Triple Net Lease deals are excellent vehicles for diversifying your real estate portfolio. They allow you to balance high-risk deals by providing a steady, reliable source of income that you can hold on to for 20 years or more.
However, just as in any commercial real estate property, investors need to make sure to do their due diligence and ensure they find the right property, with the right tenant, in the right location.
Below are several warning signs of a risky investment.
No two markets are alike. If you consider purchasing a Triple Net Lease property, you need to make sure you have thoroughly investigated certain factors.
Such factors may include:
- local market conditions,
- population demographics,
- employment statistics,
- and any upcoming zoning changes in the area
Using these to evaluate your property’s position will help you estimate the property’s present value and future profit potential.
In terms of gathering data, you can either use a specialized online service, or hire an assistant to gather the date from online websites, city and county offices, or by speaking directly to city officials and residents.
The cost of converting buildings used for specialized tenants can be significant, and there is no guarantee that you will find the same type of tenant as the one that is vacating the property.
Standard buildings fare better, even though they too must be renovated at the end of a long lease. A consultation with a commercial broker who knows the area well can help you find a Triple Net property with a long lease and a tenant that is likely to renew.
Non-Investment Grade Tenant Risks
A stable tenant is essential to the success of any Triple Net Lease property, or indeed, to commercial properties in general. Since their success strongly depends on their business model and financial strength, investigating a potential Triple Net Lease tenant requires delving into data on numerous aspects of the tenant’s business.
Some of the criteria to consider include:
- training and stability of management
- operating margins
- debt to equity ratios
- number of stores
- outlook for the industry sector
Some industries are better prospects than others. Looking at economic or industry trends can give you an idea of the types of tenants that are better positioned for success in today’s economic climate.
For example, drug stores and healthcare facilities are well positioned to take advantage of the rapid growth of the elderly expected to take place over the next ten years. Well-managed brands like CVS and Walgreen’s, for example, are strong investment grade tenants.
Other businesses are not tied to a particular trend, but they historically prove to be quality tenants. Dollar Tree, AutoZone, and McDonald’s are some examples of tenants with strong credit histories that make them ideal tenants.
If you’re unsure about a tenant’s credit rating, it’s simple enough to pull up their credit ratings online. If they are publicly traded companies you should be able to find detailed information such as bond issues and stock analyst reports. With careful examination, you should be able to get a relatively clear picture of how well the parent company is doing.
Refinancing With A Higher Interest Rate
The interest rate of a Triple Net property has an immediate effect on the property’s value.
As the interest rate rises, the value of your Triple Net lease property goes down. So, if you were expecting to get a 6% yield from the rent, and upon refinance, the interest rose from 4.5% to 7%, then you’ll be left with less than 1% spread. This could have a serious impact on profit.
Instead, if investors are unable to purchase the property in cash, they should avoid refinancing unless they can lock in an interest rate and loan terms which are favorable.
End Of Lease Expenses
These are the expenses involved in finding a new tenant. While these can technically be quite high, particularly if the present tenant chooses not to renew and the building remains vacant for a period of time, the cost of renovating the property is born by the tenant, not the investor.
Avoid end of lease expenses in two ways.
- First, choosing quality tenants means they will choose to stay in the place where they have been for the last 15 – 25 years. As long as the location is still a good one, industrial grade tenants will choose to renew when the lease ends.
- Second, if there is any doubt that whether a tenant will renew, DO NOT purchase the property if the tenant is towards the end of their lease.
The truth is that there are risks when investing in any income property. As an investor, your goal is not only to decide what level of risk you feel comfortable with, but to correctly anticipate the best and worst-case scenarios for the future.
A qualified broker will be able to help you work through the numbers, and will also have information about similar properties or other properties in the area.