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Are Triple-Net Leased Properties a Safe Harbor in a Stormy Market?
by Allison Chapleau
The current environment is marked by a flight to safety, constrained capital and economic weakness, a combination putting pressure on real-estate values. This is encouraging some multifamily property owners to consider diversifying or exchanging into single-tenant, net-leased, nonmanagement-intensive deals. If an apartment property owner is weighing such an option, there are several factors to take into consideration.
A triple-net lease can apply to retail, office or industrial properties. Depending on how the lease is written, the lessee is often responsible for real-estate taxes, insurance and all maintenance/expenses. The rental income paid to the landlord can be net of all expenses. These properties typically have no management responsibilities, are leased on a long-term basis to a tenant for a period of 10 to 50 years and offer stable cash flow.
Properties that have triple-net leases have gained wide popularity with investors due to the predictable income stream, plus the lack of management and expenses. Also, it is relatively easy to find triple-net properties quickly that meet investors’ exchange needs. Statistics show that approximately 50% of the buyers in the market for triple-net properties are involved in tax-deferred 1031 exchanges, and of that 50%, approximately 70% come from apartments, while the other 30% are coming from retail properties. The 50% not involved in 1031 exchanges are investors seeking to diversify their real-estate portfolios.
Pros
There are great opportunities to acquire triple-net properties for investors in today’s marketplace; cap rates are the highest they have been in three years and are currently between 50 basis points and 75 basis points higher than they were a year ago. There is a flight to quality for major retail, office and industrial properties in strong locations with credit tenants.
Depending on how the lease is written, the tenant often is required to pay all expenses, including property taxes, fire insurance, all maintenance and repairs of the building and premises, and all utility costs, including water, sewer, garbage, gas and electricity. In some cases, the expenses are paid first by the landlord and reimbursed by the tenant, but generally expenses are paid directly by the tenant.
The tenant is also responsible for all onsite management issues and/or expenses of the property. This means there is no time spent paying bills and checking expenses, no workers compensation and payroll tax to calculate every quarter, no occupancy reports and turnover and rerent expenses, no repairs to assess the need for and to get bids on, no contractors to hire and oversee, no phone calls or tenant complaint letters, and no violation letters from the local government.
The tenant’s livelihood and income depends upon the appearance and condition of the property. Therefore, tenants are proactively interested in maintaining the property. No management responsibilities mean less legal exposure resulting from operation or maintenance issues.
Also, this property type has no exposure to the threat of rent control or commercial property tax increases. Another positive is the predictable income stream that a triple-net property provides. Short-term vacancy and increasing operating expenses will not affect the investor’s cash flow.
Cons
If the tenant does not renew the lease or doesn’t pay rent, the new owner will have a problem. Unless the owner is comfortable with these potential risks, this property type is not recommended. This decision will be based upon several factors, including the owner’s evaluation of the experience and financial strength of the tenant and the business, and the current and long-term prospects for both the tenant and the business in this location.
These investments often have high rent per sq. ft. and high cost per sq. ft. and, in some cases, the buildings are single purpose. Additionally, every deal is different, but many single-tenant transactions have very little or no increases in rent during the term of the lease, while other types of leases feature increases at specified intervals.
Analyzing the Deal
The first step in analyzing a single-tenant net-lease property is to see the property. Often, the building maintenance is the responsibility of the tenant; therefore, these issues are sometimes less crucial for the landlord. (With respect to a newly constructed property, there may be more issues to take into consideration.)
Once the investor has decided that he or she is interested in the property, he or she will need to closely examine the creditworthiness of the tenant. Is the tenant a corporation or franchisee? If the operator is a franchisee, it is important to know how many locations it operates and how long it has been in business. It is also helpful to review the agreement between the franchisee and parent company.
The investor should analyze sales trends during the last two to three years, including rent-to-sales ratio; fixed-charge ratio (business cash flow to rent); earnings before interest, taxes, depreciation and amortization; corporate credit and default risk; economics; employment; competition; local development issues; and traffic counts in the immediate vicinity of the property.
The investor should then look into the lease terms. This evaluation can be outsourced to an attorney who is experienced in the administration, understanding and enforcement of leases.
Some standard lease questions include: Who is the guarantor of the lease, and what is the financial backing of the guarantor? Can they substitute a tenant of lesser net worth? When does the lease commence and end? What is the rent? Are there any escalations and when? What is the precise square footage, the rentable square footage of the store and the lot? Who is responsible for all expenses, including but not limited to, property tax, property insurance, liability insurance, maintenance and repair of all types, all utilities and management? Are all expenses billed directly to the tenant or paid by the landlord and subsequently reimbursed? Does the lease call for percentage rent? Does the lease have options? If so, at what terms? Is there a right of first refusal to purchase the property? Is there a right to terminate the lease early? Does the lease call for the tenant to produce an estoppel agreement and a Subordination, Nondisturbance & Attornment Agreement? Is it in a form acceptable to your lender?
Also, make sure to obtain proof of insurance as required by the lease, for a lender often will request it and may require more insurance of you as the borrower, to lend. More generally, make sure to obtain an estoppel and an SNDA, and check the insurance requirements.
Once the investor has decided to move forward with the acquisition on a single-tenant net-leased property, it’s time to consider the financing aspect. Do not assume the normal lending procedures apply in the single-tenant arena. Many single-tenant deals are sold without any financing, or very little financing. Lenders approach single-tenant transactions differently than they approach apartment financing transactions. Lenders are more restrictive in their underwriting, loan-to-value ratios and evaluation of the credit of the tenant. For example, sometimes lenders will require more insurance than the lease requires of the tenants, (loss of rents, etc.) Also, they may not lend on a deal due to perceived risk, or they may require lower LTV ratio or less favorable terms in general.
Overall, the advantages outnumber the disadvantages when it comes to acquiring a single-tenant net-leased property. They are stable, long-term investments for multifamily property owners who are looking to diversify their portfolios with low-risk, low-management properties.
The opinions expressed in this article are those of the author, and do not necessarily reflect the viewpoint of the SFAA or the SF Apartment Magazine. Allison Chapleau is a senior associate in the San Francisco office of Marcus & Millichap Real Estate Investment Services, and can be contacted at achapleau@marcusmillichap.com or 415-391-9220 x278. Copyright © 2008 by Black Point Press. All rights reserved.