Net lease—investment you can depend on

March 20, 2018

 

Single tenant net lease (STNL) investments consist of a long-term lease with a retail tenant such as Walgreens, Starbucks, or AutoZone. A STNL offers landlords the ability to secure consistent and reliable cash flow, while simultaneously shifting the headaches of traditional management to the tenant, all of which is governed by the lease in place. There is a myriad of factors to consider when exploring STNL investments and deciding the best opportunity for you requires fact-driven analysis of key metrics.

The myriad of product types available within real estate gives investors great flexibility to achieving their specific goals.

 

Those that want to achieve long term appreciation often sacrifice the passivity of the income realized, in exchange for value creation through sweat equity.  The underperforming multifamily investment is a great example of an investor’s ability to create value through effective, hands-on management.  They sacrifice cash flow today due to necessary capital expenditures and ongoing operational expenses for the chance of creating greater value in the future.  San Francisco apartment owners have recognized great success in this endeavor. 

 

Alternatively, those investors who have realized great appreciation through their efforts, may now be looking to secure a passive income stream in a real estate investment that will offer more predictable and consistent cash flow with less management responsibilities.  

 

Folks are entering a stage in their lives where they have recognized value creation through hard work and improving market conditions and are now rethinking what is important to them from an investment standpoint.  Is growth a motivating factor, or the freedom of more time and less responsibilities? 
 

 

The Solution – Single Tenant Net Lease

 

For those who have maximized the value of their current investment, moving their equity into another performing asset can produce exceptional results.  Through the advantages proffered by IRS Sec. 1031—see previous post—an investor can defer the gains realized upon sale, and reinvest the proceeds into a product type that will achieve their new goals: consistent cash flow and management-free.

 

Enter single-tenant net lease investments.

 

Throughout the United States, retail tenants are signing long-term leases offering attractive returns that are both consistent and reliable.  As the landlord, you are able to secure a passive income stream that requires minimal, if any, management responsibilities.  Investors are moving away from a labor-intensive product type like apartment buildings into single-tenant assets to achieve a key objective—more time.

 

As with any investment, net lease included, there are factors to consider and risks to mitigate.  Failing to do so can negatively affect your bottom line.  Conversely, recognizing the risks and taking proactive measures will inure to your benefit.

 

Factors to Consider

 

Double-Net vs. Absolute Triple Net

 

Leases are typically structured between two (2) category types—NN vs. NNN.

 

Both double-net (NN) and triple-net (NNN) leases shift the responsibility for operational expenses like property tax, insurance and basic repairs of the premises to the tenant. This is a significant shift from investments in apartments for example, as the landlord is responsible for all expenses arising in the course of their ownership. The missing “N” in double-net (NN) does obligate the landlord to certain responsibilities arising under the lease. Responsibilities include, but are not limited to, capital costs incurred with respect to structural elements of the building, roof, and upkeep of the parking areas.

 

The key difference between a double-net lease and a triple-net lease is that the limited management responsibilities in a double-net lease are assumed by the tenant under a triple-net lease. In addition to paying the operational expenses on the property, the tenant also assumes responsibility for upkeep and replacement of the roof, structure, and parking areas.

 

The limited landlord responsibilities under a double-net lease can be mitigated. Sites that were recently developed often have roof warranties that transfer to the new landlord upon close of escrow. The usual issues arising from a new roof that would require landlord’s attention can be redirected to the warranty company, who is typically a local company that can address the issue far quicker than the landlord might. Third party warranty companies provide additional warranties on structural elements for newly-built locations. A property condition assessment (PCA) performed by an engineer can provide investors great insight into the useful life of various components of the building, to determine if the investment will require landlord expenditure in the near future—a cost that can be passed to the seller during escrow.

 

Whether you decide on a double-net or triple-net lease depends on how passive an investment you wish to have. In any event, the responsibilities arising from either lease structure is de minimis, as compared to other product types within real estate investments.

 

Creditworthiness

 

A key consideration when selecting a single-tenant net lease investment is the strength of the guarantor behind the lease. Cap rates—the rate of return on your investment—is strongly correlated to the creditworthiness of the tenant, among other factors. The better the credit behind the lease, the lower the cap rate. Conversely, if the guarantor has shaky credit, then the investor expects to receive a better return, since they are assuming more risk.

 

The correlation between cap rates and creditworthiness is not unique to net lease investments. Consider the potential return an investor of Bitcoin might expect, given the associated volatility, as compared to an investor in the S&P 500 index, which spreads the risk across 500 of the largest companies. The vastly varying levels of risks also results in significant differences in the returns realized.

 

A lease that is guaranteed by a corporate tenant like Starbucks, Chase, Walgreens, AutoZone, etc. will naturally command a lower cap rate than a lease guaranteed by a franchisee with only four (4) units under operation, or a local tenant that does not have the financial strength of a national retail chain.

 

The important takeaway is that landlords need to carefully study the financial solvency of tenants signing long-term leases, and make a determination as to whether the guaranty behind the lease can support the obligations owed by the tenant to the landlord.

 

Location, Location, Location

 

Above all else, the location of your real estate investment can be decisive. This is true for most, if not all, asset classes within real estate.

 

Investors who acquired in the Bay Area after the 2008 downturn have realized fantastic growth. Increased rents due to the influx of people from the thousands of high-paying jobs created has pushed real estate values to new heights.

 

Long-term success in net lease depends very much on the location of the asset. A growing urban locale, like Oakland, can bring additional retailers to the area to service the growing population. More retail tenants in a growing area drive up the need for commercial space, and serves to push market rents. The differential in current rents vs. market rents is upside that the investor can capitalize on when the term is up and it is time to negotiate with the tenant. Conversely, net lease investments in over-retailed submarkets, where rents remain flat and storefronts sit vacant for extended periods of time can adversely impact the value of your investment.     

 

Mitigating Risk

 

The biggest risk the investor of single-tenant faces is vacancy.  Since only one tenant is paying rent, a concentrated bet is being made that the tenant will endure.  The concern of owning an empty building after a tenant leaves, while having to then assume the operational expenses that were previously passed to the tenant without the benefit of incoming rents, is perfectly reasonable and explains the reluctance to consider net lease as a viable investment option.

 

Those who have traditionally invested in other real estate asset classes, such as multifamily, feel safe in that the risk of vacancy is spread across the many units that are occupied.  In San Francisco, a vacancy potentially means more rent, given the strict rent control laws, and is therefore seen as a positive.

 

The factors to consider when reviewing net lease offerings remain pertinent to mitigating the risk of vacancy.  A corporate guarantee from an investment grade credit tenant, as determined by Standard and Poor’s or Moody’s credit rating agency, is a threshold criteria that every investor must consider.  The stronger the guarantor, the more confidence there is that the tenant will not default under the lease.

 

The length of the base term on the lease is another important consideration.  To the extent an investor can secure investment-grade credit on a long term lease assures a guaranteed income stream for that period of time.  New leases can provide investors up to twenty (20) years of consistent and reliable income.  Cash flow realized can be reinvested, or left in an operating account for lease up fees in the event the tenant decides not to exercise their option to extend the lease.  Careful study of the submarket in which you invested in can serve to mitigate the risk of vacancy, since market rents would have increased in a growing market, such that you can achieve a higher rent were the tenant to vacate.

 

Other factors to consider when mitigating risk includes reviewing store sales, when available, to determine if the rent-to-sales ratio is at a healthy and sustainable level.  Studying demographic data in a 1, 3 and 5 mile radius to determine densities, household incomes, and trends in population growth.  Identifying triple net leases that have built-in rent increases to provide income growth and a hedge against inflation.  Understanding the retail landscape in a particular submarket to determine proximity of other major retailers to the subject property—an important consideration if the site were to ever become vacant.  The more retail tenants in close proximity to your property, the easier it will be to lease up.  Consider the industry-type and the effects Amazon has had on big box tenants like JC Penny, Sears, and others.  Accounting for a changing retail landscape, and considering tenant profiles that have traditionally weathered recessions, and the online effect, can mitigate risks of the tenant filing for bankruptcy in the future.  The size and use of the building is an important consideration when determining the ease in which the building can be leased up without onerous landlord contributions for tenant improvements.

 

By taking account of the aforementioned factors, an investor can reduce their exposure to vacancy, and rest assured that they have taken every effort to maximize their investment. 
 

 

Conclusion

 

The fundamental benefit realized by investors who decide to acquire single-tenant net lease is freedom of time.  The tenant assumes a majority of responsibilities under a double-net lease, and all the responsibilities under an absolute, triple-net lease.  The landlord benefits by receiving rent every month without the traditional duties of owning real estate—property taxes, insurance, repairs & maintenance.

 

The factors to keep in mind—creditworthiness of the tenant, length of the lease, and location—are critical elements to mitigate any risk of default.  Our team at Colliers International focuses on the absolute best quality net lease investments available on the marketplace.  We guide our clients through the plethora of net lease offerings, to insure they secure an investment that meets their goals and provides the necessary assurances to sustain peace of mind.
 

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