Have you been researching triple-net (NNN) lease properties as investments, but you’re not sure where to start the process? Are you overwhelmed with the terminology and what you need to know to make a wise decision? Westwood Net Lease Advisors is here to help you navigate the NNN market – our team enjoys helping new investors learn the ropes and walk them through the process, from pre-property search to closing. So, to help as you work toward making your real estate investment goals a reality, we’ve put together the following alphabetized reference of key NNN terminology and tips for new investors.
Under Section 1031 of the Internal Revenue Code (IRC), a 1031 exchange allows you to invest profits from the sale of one or more investment properties into one, two, or three similar or “like-kind” investment properties of equal or greater value within 180 days, and defer capital gains tax. This is a favorable option to relinquish heavy, high-maintenance or underperforming properties for low or no-maintenance NNN investments.
Absolute Triple-Net (NNN) lease
An absolute triple-net lease is a long-term lease that requires the tenant to pay all expenses, taxes, and insurance. You, as the property owner/landlord, have zero responsibilities. Typically, NNN tenants are high-credit, national corporations that want control of all aspects of their properties for brand recognition, so you just sit back and collect monthly rent with no worries.
In a property exchange, “boot” is cash or other property that’s added to make the value of the traded goods equal. In the case of a 1031 exchange, the IRS does not consider boot like-kind property. Therefore, the capital gains on the base amount remain tax-deferred, but the boot is taxable gain.
A buyer’s advisor is not a salesperson, but a personal representative who ensures your best interests are met throughout the investing process. The advisor-buyer relationship typically begins before the property search and remains until you close on your property investment, and often, thereafter. There is no charge to the buyer for this service.
Capital Expenditures (CapEx)
Capital expenditures are expenses taken when a property is upgraded with a new roof, parking lot, HVAC system, or any other big-budget item that will eventually need to be repaired or replaced. When you own an absolute NNN lease property, CapEx is typically taken care of by the tenant.
Capital Gains Tax
A capital gains tax is a levy on the profits from the sale of a property or properties. In a 1031 exchange, this tax, which ranges from 10-20%, is deferred. After the investment and the exchange is complete, an investor sees a return on the tax dollars that would have been paid to the federal government.
Capitalization Rate (Cap Rate)
The capitalization rate (cap rate) is the level of equity return on your investment and is calculated on an all-cash basis. In an absolute NNN lease property cash transaction, cap rate compares the purchase price of the property to the income (rent) it generates. Therefore, your ROI is simply the cap rate, or rent received, as there are typically no landlord expenses. Example: $60,000 (Net Operating Income)/$1,0000 (Purchase Price) = 6.00% Cap Rate
Cash-on-Cash (CoC) Return
When you obtain debt to buy a NNN investment, your cash-on-cash return is the amount of cash you receive (rent minus debt service) divided by the amount of cash initially invested. Example: if rent earned is $110,000 and your debt service is $50,000, your cash flow is $60,000. If your down payment was $1,000,000, your CoC return would be $60k/$1mm = 6% cash-on-cash.
Common Area Maintenance (CAM)
Common area maintenance charges are controllable and uncontrollable operating costs. CAM is charged in addition to the base rent for maintenance fees and upkeep on the common areas of a property, such as parking lots, outdoor lighting, and landscaping. With absolute NNN properties, the tenant pays all CAM.
A corporate-guaranteed lease is a long-term lease that is guaranteed, as stated in a lease clause, to be paid by the corporation with no franchise involvement.
Cost Segregation Study (CSS)
A cost segregation study identifies and reclassifies costs that would normally be depreciated over a 39-year period into a much shorter depreciation period. A CSS must be performed by specialists with engineering, architecture, construction, and tax accounting expertise.
Cost Segregation depreciation (CSD)
Cost segregation depreciation (CSD) allows money spent on non-structural improvements, such as carpet, indoor and outdoor lighting, heating and cooling systems, and landscaping, to be depreciated over five, seven, or 15 years, versus 27.5 or 39 years. This substantially shorter depreciable tax life helps preserve capital, increase cash flow, and achieve significant tax benefits on new and existing buildings.
Credit Tenant Lease Financing
Credit tenant lease financing allows you to purchase a property by using the rent paid by the tenant as security. Financing is structured as nonrecourse debt, which means the property becomes collateral for the loan. If you default, the lender can only seize the property and cannot sue you for further compensation, even if the value of the property does not cover the loan. If you choose this type of loan, you will most likely receive a slightly higher interest rate and possibly have a larger down payment. Non-recourse debt is typically only available on properties leased to investment-grade tenants, such as Walgreens, Walmart, etc.
A creditworthy tenant is a tenant with strong financials who is typically backed by a corporate lease. If the tenant is an independent franchise owner, to be considered creditworthy, he or she should own a minimum of 50 high-performing locations and provide a lease guarantee, effectively putting the larger, multi-unit organization behind that individual location.
When the sale price of a property exceeds the tax basis or adjusted cost basis, the difference is “recaptured” by reporting it as income. In a 1031 exchange, not only can you defer the capital gains tax, you may also defer the depreciation recapture tax, which can provide an additional savings of 25%. When coupled with the capital gains deferral, a significant amount of capital can be freed up to reinvest.
In a double-net (NN) lease, the tenant pays base rent along with property taxes and insurance. If there is more than one tenant, these fees are split among all tenants, although not necessarily equally. Some tenants may opt to pay a higher base rent in exchange for a reduced share of the expenses.
A gross lease, also known as a full-service lease, is commonly used with multi-tenant properties, industrial, and some retail properties. The property owner/landlord pays all expenses, including property taxes, insurance, operating, and maintenance expenses, then calculates one rent amount that covers all the monthly costs. The tenant then pays a base or “gross” rent, which includes a pro-rated or “pro-rata” share of those expenses.
A NNN ground lease is a land-only rental from 20 to 99 years. As the property owner and landlord, you hold the title on the parcel while the tenant is responsible for all expenses related to the development and improvement of the property, taxes, repair and maintenance, insurance, and financing costs. You collect monthly rent on the land with no responsibilities or landlord expenses. It’s important to note, since the tenant owns the building, the landlord cannot depreciate this type of asset.
Internal Rate of Return (IRR)
Where ROI indicates total growth start to finish, your internal rate of return, or IRR, identifies the annual growth rate. This calculation is less straightforward, but in the simplest of terms, you could add your principal paydown and include any tax write-offs, such as depreciation, to get to the IRR. Taking depreciation and other tax benefits on your investment could turn a pre-tax return of 6% into an 8-10% IRR.
Corporations with a BBB- or better from the bond rating firm Standard & Poor’s are considered “investment-grade” tenants. The higher the credit rating, generally, the more stable the company. When it comes to NNN lease tenants, most will have high ratings with solid financials.
The property owner is the Landlord. This is true no matter which type of commercial real estate is owned – single-net, double-net, or triple-net lease.
Lease Clauses and Lease Term
Lease clauses define every major and minor lease detail, starting with the definition of your NNN lease and basics like property address, amount of security deposit and rent, and length of lease, which is the “lease term.” Lease clauses can be very detailed and usually include things like direct depositing rent and the day it’s due, as well as rent adjustments every so many years, how those adjustments are determined, and renewal options. In the case of corporate-guaranteed leases, corporations will use a form lease, which cannot be negotiated.
A leasehold exchange is a form of 1031 exchange where you purchase land as a replacement property. If part of a 1031 exchange, the new property’s value must be equal to or greater than the price of the property you’re selling, or you may be liable for “boot.”
Letter of Intent (LOI)
A Letter of Intent is used as a non-binding, good-faith proposal by a buyer to a seller that sets the goals for an official offer to purchase and is often used in a 1031 exchange. An LOI is a time saver that crystalizes the prospective transaction details, minimizes misunderstandings, and documents progress toward an official offer.
According to the IRS’s 1031 exchange “like-kind” guidelines, all commercial properties are considered “similar in nature.” Therefore, you would have no problem exchanging an apartment building for a single-tenant NNN convenience store or an office building for unimproved land and taking the tax break, so long as you invest 100% of the capital gains and the property you are buying is equal or greater in value.
Modified Gross Lease
A modified gross lease (MGL) is also known as a double-net lease. This is commonly used for office complexes and retail centers where there are many tenants, as well as some single-tenant units leased by national corporations (Starbucks, O’Reilly Auto Parts). Each tenant pays a portion of the net operating costs directly related to the space they rent (utilities, maintenance or CAM, minor repairs, security, janitorial services, etc.). Tenants either pay operating costs directly to suppliers or pay a portion of the expenses directly to the landlord in addition to rent. The property owner/landlord pays building maintenance and structural costs, as well as the real estate taxes and insurance.
Multi-tenant properties like apartment complexes, retail centers, and office buildings, have multiple tenants paying rent. Different types of tenants with an array of lease durations and types and different industries can help mitigate the risks inherent with these types of properties.
Net Operating Income (NOI)
Net operating income is calculated by subtracting the day-to-day operating expenses from the income a property produces. However, if you invest in an absolute NNN lease property with zero operating expenses, NOI is simply the rent you receive.
Risk tolerance is the degree to which you are comfortable with different types of investments, how you withstand market fluctuations, and what you need for a return on investment. Though NNN lease properties are relatively low risk, there is always a bit of risk with any investment, so it is wise to assess your tolerance.
In a sale-leaseback, a corporation or entity sells its property and/or building yet remains the tenant and maintains control of the site and operations. At closing, the corporation will “sell” the property to an investor and “leaseback” the space with an absolute NNN lease, thereby becoming the tenant.
A single-net lease directs the tenant to pay property taxes plus a base rent. The property taxes are usually paid through the owner in order to ensure they are paid on time. As the owner, you pay common area maintenance fees (CAM), property insurance, and all other operating expenses.
Most often, single-tenant properties are rented by corporate-backed, absolute NNN lease tenants with strong credit. They are typically consumer staples in prime locations that do well in any economy without wide swings in value, so they tend to be lower risk and more recession-proof.
Tenant financials will prove if your tenant is creditworthy. Financially strong corporations with a low risk of default will have an S&P investment-grade rating of BBB- or better. These investment-grade tenants tend to have the most stable financials. If the tenant is an independent franchisee owner with multiple, high-performing locations, perform due diligence on the owner’s financials, as well as the other stores’ history of financial performance.
To Wrap it Up – Know Your NNN Terminology & Consult a Buyer’s Advisor
As you can see, the commercial real estate buying process can be complex – you need a personal representative who will help you learn the NNN industry in-depth, beyond just the terminology, and get to know you and your goals. Westwood Net Lease Advisors focuses on representing first-time and experienced buyers with every step, from the property search through closing – at no cost to you. To get started with absolute NNN lease investing and have the peace of mind that comes from maintenance-free, regular monthly income, contact us today for a free, no-obligation consultation, 314-997-5227.