At some point in most serious real estate investors’ careers, they start to consider commercial properties for the potentially fewer headaches and more responsible tenants. When that time comes, experts say a great introduction to commercial leasing is the triple net lease.
Triple net (or NNN) leases are leases which require the tenant (lessee) to pay for net real estate taxes, net building insurance and net maintenance costs, in addition to the base rent and utilities. The fact that the lessee pays for these three net expenses is (clearlly) where the name ‘triple net’ is derived.
Triple net leases are most commonly used in retail and single-tenant buildings, e.g. fast food restaurants, pharmacies and banks. Generally they are used for commercial buildings, but can occasionally also be found among single-family dwellings, for example in the case of a daycare facility.
To bring this concept to life, let’s flirt with the example of a deli shop. The First Avenue Deli small business owner signs a triple net commercial lease for 1,000 square feet with Landlord, Inc. for $10 per square foot (per year) over a ten year term. In this case, the $10 per square foot, or $10,000 per year, is the base rent for the leased space. It is commonplace that commercial leases incorporate annual increases to account for inflation, especially with a term as long as ten years. Let's say that First Avenue Deli's base rent increases $1 per year. So the deli's base rent will increase from $10 in the first year to $11 in the second year, $12 in the third year and so on.
With the base rent established, what about the N’s of this triple net lease? If it costs the landlord $1,000/year for real estate taxes, $500/year for insurance, $500/year for repairs and maintenance, $500/year for security, and $500/year for cleaning, then the total expenses for the property would be $3,000/year. To conclude, during the first year of the lease, First Avenue Deli will pay Landlord, Inc. $10,000 in base rent plus $3,000 in reimbursements (all the net expenses).
Triple net leases offer investors a number of significant benefits including the obvious freedom to pursue other adventures while tenants carry the burden of physically and financially overseeing the property. The promise of a long-term lease offers investors stability and security over the long haul as most triple net leases contain terms lasting anywhere from five to ten years or more. Commercial tenants often can be screened more extensively, by evaluating both the individual owners’ credit and financial statements, and the business’s credit and finances. For the former residential investor, the transition means no more worries over late night emergency plumbing or lockout calls – perhaps the greatest benefit of all.
So, what’s the catch? Why haven’t most residential landlords and property managers crossed over already? The reason is quite simple: large up-front investment and small back-end profits often prevent the new commercial investor from entering the game, especially considering the lower returns associated with triple net leases.
Lower rents and cap rates, the very features that render triple net leases appealing to the commercial tenants, can be the biggest disadvantage for some investors who would prefer larger returns and higher rents, no matter the risks.
Although triple net leases may be considered low-risk investments because they most often attract credit-worthy tenants with long term leases, it does not mean these leases come with no risks at all.
Investors are warned to be diligent about checking both the personal and business credit of commercial tenants. Personal credit reports and criminal background checks can be done through this website, while business credit histories can be obtained through servicers such as Standard & Poor’s, Bradstreet & Dun, Business Experian and Business Equifax. Commercial landlords should also collect a personal financial statement from all tenants and guarantors, which provides the combined benefit of helping to evaluate prospective tenants and also detailing all of the tenants’ assets and income, in the event of a lease default. Selecting the wrong commercial tenant will have the same repercussions as selecting the wrong residential tenant, and can cost owners dozens of thousands of dollars in unpaid rents as well as unexpected expenses, e.g. property taxes which were supposed to be paid by tenant.
Another consideration for investors interested in triple net leases is unit level economics. Using our deli example from above, before a landlord would consider doing a triple net lease deal with the deli owner, he would want to have sales data along with revenue and profit history for the deli. An investor may also want to do a performance comparison with other neighboring delis.
Investors who are seriously considering triple net leases and want to learn more about what to consider can view more here.
Share your experiences with us. Have you heard of triple net leases? What type of leases are you currently doing or considering?
