Are you interested in investing in Commercial Real Estate? In this article, we’ll review one of the most popular commercial property types – “triple-net,” also known as “NNN.” Triple-net deals are usually single-tenant retail properties leased to stable tenants with high credit ratings. This ultimate guide for 1031 exchange and NNN properties will discuss what they are, the benefits and risks, and what to look for when investing in NNN and 1031 properties.
Let’s get started!
What Are NNN Properties?
NNN Properties are usually free-standing buildings that tenants lease for a 10 to a 25-year term. The NNN Properties offer the benefits of little to no management responsibilities as the tenant pays for most, if not all of the expenses. The investor gets their rent with little to no involvement.
Here’s one simple example of a triple-net lease: The tenant pays all of the operating expenses, utilities, insurance premiums, property taxes, maintenance, and repair. The landlord (you) collects monthly net rental income just as she or he would with a traditional real estate investment. This type of lease typically extends over the long term, with a financially strong corporate entity guaranteeing a lease from 10 to 25 years.
NNN properties are usually bought at a CAP rate. A CAP rate is a yield which is calculated by dividing the tenant’s annual payment by the buying price. For example, if Walgreens is paying $325 thousand annually and the purchase price is $5 million, the CAP rate is 6.50% ($325,000/$5,000,000).
The tenant-quality in NNN Properties is divided by the quality and the type of business that the tenants are in. Quality NNN Properties have either credit or non-credit tenants. The most desirable (least risky) NNN property has investment grade (rated BBB and better) credit tenants.
Non-credit tenant NNN properties have tenants who are not credit rated. These tenants are frequently regional or local businesses or companies who are unrated. Some tenants are credit-worthy yet are considered unrated because they bear no debt on their books.
What To Look For In NNN properties?
Three essential components will have a significant impact on the success and quality of your NNN investment. Those are:
The Lease
It’s a critical to have a thorough understanding of what is and is not on the lease. Accordingly, you, your broker, and your attorney should thoroughly read the lease, all supplements, amendments, and exhibits. Make sure to retain an attorney who has vast knowledge and experience in leases.
Part of the relevant things to look for in the lease include:
- The lease type: What’s the lease structure? NNN? NN? You should confirm both the tenant’s and the landlord’s responsibilities assigned by the lease. An absolute triple-net lease should NOT have any landlord responsibilities.
- The lease term: What’s the primary lease term? What are the renewal options? Long-term leases (15 to 25 years) may be preferable to the investors who wish to sell the property after holding it for a couple of years, as leases with major primary term remaining are attractive to more buyers.
- Termination clause: Some NNN leases can have an early termination clause that gives the tenant a one-time option to terminate the lease before the expiration of the primary lease term. This effectively turns a long-term lease into a short-term lease.
- Rights of tenant and landlord: Under what conditions can the tenant terminate the lease? How about the landlord? The lease will contain many other tenant and landlord rights that need to be understood.
- Rent increases: Periodic rent increases can offset inflation throughout the lease term, and help the investment maintain its value. The rent increases will usually be a particular percentage (for example, 15%, 10%, or less) every 5 years, but from time to time, a lease will contain annual rent increases. Annual increases, from a time-value-of-money perspective, are more desirable.
- Financial reporting: Ideally, you, as a landlord, want a lease that requires the tenant to disclose their financial statement to you periodically. This will allow you to monitor their operations’ success. Many franchisee leases require this reporting. However, the majority of parent companies or franchisors will not agree to report this statement, due to competitive concerns or restrictions about disclosure of material inside information.
- Parking: Does the property have a shared or dedicated parking agreement? If parking is shared with other nearby businesses, it can be problematic.
- Insurance: What type of insurance does the tenant carry? Are you named as an additional insured? You may need to ask specifically for a certificate of endorsement.
- CCRs: Covenants, Conditions, and Restrictions are governing documents that may apply to the property if it is part of a larger commercial development. So be sure to review these as a part of the lease review. Pay particular notice whether you are responsible for any maintenance. Also, confirm that the lease points out whether you or your tenant need to fulfill these responsibilities.
The Tenant
Your investment’s success will hugely depend on the success of your tenant. So if you plan to rely on the income from this property, be sure that your tenant is financially strong and that you can expect timely rent payments. Some of the tenant factors you should examine include:
- Lease guarantor: The strength and success of the organization standing behind the lease are critical for the security of your property investment. Large parent companies or franchisors will usually provide greater security than the small franchisee guarantors.
- Financial statements: It’s crucial to review the tenant’s financial information as a part of the due diligence process. Financial statements will be publically available if the guarantor is a public company. If it is a franchise, request a few years’ worth of financial statement as part of your due diligence process before buying a property. Be sure to review the financial information for revenues, operating margins, liquidity, and debt. Ideally, tenant sales will show an upward trend. For franchise guarantors, review the financials for the subject property and the franchise’s other stores, and then compare the property’s results to the system-wide averages. If the results are above average, that’s great for the property’s ongoing stability, but if they are below average, that can be a red flag.
- Units: How many stores does the lease guarantor operate? Some large parent companies can run a few hundred, or even a few thousand, stores. Franchisees can operate anywhere from one store to hundreds of stores.
- Credit ratings: If the guarantor has issued public debt, do check its credit ratings from Fitch, Moody’s, and S&P. A company’s credit rating is an evaluation of its ability to fulfill its obligations. Investment grade credit ratings are better compared to speculative-grade ratings. You can review credit ratings at each agency’s website.
- Operator experience: Review the experience and backgrounds of the operator and management team. If the operator has a significant industry experience, then he or she is likely to have the necessary skills and knowledge of what it takes to be successful in the industry, as opposed to a new, just-starting-out franchisee.
The Location
If you are familiar with this niche, then you know that the location is the most important thing. A good location is crucial to the success of any business, especially retail. When buying a commercial property, make sure to see if the location meets the current tenant’s needs and if it will continue to meet future tenants’ needs. Things to consider when evaluating a location include:
- Visibility: If the customers have a hard time finding a company because they cannot see it, then that business is likely to suffer. A clear visibility from multiple directions is a huge advantage. Corner lots are an excellent example of locations offering good visibility.
- Access: Can the customers get to the building easily? Can they enter from multiple access points?
- Demographics: What are the demographics of the property? Is the population growing? What are the household incomes? Is there strong employment? Are poverty rates low? Make sure to check this all since strong demographics support sales.
- Traffic counts: Locations on great commercial corridors with high traffic counts can translate to higher client counts for a company.
- Parking: Is there adequate parking for employees and customers?
- Activity: Is there a significant consumer activity in the area? Thick retail locations with nearby big-box stores (Wal-Mart) or shopping centers can generate a high consumer activity.
- Track record: A business that has been running successfully at the exact location for a more extended period speaks to the quality of the area. This can take a ton of the guesswork out of assessing a location.
Now here are some of the risks of triple-net investment.
Risks Of NNN Investment
You know that every investment comes with risk. So before investing, it’s essential to understand what the risks are, and how you can mitigate them. Part of the dangers of investing in NNN properties include:
Single-Tenant vs. Multi-Tenant
While single and multi-tenant triple-net properties have similarities, they are different when it comes to particular risks and benefits. Most multi-tenant properties (for example, strip centers) are characterized by leases that might not be absolute Net-Net-Net, and that may place some of the management responsibilities and property costs on the landlord.
Single-tenant Net-Net-Net properties are much more probable to have absolute triple-net leases in place with no management responsibilities or costs borne by the landlord. Also, single-tenant properties will have the most extended leases, typically ranging from 10 to 25 years of the primary term. On the other hand, most multi-tenant leases usually will be between 3 to 10 years.
One of the disadvantages to a single-tenant property is your reliance on a single-tenant for your income. If your tenant fails on the lease, then your income stops. If you have very little or no debt on the property, and if you are wisely budgeting for costs (for example insurance and property taxes), then your risk is much much less than if you have a considerable debt on the property and have to make the loan payment each month. The expense-side of equation increases the need to make sure your property’s location and tenant are strong. Also, if you lose one tenant in a multi-tenant property, then your income drops but not to zero.
Rental Rate
Be sure to always compare the rental rates in the lease to the current local market rental rates. As you may know, commercial property values are calculated by the NOI that the property produces and lease rental rates drive NOI (Net Operating Income). Therefore, if a lease sets higher-than-the-market rental rates, that inflates both the purchase price of the property and the NOI.
Now, if the tenant remains in place, that may be fine – but if the tenant vacates, you might have a difficult time finding a new tenant who will agree to pay that higher-than-the-market rate. If the new rental rate is especially lower than the old rental rate, this can drop the value of your property. On the other hand, if a lease sets rental rates under the market average, it may present a future opportunity – that is, the landlord can increase the building’s NOI and value by re-leasing it at the market rates after the current lease expires or the tenant vacates.
Building Reuse
Special-purpose buildings like gas stations, lube shops, and some fast-food buildings can constitute a problem to the landlord if the tenant vacates. For instance, a gas station is built to be just…well, a gas station. If your tenant leaves, you will likely need to find a service station company to lease, or you’ll need to alter the premises significantly (at your cost) to make it acceptable for a new nongas station tenant.
General-purpose buildings, like offices or box-type stores, are usually cheaper and easier to renovate for other tenants’ use than special-purpose buildings.
Benefits Of NNN Investment
Now that we’ve reviewed part of the risks of investing in triple-net properties, let’s look at some of the compelling benefits that Net-Net-Net leases offer.
Stable, Long-Term Income
As we have mentioned above, single-tenant triple-net leases can be for long terms – up to 25 years, plus there are plenty of renewal options. A lease of this time span, secured by a strong tenant (and with continual rent increases), can provide you the security of long-term, stable income.
What About A 1031 Exchange And Ranch Property
Let’s talk about a 1031 Exchange for Ranch Property. Consider that returns of equity on ranch operations vary (as measured by cash flow), but in general, they fall in 1% to 2% range. Alternatively, high-quality real estate investment can provide cash flow returns of 5% in the current market. Therefore, those who decide to sell ranch property and reinvest into commercial real estate can earn a significantly higher income. So, maybe it’s time to sell that property and reinvest through a 1031 Exchange.
1031 Exchange
Are you selling a highly appreciated ranch or farm? If yes, then the 1031 exchange gives you an opportunity to take advantage of the two compelling benefits of this good tool – wealth accumulation and tax deferral. With a 1031 exchange, you can preserve the equity that you’ve built up on the farm by deferring taxes on the sale. It is possible not only to delay capital gain taxes but also to eliminate them indefinitely by holding the replacement property (or exchanging it into other properties) until the end of time.
Under the current tax law, when a ranch is inherited after you pass away, your heirs get a reinforced tax basis to the upright market value of the property. If they then decide to sell the property, they can sell it for little or zero gain and entirely avoid the capital gain tax.
Furthermore, not only you are saving taxes with an exchange, but by reinvesting the sales profits that would have been lost to paying the capital gain tax, you’re putting that saved capital to work, creating more wealth and generating more income by buying more and more real estate.
Relief from Active Management
Those who are selling ranches and farms and exchanging into NNN properties are usually converting because of a couple of factors. These factors are (often) that they want to decelerate the business-pace of life a little (and perhaps follow some other interests now that they are not running their ranch operation), and they do not want to reinvest into a role that involves the management of rental properties. Absolute Net-Net-Net leases require that the tenant presumes all management responsibilities and costs of the property. This will allow you to enjoy a passive real estate investment and just collect your monthly rental check.
Inflation Hedge
Many triple-net leases provide rent increases all the way through the primary term of the rental agreement and the renewal options. The rent increases can help shield against the effects of an inflationary environment. Also, any future appreciation of the property can be an effective shield against inflation, too. Appreciation will be largely determined by the overall commercial real estate market conditions.
Tax Shelter Through Depreciation Deductions
Current tax law allows the commercial buildings owners to “recover” the costs of their investment through depreciation deductions. Thus, you can offset part of the rental income that you receive with depreciation deductions.
However, note that if you’re completing a 1031 exchange, the basis of the property you sold (your relinquished property) will carry over to the property you purchased (your replacement property). If you are selling a ranch or farm that has been in your family for many years, you probably have a little tax basis in the property. And in this case, you can have limits on your depreciation deductions. Contributing cash or increasing debt to the purchase transaction will build an additional depreciable basis for deduction purposes.
Note: if you are purchasing a ground lease property, you will not receive depreciation as land cannot be depreciated.
Having mentioned that, let’s learn what a ground lease is.
What Is A Ground Lease?
A ground lease is a way of separating ownership of the building (improvements) from the ownership of the ground (underlying fee). Usually, ground leases are long-term NNN Leases where the tenant pays all the expenses except the debt service. The tenant also pays any financing for improvements. The ground lease, in some cases, is subordinated to the debt on the buildings.
On an unsubordinated ground lease, there’s no lien placed against the underlying fee simple title to the land. Rather, the leasehold estate is the primary security for the debt on the buildings. There’s no depreciation with the ownership of the ground lease.
Many investors opt for ground leases because they do not need to use their own money to build the buildings, and end up owning the buildings on completion of the lease. When the NNN lease ends, the buildings return to the owner of the ground lease and the owner benefits from the full rent from both the buildings and the land.
Tenants love ground leases because they minimize the tenant’s cost of development by removing land acquisition expenses. A long-term triple-net lease provides predictable rental payments that are deductible by the tenant for state and federal income tax purposes.
Usually, ground leases are long-term Net-Net-Net Leases and include foreclosure rights, set rent escalations, and returning right (buildings return to the owner of the ground lease at a termination of the lease).
Triple-Net Lease Alternative
Are you considering NNN properties but would like to invest less cash and still have little or no management responsibilities? Then Tenant in Common (TICs) is a great option to consider.
Advantages of TICs are the lower minimum investment (beginning at $50,000), due diligence material, and prepackaged financing (if any). Because TIC’s are a deeded interest and not a security like REIT or mutual fund, they qualify for a 1031 exchange providing they follow IRS Rev Proc 2002-22.
However, the most frequent objection to TIC ownership is that TIC owners have a proportionate vote on the major ownership issues (as opposed sole decision-making power in the case of 100%-owned triple-net properties).
TIC investors can invest in fractional ownership of triple-net properties and another multi-tenant real estate. A significant advantage of TIC ownership is the ability to minimize the overall risk by diversifying into multiple investment properties.
If everything is clear about NNN investments, let’s go back to the 1031 exchange to discuss further.
What Is A 1031 Exchange?
A 1031 exchange refers to the section 1031 of the Internal Revenue Code Section that allows an investor to sell a property, reinvest the money in a new property, and defer all capital gain taxes.
Why 1031?
With a 1031 exchange, investors can consolidate, trade up, leverage, diversify, or relocate their investments and not be charged by having to pay the capital gains or recapture (the sum deducted while owning a property is taxable if that property is sold). The taxes are postponed until the investor makes a non-1031 Exchange sale or until the property goes to the investor’s estate. When the property goes into an estate, there’s step-up in basis to it at that time-current market-value.
1031 exchange can be both a mighty wealth-building machine and a way of adjusting the investment portfolios to more accurately reflect lifestyle choices and circumstances.
Here’s an example: An apartment owner wanting to trade into Net-Net-Net Properties or TIC properties that require little or no management responsibilities.
Other investment objectives are to modify the amount of risk and unpredictability of one type of property, boost cash flow or to take the topmost amount of money out of a real estate holding without provoking any taxes by using a Zero. And what is a Zero?
Zeros are used by investors who sell highly leveraged properties, and also by investors who have given up the property in foreclosure and for real estate planning purposes when no need for immediate cash flow. Typical leverage for Zeros ranges from 80% for fee simple properties to 90% for leaseholds.
Guidelines for 1031 Exchange
There are specific 1031 exchange requirements for identifying like-kind replacement properties in your 1031 transaction.
- The equity in the 1031 replacement property has to be equal or higher than that in the relinquished property.
- The value of the 1031 replacement property has to be equal or higher than that of the relinquished property.
- All of the net profits from the sale of the 1031 relinquished property have to be used to acquire the 1031 exchange replacement property.
- There’s a prohibition of constructive receipt of sales profits during the 1031 Exchange process.
- One has to follow deadlines for identifying and closing the 1031 replacement property.
What are 1031 Accommodators and Qualified Intermediary?
1031 Accommodator and Qualified Intermediary are the same. Frequently, 1031 Accommodators are called QI (short for Qualified Intermediary). Their role is similar but not entirely identical to that of a real estate escrow company. They handle the paperwork and transfer of title for 1031 exchanges (unlike the escrow company).
The seller of the 1031 Exchange property goes into a written agreement with the 1031 QI. The duties of the 1031 QI include transferring the 1031 replacement property to the seller and transferring the relinquished property to the buyer under the 1031 Exchange agreement. The 1031 QI holds the profits from the sale of the abandoned property beyond the actual control of the taxpayer of the 1031 Exchange property.
The 1031 QI also prepares the needed 1031 Exchange documents to accomplish a tax-deferred 1031 Exchange. That includes documenting the accurate identification of the 1031 replacement property within the 45-day time limit.
Anyone who’s related to the seller, or who have had some financial relationship with the seller within the two years before the close of escrow of the 1031 exchange cannot be used as the 1031 QI or Accommodator. That means that the seller cannot use his or her current attorney, real estate agent, or certified public accountant as the 1031 QI.
A 1031 QI or Accommodator should be properly insured and bonded. Relevant education and experience in tax, finance, or law are highly desirable. 1031 Exchange finances should be kept in a separated account (not commingled with other money) and placed in highly secure investment instruments.
What is 1031 Exchange Like-Kind?
Real or personal property of the exact nature or quality is like-kind in a 1031 Exchange. Usually, 1031 Exchange real property is like-kind to all other real property as long as it’s held for investment in a trade or business. A foreign real property can be exchanged for a foreign real property while a US property can only be exchanged for a US property. Personal property has to be either the exact General Asset Class or a Product Class for a 1031 exchange.
What is a “Multi-Asset” 1031?
A multi-asset 1031 Exchange includes both real and personal property. For instance, the sale of a hotel often involves both real estate and equipment and furnishings. In this instance, a 1031 Exchange would be done for the building and land and another 1031 Exchange for the equipment and furnishing in a separate 1031 exchange.
To Wrap-Up
Owning commercial real estate is a different means of living off the land. Rather than you working the land, in a commercial real estate, the land and building work for you.
For farming families who sell highly appreciated real estate and who want long-term, steady income with little or no management responsibilities, NNN lease properties can make compelling sense when utilizing a 1031 Exchange.
