Net leases are becoming an increasingly attractive option for investors looking for a stable, hands-off investment property.
A quick refresher; a net lease requires tenants to pay for some property expenses the owner would typically cover. These added costs are in addition to their rent and may include things like utilities, maintenance, real estate taxes, and insurance.
In general, a net lease renter is going to be a single tenant of a free-standing building. So, this might include a bank, a fast food restaurant, or a store.
Investors looking for a safe place to keep their money are drawn to net leases. Leasees are on the hook for years at a time, giving investors a stable, predictable income.
Investing in long-term single tenant leases may provide far more stability than you’d find with your average apartment building or office park.
Now, this is just generally speaking. There are a few different types of net leases. Here’s a look at the difference between a triple net lease and a net lease, as well as some of the variations in between.
How Net Leases Work
In a traditional lease, the landlord takes on the responsibilities of caring for the property. They’ll pay for property taxes and maintenance, and often, certain utilities. These expenses are typically built into the rent charged to tenants.
Traditional leases are far more common than net contracts, but they put more risk on the landlord. Net leases, put some of those risks onto the tenant.
Here’s a look at the different types of net lease agreements:
Single Net Lease
Single net leases aren’t very common, as less risk is placed on the tenant. In this case, only property taxes are covered by the tenant, while the landlord is still responsible for maintenance and other expenses.
Double Net Lease
Double net leases are relatively common in commercial real estate. The tenant pays insurance and property taxes, while the landlord still deals with maintenance.
You’ll see this model in places like shopping malls or office parks—as these are multi unit spaces. The landlord can divide these costs among tenants based on the amount of space they rent.
Triple Net Lease
Triple net leases or NNN leases give landlords the least amount of risk out of the three. Tenants pay property taxes and insurance, as well as all of the maintenance costs.
As we mentioned above, this model works best with tenants renting a freestanding unit, as they can operate autonomously.
Still, this arrangement isn’t always ideal for the tenant. Often tenants attempt to break a lease when they find maintenance costs exceed their expectations.
To prevent this from happening, landlords may opt into a bendable triple net lease. This arrangement stipulates that a tenant cannot break free from their contract until the expiration date outlined in the lease. Rent cannot be altered, even if maintenance costs exceed the monthly payment.
Net Lease vs Triple Net Lease Properties—Which Is Better?
A single net lease is a commercial real estate agreement where the tenant pays the property taxes and the rent. As mentioned above, a net lease might be a lot of work. Property owners will still need to take care of certain expenses, like insurance and repairs. As such, it can be a challenge to calculate monthly income, as things like structural repairs can come into play.
A triple net lease, by contrast, is an investment that works for folks with a busy schedule. You’ll get a better ROI when all three nets are accounted for—taxes, insurance, and maintenance.
Why Single Tenant Triple Net Leases Are Perfect for Generating Passive Income
Single-tenant triple net lease investments are ideal for risk-averse investors. This is a real estate ownership that goes beyond a piece of paper—it’s an agreement that puts the investor in a passive position, while the tenant receives a property they can make their own.
This type of investment is suitable for anyone looking to buy commercial property. Because the tenant handles typical landlord duties, a triple net lease is ideal for someone who is too busy to deal with HVAC issues and structural repairs on their own time. Think retirees, remote landlords, and working professionals.
This is also an excellent opportunity for out of state investing. Because management duties are off the table, it doesn’t matter so much if you’re close to your investment property.
What’s more—certain states like Washington, Florida, Alaska, and South Dakota are income tax-free states, so you may get some additional tax benefits if you buy in these areas.
What Are the Risks of Single-Tenant Net Lease Properties?
The main concern for the investor will likely be early termination clauses.
Triple net leases do transfer most of the risk to the tenant. However, there are some cases where the landlord may be responsible for certain expenses.
In the case of an older unit, a landlord may be on the hook for structural repairs. Additionally, things like legal and accounting expenses are not covered by the tenant.
Credit vs Non-Credit Tenants
A tenant’s financial strength is a huge factor when it comes to obtaining funding and determining risk. This, in turn, affects your ROI and financing options.
Credit tenants are companies that have investment-grade ratings with one or more of the three major commercial credit agencies—Moody’s, Fitch, or Standard & Poor. Companies that fit the bill are large companies—public, well-known entities with stable finances and a low risk of default.
For single tenant net lease agreements, your ideal tenant is likely a large chain—think fast food restaurants, a new Whole Foods, a Walmart, and so on.
Non-credit tenants can be any type of business. Local mom and pop shops fall into this category, as well as standalone restaurants and franchises.
These tenants don’t have the financial stability or track record you’ll find in a large public company, so they pose a greater risk in the event of a downturn.
That said, credit tenants often provide a lower return on investment—you know how it goes, with greater risk comes the possibility of greater reward.
The other difference between the two groups is that credit tenants and non-credit tenants begin the lease with different terms in place.
A credit tenant may start off with a 20-year lease, which again, gives the investor a steady, long-term income. Non-credit tenants may be given much shorter terms—say, five or ten years, as they’ve yet to prove themselves as reliable debtors. In both cases, leases usually have terms that tenants can renew down the line.
Net Lease Terms and Financing
The definition of net lease varies considerably. As such, you’ll need to make sure that you go over the ins and outs of what the contract includes.
When you find a property, the first thing you’ll want to do is obtain a copy of the existing lease before diving into market studies and negotiations. You might find that there’s something in the contract that disqualifies the property—thus wasting a whole lot of time.
Property owners should focus on the terms of the lease. More often than not, investors will be taking over a property that already has a tenant installed.
This is an essential factor when it comes to financing. If you’re buying a property with say, three years left on the lease, it will be difficult to secure a loan for that time frame.
Instead, loan terms should track with financing. If a tenant has five years left in a 15-year lease, the investor will likely get a loan with no more than a five-year term.
Loans are generally offered in 5, 7, and 10-year terms, so keep that in mind when you’re looking for a property. If you’re considering a property with just a couple years left, you’ll need to start considering renewal negotiations before the lease ends.
You may need to sweeten the deal for tenants with incentives to get them on board early. Having these agreements in place before the initial investment can help lenders feel good about a longer-term loan.
Other Tenant Considerations
In NNN investments, half of the value of the venture lies in the physical real estate—location, condition, and use. The other half lies in the quality of the tenant.
In addition to the credit score and profile, you’ll want to look at the tenant’s business plan, sales numbers, and
If you’re looking at leasing to public companies, you’ll want to consider things like the demographics the company caters to, compared to the people that live and work where the property is located.
You’ll also want to look at how businesses like your potential tenants are performing in similar areas. Are there a lot of closures in this industry? Is the company closing stores? If you’re looking at fast food restaurants, has the company had any recent outbreaks?
Do You Need to Work with a Property Management Company for an NNN Investment?
No. Again, the whole benefit of the NNN arrangement is that your responsibility as a property owner is kept to a minimum.
Best case scenario, your tenant is a multi-million or billion-dollar company that deals with all of its own property taxes, maintenance, and insurance.
Leaseholders are concerned with appearances themselves. As such, you can rest assured that the vast majority of tenants will do their part and take good care of your building, keeping up with paint jobs and roof repairs to make a good impression on customers.
When Is the Best Time to Invest in a Net Lease Property?
Net lease properties are good investments in just about any economic climate. Net lease investments don’t come with the same level of risk as other investments.
Provided you do your due diligence and pick a credit-worthy tenant; you’re looking at a regular income for 10 to 25 years at a time. This is regular checks coming in from a Chase bank or a Home Depot. You’re not playing the stock market or dealing with all of the moving pieces of a multi-tenant apartment building with short terms and high turnover.
What Do You Need to Make a Triple Net Lease Investment?
In case you were curious about what it takes to get the ball rolling on your next commercial real estate investment, here’s are the basics for finding and securing an NNN investment of your own.
Look at the Physical Real Estate
Like any real estate investment, you’ll want to evaluate the asset before pulling the trigger. While you’ll be passing off the tax burden and most repairs, it’s essential to get a sense of the space—from the parking lot to the condition of the unit, early on.
Ultimately, the value of the property itself is the long-term investment. If your tenant vacates the space, you’ll need to be able to rent it to someone else.
You’ll want to look at the property in person. Look at the office spaces, the retail space, and consider how the tenant is using the space.
What’s more—you’ll want to get to know the tenant before pulling the trigger. You’re entering a long-term relationship, one that could potentially be passed down to your children.
Specific uses come with environmental considerations like automotive businesses or dry cleaning companies. Other factors include things like parking—in the case of box stores or supermarkets.
With that in mind, you’ll want to consider potential tenants before closing on a property. A lack of parking might not be a huge deal for a restaurant, but something like a Costco would suffer greatly.
Additionally, lenders and renters don’t love buildings with an unusual shape—as they limit potential tenants.
Is It Easy to Get Financing?
With most real estate properties, lenders consider financing options against the value of the property.
Single-tenant properties are a bit different. Instead, lenders consider the tenant credit along with the value of the property, which gives investors more options for financing.
Single-tenant properties can be more affordable than other types of commercial properties. While properties can quickly reach the multi-millions, in some cases, you may be able to find single tenant spaces for as low as $500k.
The availability of financing depends on several factors. Federally insured lenders like credit unions and banks usually give borrowers the lowest rates, while CMBS is a good option for investors looking for more liquidity.
CMBS is likely off the table, though, if you’re a new investor. Loan amounts start around $5 million, and you’ll need to be rated by Moody’s to qualify.
The other option is looking into a private lender. While this option comes with higher rates than the other options we mentioned, they can be a lifeline if you need to lock down funding in a short amount of time.
1031 Exchange Properties
The term 1031 exchange is gaining traction among investors at the novice and pro levels alike. In very broad terms, 1031 refers to the practice of swapping one type of investment property for another.
Most swaps would be taxable as a sale; however, if you meet the IRS’ requirements for 1031, you’ll have minimal or no tax due at the time of the exchange.
1031 exchanges don’t cover personal use property. For example, you can’t just swap out your vacation home for a future Bank of America.
The benefit of doing a 1031 exchange comes in when you go to sell an investment property. Even if you weren’t the original buyer, you could be responsible for capital gains tax. While the 1031 code stipulates that you must swap one property for like-kind, you could trade a high-maintenance investment for a low-maintenance one.
Or, you could trade several residential units for a retail store or a business park. The bottom line is, 1031 exchanges offer 100% preservation of equity. This process can help you build wealth in the long-term and protect your investment.
About Those Lease Terms
The lease terms will be critical, as well. You’ll need to make sure you’re working with a lawyer. The lease should be written in clear language, so there is no ambiguity for you as the investor or your tenants.
You’ll also need to consider an inflated rent analysis. Some investors opt to raise the rent to make the return on investment higher from the outset. If you choose to inflate, rents may decrease during renewal negotiations if the current market value is cheaper.
As such, a clear understanding of current market rates is essential. Tenants will be doing their research, too. And while it’s natural to want to maximize your earning potential, offering a fair deal will give you the loyalty and predictable income you’re looking for in this type of arrangement.
Will You Need a Broker to Help with the Process?
The short answer is–yes.
You’ll need a broker to help you get the best deal. You’ll want to find a firm that is well-acquainted with the ins and outs of the sales and procurement process.
Properties in a great location with demographics to match the tenant are competitive. You’ll need help compiling research on potential tenants and properties that will create a win for both parties.
A triple net investment is an excellent choice for an inexperienced commercial real estate investor or anyone who wants to add a low-maintenance investment to their portfolio.
Learn more about investing in triple net lease properties, contact Sands Investment Group today.