When considering triple-net (NNN) lease investing, how do you ensure you buy the right property for your financial goals and lifestyle without losing money and wasting time? By performing upfront due diligence on the property, tenant, and lease. This precise investigative process is typically not one you, as an investor, can do on your own. One must have access to documentation and information that is not typically available to the public.
That’s why it is best to work with a specialized Westwood Net Lease Advisor who has industry experience, a network of contacts, and a thorough approach. One who performs in-depth due diligence to ensure the investment you choose is sound before you purchase.
What Does it Mean to Perform Due Diligence on an Investment Property?
During the due diligence period, which is typically 30 days after you go under contract on the NNN property, we investigate to confirm that the property and lease are exactly as advertised, that the property is being used as per its legal description, and that there are no surprises. Your offer to purchase will be contingent on the due-diligence results not turning up anything that plagues the investment down the road.
The information disclosed by a due diligence review – tenant financials, lease review, title review and easement details, environmental report, and as-built survey – is typically used to confirm that your investment can go to closing with the original terms. If the review reveals any discrepancies within the due diligence period, it can be used to exit from the deal without risking your earnest money deposit.
When you make an offer on a NNN property, the following five actions are what your Westwood buyer’s advisor will do to conduct due diligence and help you adjust anything necessary to either close the deal or end the transaction.
#1. Review of Tenant Financials
If your NNN investment property is leased by a public investment-grade corporation like Dollar General or Walgreens, all financials and the company’s credit rating are available online. Credit rating agencies, such as S&P and Moody’s, investigate the corporations’ creditworthiness, which makes this part of the process a bit faster and more straightforward than with an independent company.
However, if you’re leasing to a franchisee or small company, it will not have an S&P or Moody’s rating. It is up to your buyer’s advisor to analyze the company’s financial statements and determine whether it is a good, profitable business. Your advisor will look at whether the franchisee or small company financials are on par with industry averages and assess income and EBITDA, which is the true cash flow measure of a business. This part of due diligence is critical to a stable investment, especially with fast-food/QSR properties.
#2. Lease Review
When commercial properties are purchased with a lease in place, which is common with NNN lease properties, the lease contract must be reviewed for hidden clauses and evaluated financially. We want answers to the following questions before you move forward with the purchase.
- Is the lease an absolute NNN with a corporate-guarantee for the full length of the lease?
- Do escalation clauses favor the tenant and not the owner? We want them to favor you, the investor.
- If the lease will expire soon, what are lease rates for newly leased, similar properties in the same area?
- Does the tenant have a renewal option at the end of the lease? If so, what are the terms of the renewal?
- What are the landlord responsibilities; what do those responsibilities entail?
- If NNN lease, is the landlord/owner reimbursed for all taxes, insurance, and common area maintenance (CAM) or does the tenant pay those without landlord involvement?
- Are there termination clauses?
- Are there rent increases?
- Does the tenant have proper building insurance coverage and liability insurance?
- Is there an assignment clause – can tenant assign to another tenant and relinquish its obligations under the lease or does the original tenant stay on board if there is an assignment?
When answering the last question, if the original tenant is allowed to be relieved of duties, are there certain benchmarks written into the lease that need to be met for the next tenant? For example, is the new tenant required to have a certain amount of net worth or number of units they must operate (common with fast-food restaurants and QSRs)? In this case, a lease may be guaranteed by a franchisee with 50 units and have an assignment clause that will only lease to another franchisee with a minimum of 15 units.
It is critical to review the assignment clause in detail, especially for a QSR lease backed by a franchisee.
#3. Title Review & Easement Agreements
When it comes to title and easements, your Westwood Advisor will confirm if there are any property restrictions in place. For example, if you’re purchasing a shopping center that’s already tenanted, there may be a restriction on type of business that can lease from you if there’s another similar type of business in the center. On rare occasions, the restrictions can be so strict, they can severely limit the use of what your building can be used for in the future if your current tenant leaves.
Therefore, it is essential to evaluate the title agreement on all properties. We not only look at restrictions, we look at CAM. Does the owner/landlord have to pay a certain sum for common area maintenance? Is that sum reimbursed to the landlord and is it in the lease? If the property is advertised as a NNN lease property, confirm that it is in fact a NNN and the tenant reimburses the landlord for those costs.
Your advisor will also confirm the actual right of easement, or access to the property, and ensure there are no variances that could affect ownership or tenanting the building.
#4. “Phase 1” Environmental Report
A Phase 1 evaluation is also extremely important. It is necessary to ensure the property has a prior “clean Phase 1” with no historical or current recognized environmental conditions (RECs). If there are prior RECs, a Phase 2 environmental study should have been completed. If the Phase 2 were completed, it would’ve involved an actual dig where soil samples and groundwater were tested for contamination, and we would request those records to ensure a clean property. If a Phase 2 needs to be performed and you still want to buy the property, your Westwood Advisor will help facilitate obtaining bids from reputable sources, secure the best price and timeframe available, and follow the process through to a clean Phase 1.
And finally, as part of the due diligence process, your advisor will solicit bids from regional and national surveyors to survey the property to make sure there are no issues with the construction. For example, the survey will show if the building setback is approved by the city and in compliance with local building codes. Such codes may require a 25 ft. or 50 ft. setback from the street. If it the property is not code-compliant, it is considered an encroachment, which becomes a legal survey issue.
Encroachment is more common with older properties as codes change. If the building you want to buy encroaches, we look to see if it is “grandfathered.” If it is, this is considered a legal non-conforming use, which means you don’t have to demolish the building and move it. However, if your NNN tenant decides to rebuild at any point during the lease term then current zoning laws would take effect with potentially more restrictions. If your impending investment is encroaching, your advisor will help you decide if it is still a wise investment.
To Wrap it Up – Due Diligence is Essential to Ensure a Stable NNN Investment
Due diligence is an essential investigative process that ensures your potential NNN property investment is sound. If any of these five areas turn up any inconsistencies or issues, you could have the right to cancel your offer contract and move on to another property.
However, when you engage a Westwood Net Lease Advisor from the very beginning of the process, we make sure these factors are not only researched but solved to ensure you end up with a stable, valuable asset that provides reliable, long-term income and landlord freedom. Our team represents you throughout the transaction, at no cost to you. Contact us today for a free, no-obligation consultation, 314-997-5227, and learn how NNN investing can benefit your financial future.due diligence, due diligence NNN, due diligence period