Triple-Net Leases: What the Three “N”s Mean to Investors
A triple-net lease refers to an arrangement whereby the tenant is responsible for all of a property’s major operating expenses. This article compares triple-net with other common lease types, and explains what to consider when evaluating a triple-net lease investment.
Commercial real estate lease structures may vary considerably depending on the property, tenant profile, and business model of both the tenant(s) and the property operator. Over the past several months, EquityMultiple has offered several triple-net lease investments, including an Amazon procurement center and an addiction treatment facility.
The Three “N”s
Triple-net leases—often abbreviated as NNN or Net-Net-Net—are most often found in the office, industrial, and retail sectors. The structure is most popular with single-tenant properties where one tenant occupies the entire leasable space of the property. Generally, the NNN structure leads to lower contractual rent payments as the tenant reimburses the landlord or pays directly for all operating expenses. The three “N”s typically refer to common area maintenance (CAM), real estate taxes, and property insurance expenses. Some lease structures also require tenants to be responsible for roof and structural maintenance. These are often referred to as Absolute NNN Leases.
NNN vs. Other Lease Structures
The more traditional lease is often referred to as a Gross Lease where the tenant simply pays an agreed-upon rent amount and the landlord is responsible for all operating expenses. Within the net lease space, modified structures can also include Single-Net (N) and Double-Net (NN) leases as well. Under these structures which are also referred to as Modified Gross Leases, operating expenses are split between the landlord and tenant.
Considering tenants pay for major operating expenses, the triple-net lease generally entails the lowest rents of any lease structure, all else being equal. More importantly for the property owner and corresponding investors, it shifts the burden to maintain the property onto the tenant and offers a more passive asset management plan.
Single tenant net lease terms can range from 1-2 years to 15+ years, with 10-year terms being most common. The long-term lease structure allows the property to produce bond-like cash flow over a long time period. When structuring a triple-net lease, the property owner seeks to include frequent rent escalations (e.g annually, or every 5 years). The contractual rent escalation can also be linked to the Consumer Purchase Index (CPI) to keep up with inflation.
Considering the long duration and payment responsibilities, NNN structures are best suited for industrial, warehouse, self-storage, and retail properties. They may also be a fit for credit tenants who have demonstrated financial strength and sound business operations.
CRE investors should carefully consider the lease term’s merits in relation to the investment’s return and risk profile. Compared to other lease types, the triple-net lease can lower operating expenses but also temper the property’s revenue potential. Triple net leases may have a zero-sum effect on the net operating income; however, in transferring the responsibility to pay operating expenses, the property owner also transfers the risks of increasing operating cost. In the event of unforeseen circumstances—such as a natural disaster, change in tax policy, or damages—the tenant will be liable to cover the increased cost on top of the rent.
As previously noted, the tenant is also solely responsible for maintenance and all necessary repairs and/or replacements to the property. This includes the roof, landscaping, exterior and structural portions, foundations, and parking lot. Because the tenant pays for their own maintenance, insurance, and taxes, the property owner has fewer managerial responsibilities. Thus, investors can benefit from decreased property management-related fees.
When combined with a strong-credit tenant, the triple-net lease can help investors secure attractive long-term debt financing with low interest rates, further boosting bottomline returns to equity investors. NNN transactions are often levered conservatively with long-term debt in the 50-65% LTV range. The low debt service mitigates default risk and creates an opportunity for investors to capture enhanced current yield. NNN investments may be most appealing to investors who are relatively risk-averse but still seeking current yield.
Why Triple-Net Lease Investments are Appealing Now
With the Federal Reserve indicating the nominal rate will be kept near zero through 2022, investors may need to consider alternate income strategies. High-yield and current-income driven investors expecting consistent and stable income should strongly consider triple-net investments.
NNN lease investments backed by corporate guarantees may offer meaningful downside protection. These investments can generate attractive cash-on-cash yields that can outperform the high-yield bonds on an investment-grade credit. While the price of high-yield bonds fluctuate as market sentiment shifts and credit spread widens, triple-net investments can benefit from stable rent collection. Despite the COVID-19 pandemic disrupting tenants’ normal business operations, W.P. Carey (NYSE: WPC), a public REIT solely focused on triple-net leased single-tenant properties, reported a 98% quarterly rent collection rate in Q1 2021 and 99% monthly rent collection rates in Q2 2021.
Considerations for Triple-Net Lease Investment
When evaluating a NNN lease investment, tenant creditworthiness is crucial. Since triple-net lease terms can be long, investors must discern the tenant’s ability to meet obligations throughout the investment hold period. Reviewing the tenant’s corporate credit rating is a good starting point in understanding the tenant’s credit quality. Credit rating agencies, such as Standard and Poors (S&P), Fitch, and Moody’s assign letter grades to indicate the creditworthiness of public companies and reflect the tenant’s ability to meet financial obligations. Beyond credit ratings, investors can look into financial statements to ensure the tenant has sufficient liquidity under distressed situations. It may also help to examine the capital structure to ensure conservative leverage.
Investors should consider the relationship between the property and the tenant’s business operations, particularly for single tenants. Tenants are incentivized to continue the tenancy even amid a tough economic environment when the property is mission-critical to business operations, located in a valuable location, or in the case of retail, has demonstrated sales performance.
Finally, investors should consider the lease term and lease rate of the existing tenants. To avoid or minimize lease-up risks, the remaining lease terms on average should be longer than the investment hold period. Lease rates should also be in-line with the market.
Was this content useful?
We'd like to hear from you. Your feedback will help us provide new material that is useful to you.