3 Things to Watch Out for When Buying a Triple Net Lease Property

Nov 24, 2021 | Blog, CRE - Commercial Real Estate, Triple Net - NNN or Net Net Net

Triple net (NNN) properties present numerous opportunities for investors interested in earning a steady stream of reliable income. Even if you prefer high-risk investment properties, NNNs are an essential addition to any portfolio – their low-risk, management-free nature is a great way to diversify your holdings and provide a guaranteed source of income you can count on, potentially for decades.

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 the areas that warrant special consideration.

1. NNN Tenant Creditworthiness

check box on paper "are you at risk of losing money?" yes or no

The value of commercial real estate (CRE) investments is strongly influenced by the strength of the tenant. Tenants should 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.

When it comes to triple net lease tenants, they are responsible for covering nearly all expenses associated with the property. This includes utilities, property taxes, insurance, and repair and maintenance costs in addition to the monthly cost of leasing the property. That’s why it’s especially important you ensure any tenants you consider when purchasing a NNN property are creditworthy.

The best way to do this is to evaluate tenant creditworthiness using a standard rating system such as Standard and Poor’s (S&P Global Ratings), Moody’s Investors Service, and Fitch Ratings. S&P is generally the most trusted rating when evaluating CRE properties.

Types of Credit Ratings

S&P Global Ratings assigns credit ratings ranging from AAA to D. Ratings to reflect a candidate’s ability to meet their financial commitments are 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.”

When it comes to NNN 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 type. These investment-grade tenants provide greater stability of income and value and can reduce your exposure to risk in a volatile market.

2. Determine the Strength of the Lease Agreement

Commercial Lease agreement with money on a table.

As hinted 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 an absolute triple net lease when really it’s a modified triple net (NN+) or even a double net (NN), which often have a lease clause stating that the landlord is responsible for roof, structure, and/or parking lot. 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, are they connected to fair market rate? This is important since NNN leases can range anywhere from 10 to 20 years, but if there is no accommodation made for inflation, you as the owner could end up losing a great deal of money.

The next area you’ll want to investigate is the taxation burden and other fees as defined in the lease. In triple net leases, the burden of paying property taxes and insurance, common area maintenance (CAM) fees, and any other fees are typically paid by the corporations backing the lease.

In modified NNN leases, the taxes and insurance are usually paid by the tenant, however, some CAM charges may not be – this is why it’s important to read the entire lease and know exactly where your responsibilities lie.

3. Watch Out for Inflated Lease Rates

At first glance, many investors would be thrilled to have a tenant that pays more than the market rate for their lease. After all, who doesn’t want to make more money? But watch out for inflated lease rates.

Believe it or not, this is actually something you want to avoid, for three important reasons.

  1. 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 more money than you should.
  2. What will happen when the lease ends for this tenant? They may 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.
  3. When you’re left with a vacant building, in addition to the costs you’d incur marketing the property, you now have to pay all the expenses that were previously the 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. If you’re unable to get that data, you can 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.

If you want to know true standard market prices, the easiest and most reliable way is to reach out to a Westwood Net Lease Advisor who can provide that information to you, at no cost.

To Wrap it Up – Understanding Tenant Credit, Lease Lingo, and Inflated Lease Rates Will Help You Purchase the Best NNN for Your Goals and Avoid Disappointment

Businessman with dollar sign .

Don’t let understanding tenant credit, lease lingo, or inflated lease rates warn you off of buying triple net properties. 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 both feet.

If you would like someone else to take care of the NNN due diligence details and steer you in a direction that’s best for your NNN investment goals, Westwood Net Lease Advisors uses a true advisory approach. We are unique in that we put your needs first – before the sale. When the upfront consultative process primarily cares for your needs above all else, you’ll enjoy a real estate purchase that’s low-stress, comfortable, and stable. Let us know how we can help! Contact our team for a free no-obligation conversation. 314-997-5227


 

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