30 years worth of predictable passive income.