As an experienced commercial real estate investor, you know due diligence is essential before purchasing an investment property. But what about triple net properties? How much due diligence do you need to do when investigating an NNN property? If the tenant is responsible for nearly all of the expenses, should your main concern be the tenant? And if things do go awry, are you responsible, or is the parent company?
Not All Triple Nets Are Winners
Many investors assume all triple net leases are slam-dunks, when the truth is, not all triple net tenants are the same. Some may be instant winners, such as Amazon or Walmart’s. These tenants have excellent credit ratings and are the cream of the crop when it comes to triple nets.
Other tenants may be well-known in the industry but are rife with problems like a change of ownership, multiple store closures, and employee layoffs.
Don’t be fooled by a tenant’s street rep: you must still do thorough due diligence on a triple net property, just as you would with any commercial property.
Make Sure You Have A Stable Tenant
As an investor, you have the choice between a national, regional, or local tenant.
It’s easy to assume that if you have a choice, a national tenant would be the best choice. However, it’s not always that simple. National tenants do tend to have better credit: they’re large enough and have been around long enough to establish a credit rating at S&P or Moody’s. These tenants are also backed by a guarantee from the main corporation, which theoretically means if something happens to your tenant, the headquarters should be able to bail them out – or at least pay your lease.
Sadly, that’s not always the case. If the main company goes under or files bankruptcy, then you’re out of luck. Even if they file for a reconstruction bankruptcy, which allows them to renegotiate the lease, you can bet they won’t be coming back to you to offer you more money.
You’ll have no choice but to accept the new terms or take the very risky move of trying to find a new tenant. That means you’ll stop getting the little bit of money you would have gotten from the reconstruction deal, and you’d still need to pay commissions and tenant improvement costs. And that’s assuming that you find a tenant who is willing to pay more than the reconstruction offer.
The same thing can happen if the parent company is bought out by another company. Not long ago I heard from a fellow broker about an investor who’d bought a triple net property, hoping for a steady income, only to have his regional tenant go belly up.
Another company took over the failed one and paid a penalty fee to end the lease. As luck would have it (or bad luck, as the case was), the same company that took over the failed company also owned the loan. So after they canceled the lease, they still demanded repayment of the bank loan… in a timely manner.
That left this investor looking high and low for a tenant for his property, which was specially outfitted for his previous tenant.; it also needed to be retrofitted before another tenant would be willing to sign a lease. Of course, that ended up costing more than what they received for the termination penalty, so they had to go for a refinance as well.
Get A Personal Guarantee
Regional and local tenants are at a higher risk of default and may be more susceptible to local economic conditions. However, you can minimize some of the risks by insisting on a personal guarantee as part of the terms of the lease.
Make sure, however, that the business owner has the finances to back up a personal guarantee.Keep in mind that their personal worth has to equal or exceed the value of the lease; if the business fails, you need to be able to collect the value of the lease.
If they have very little personal worth, then a personal guarantee won’t give you any recourse in the event of non-payment. But if they have a trust fund, own other properties or another business – basically anything else that isn’t connected to the success of the business under lease – then that should be enough to guarantee the lease.
The Terms Of A NNN Lease Are Critical
There are two main factors that distinguish a triple net lease from other types of commercial leases. One, triple net leases are longer than typical commercial leases. Whereas a standard commercial lease can last anywhere from one to five or so years, a triple net lease ranges from 10 to 20 or even 30 years.
Second, tenants are required to pay nearly all expenses, including property taxes and insurance, repairs and maintenance, all fit-outs, and more.
As the buyer, it’s your responsibility to take a good look at the terms listed.
Can You Replace The Income If The Tenant Leaves?
The ideal scenario for most investors interested in triple net properties is for a tenant to stay for the entire lease, and preferably, renew once the lease ends.
It’s wise, however, to prepare for the worst-case scenario: namely, what would happen if your tenant up and left in the middle of the lease? Would you be able to find another comparable tenant?
Many investors brush over this question, but the fact is that many commercial properties are renovated to accommodate a particular tenant. That means that unless you get very lucky (unlikely), you’ll most likely end up with a building that is impossible to re-use for another tenant unless substantial improvements are made.
Truthfully, fit-outs are necessary, so it isn’t much you can do about this if you’re already the owner of a triple net property, other than making sure the tenant has a high chance of success as discussed above.
However, if you are considering purchasing a triple net property, do check when the lease is due to end, since if it is due to end within a few years of acquiring the property, you run the risk of being stuck with a property you’ll have to put money into in order to get some cash flow running again.
Despite all of the above, triple nets are still a great investment. If you find a good tenant, you can enjoy all the benefits of a management-free property that gives you a steady income. You just need to make sure you treat triple net properties like the commercial income property they are, and not like an ATM machine that is guaranteed to dispense money.