One of the most popular property types in commercial real estate are “triple-nets”, also known as “NNN” deals. These are typically single-tenant retail properties leased to tenants with high credit ratings on “net, net, net” terms (hence the NNN acronym), meaning the tenant is responsible for real estate taxes, insurance and all maintenance.
At first glance these deals appear to be the perfect investment. They are typically new or nearly so, have no management responsibilities, a long-term lease to a quality tenant, stable cash flow, attractive financing, and the unique tax benefits only real estate provides. The advantages have fueled a tremendous growth in demand for the product from investors on every level. They appeal to part-time investors looking for guaranteed income with no management responsibility, and an attractive exit strategy for those with mature portfolios. However, as with any investment there are numerous factors to consider in valuing and structuring the deal.
First, like frozen food, you “pay” for the convenience of no management duties and stable long-term income in the form of lower returns than would be earned with a more hands-on, high-maintenance project. Prices start in the range of a 4% cap rate for the highest rated tenants, up to perhaps 6%–7% for lesser credit quality or those with short lease terms. (A cap rate is the percentage of return on the investment as if it were bought with all cash. The lower the cap rate, the higher the price.) Investors that use debt financing can produce leveraged returns in the 8%-9% range. But as we will see, income is not the only determinant of value.
Second, and often overlooked, is the wide range of risk exposure for NNN properties, even those with investment grade credit ratings. Contrary to popular belief, these are not “risk-free” investments, and in fact require a level of understanding beyond that of more typical real estate investments.
Risk is Always Present
In evaluating any NNN deal, be aware that all “credits” are not equal. A company’s credit rating is determined by one of the three ratings firms (i.e. Standard and Poor’s, Moody’s, Fitch) and those with a rating of BBB- and higher (S&P scale) are considered “investment grade”. Examples of the top tier tenants include Bridgestone (A/Stable), Ross Stores (A-/Stable), and Home Depot (A/Stable).
Not coincidentally, these are also the properties with the highest valuations (lowest cap rate), and they and set the upper standard for valuation. Generally, as the tenant’s credit rating declines, so does the price of their property. Historically, the vast majority of defaults have occurred among the lowest-rated issuers. The 31-year average for securities rated AA (the second highest rating) were 0.2%. Comparatively, the default rate among B-rated issuers (the second lowest) was 4.28%, but for the lowest tier, CCC/C the default rate was 26.85%. Hence, it is no surprise that the higher is the risk of a default (i.e. your tenant going out of business), the higher is the associated cap rate for a property.
But the mere fact a tenant has an investment-grade credit rating does not mean it is risk-free. The ratings establish the relative risk of default for a particular company, but no investment except a federal bond has a zero-default rate.
Understand the Tenant
To an investor assessing risk this brings up questions pertaining to the health of the tenant’s business model and financial strength, and requires additional level of due diligence.
In assessing the tenant strength, criteria may include the number of stores, debt to equity ratios, operating margins, stability of management and the outlook for their industry sector. If you’re thinking that sounds a lot like evaluating a stock, you would be right. In leasing them your property you are essentially providing capital to the business, and their continued success has a direct bearing on the long-term health of your investment. Past history and future prospects are both relevant.
For example, drug stores are considered a growth industry due to the aging demographics of the population. Well-managed brands like Walgreens and CVS receive strong ratings while Rite-Aid, another big player in the sector, has had problems in the past and a change in ownership. Their rating of B3/Negative reflects that history and a higher level of risk.
There are also “sleeper”, non-credits out there who may not have an investment-grade rating, but are poised for rapid growth or enjoy significant operating efficiencies. Chipotle Mexican Grill is one example of a well-positioned, well-run company that doesn’t even have a credit rating because they have no significant debt. Yet their 2018 sales were over $4.8 billion with healthy profit margins, an 8.7% increase from 2017.
But even with a thorough understanding of the tenant’s business fundamentals, NNN due diligence is not complete.
Real Estate Rules Still Apply
Regardless of the tenant’s credit rating, NNN deals are still subject to standard real estate due diligence investigations. These include location; local market conditions; building size, quality and use; and the lease terms. The objective is to not only determine the current value, but to quantify the best-case and worst-case scenarios for the future, including the possibility of the property being vacant, known as the “as-dark” value.
A property in a poor market or poor location can be difficult to re-lease. A fact of real estate life is that no two markets are exactly alike, so a thorough understanding of the local market conditions and the property’s position in the market is critical to establishing value. Just as location determines its competitive position within a market, local trends in population demographics, employment and income affect the marketability of a property compared to similar properties in other markets. With standardized lease terms and cookie-cutter buildings, the market factors become the major differentiator between properties.
Specialized buildings (think fast-food restaurants and oil change stores) even those in good locations, can hold significant risks in the as-dark scenario. They can be very difficult to adapt to other uses, and often must be razed for total redevelopment, lowering the residual value of the property. Even standard “vanilla-box” type buildings may require significant up-fit or refurbishment to be competitive if the space is vacated after long use. These costs must also be accounted for in the overall valuation analysis.
The lease itself is perhaps the most important piece of the NNN puzzle. It is the buyer’s responsibility to read, interpret and understand the lease terms, and most are complex documents. They are always written by the tenant, and heavily biased in favor of the lessee. They can contain land mines of unexpected expenses, cancellation clauses, or toothless default penalties. For properties with expiring leases or renewal options during the contemplated hold period, the risk increases. Few investors will consider closing a NNN deal without the counsel of an attorney experienced with the specific due diligence issues inherent to tenant-written leases.
Consider Worst Case Scenario
The appeal of the lease is that it has a corporate guarantee, and the depreciation will shelter all or most of the cash flow, kicking the after-tax return calculation up to 9-10% depending on the tax bracket. What’s not to like?
Consider looking at that deal with an old-time “look at the dirt” mindset, and the worst-case scenario at the end of the hold period. Unless the “dirt” aspects are in line with the valuation based on income, the end-game math is brutal.
If the tenant leaves at the end of the primary term, you can end up owning an empty building with little appeal for another NNN tenant.
Call me a cynic, but that sounds like a future auto body shop. And you have got to wonder if a body shop can pay enough rent to cover the debt service of a new loan.
Add to that there is no near-term or intermediate exit strategy. Since the rents are fixed there is no upside value unless demand were to exceed supply, which is not likely either. If there is plenty of new supply, existing properties will compete against the new stores with full lease terms in the resale market. That rules out a quick flip entirely, and any appreciation over the long term entirely dependent on local market conditions.
Now we can see that what looks like a sure thing is not so sure. We’ve got some work to do in making our decision, and thorough due diligence on the tenant, the market and the property makes the difference between a great investment and a flop.
Triple-Nets Do Have a Place
I do not mean this to be an attack on triple-net properties. Our loans portfolio has a few positions, and the benefits of owning a property with a NNN lease are real. These deals can be solid assets, and you could be well-positioned to build wealth over the long term if you understand the sources of risk, the overall marketability of the property, and value accordingly. Above all, don’t let the bright lights of a credit-tenant deal blind you to the fact that it is still real estate and the fundamentals do apply.
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
Should you find a great deal and have a need for financing, please consider PSG Lending (www.psglending.com) for helping you financing the transaction. We close in as little as 1 week and finance anything from flips to commercial real estate.