Top Factors to Consider When Investing in NNN Properties

It wasn’t long ago that only a select few people had ever heard of investing in triple net (aka NNN) properties. I still get asked almost daily to explain exactly what is a NNN property and how does one start investing in the asset class. As more investors decide to leave other management intensive investments, NNN properties continue to gain popularity.

NNN properties are typically leased to tenants with high credit ratings on a long-term lease. The tenants generally pay for the taxes, insurance, and maintenance of the property, making for what should be a very attractive and low-management alternative to other real estate investments.

They are particularly attractive to 1031 buyers who have realized significant appreciation of properties that have required lots of “hands-on” attention over the years. Often, these NNN assets are free-standing properties leased to tenants with very recognizable brands – think Dollar General, Walgreens, Advanced Auto Parts, 7-Eleven, Starbucks, FedEx, etc.

Credit tenants, long-term leases, recognizable brands, tenants paying for property expenses, low management……sounds great, right? And many many times, it IS great. However, before diving into this pool there are certain risk factors that must be considered.

10 Risk Factors For Every NNN Investor To Consider.

1. The Credit of the Tenant – Not all tenants are created equal. Many corporate tenants have a credit rating that is determined by one of the three ratings firms (Standard and Poor’s, Moody’s, and Fitch), and those with a rating of BBB- and higher (S&P scale) are considered “investment grade.” Even when they have highly recognizable brand names and seemingly strong corporate credit, things sometimes go wrong. Ever heard of Circuit City, Radio Shack, Borders, or Blockbuster? All of these companies filed bankruptcy and either ceased to exist or went through major restructuring and store closures.

Investment GradeBBB
High YieldCCC

Also, many corporate tenants have a franchise model, and you could be buying an asset with a brand-new franchisee with minimal capitalization. It is important for you as an investor to be comfortable with the business model and overall credit of the tenant when making an investment decision on a NNN property. It is also imperative to consider the “the rest of the story” (as Paul
Harvey would say), by assessing the other key metrics of NNN assets.

2. Location of the Property

The old adage of “location, location, location” rings as true today as ever. If you find yourself needing to re-tenant a property, it is MUCH easier to do so with a well-located asset. When thinking of what is important about location, consider the following:

  • Population density (1-mi, 3-mi, 5-mi radius)
  • Demographic data (who lives and works in the immediate area)
  • Visibility (is the property easily visible by passing traffic)
  • Accessibility (sometimes properties are highly visible, yet very difficult to access due to medians, curb cuts, etc.)
  • Traffic Counts (many retailers and restaurants require a minimum number of vehicles to pass the site each day; some also want “daytime” or “evening” traffic counts to be at a minimum threshold)

3. Rent Paid by Tenant

It is common to think “the more rent the tenant is paying, the better!” This mindset can backfire on an investor in a big way. Consider two similar properties, located across the street from each other. Both are 3,000 SF restaurant buildings and both are on corner locations of similar size. One tenant is paying $20.00 PSF in rent, while the other is paying $40.00 PSF in rent.

Think this sounds crazy? It isn’t. There are numerous examples of this exact scenario.

The higher paying tenant creates more value for the landlord, which is GREAT if you were the landlord developer who procured the tenant and got the lease executed. But if you are an investor looking at two similar assets, look through the lens below.

Property AProperty B
$20.00 PSF rent x 3,000 SF = $60,000 NOI$40.00 PSF rent x 3,000 SF = $120,000 NOI
7.00% Cap Purchase Price = $857,1437.00% Cap Purchase Price = $1,714,286

If the market rent (average rent that tenants are paying for similar assets in the submarket) is $20.00 PSF and the tenant vacates and you must re-tenant the property, the investor with Property B stands to LOSE 50% of the property value when he leases to a new tenant at the current market lease rate.

Takeaway: Always consider the market rent in the area when evaluating NNN investments.

4. Options to Renew

Many leases contain provisions giving the tenant the option to renew the lease at a specified lease rate. Often, there are multiple options that give the tenant the right to renew/extend the lease by three or five years at a time with a specified rental increase. The devil is in the details . Some leases actually contain options for the tenant to renew at LOWER rates than were paid during the original term of the lease. Why would this happen? Many times a landlord who spent an unusually high amount on tenant improvements (TI) will increase the rent in the primary lease term to make up for the additional TI dollars.

Keep in mind that the option always benefits the tenant, not the landlord. Why, because it is an OPTION. If the market rent is lower than the rent in the lease, the tenant can (and will) negotiate with you for lower rent. If the market rent has risen significantly and the tenant exercises its option to renew at a below market rate, the tenant wins with a lease at below market rates. Yes, the landlord keeps the tenant. However, there are times when a landlord has other tenants willing to pay a higher lease rate for the property. Again, the tenant wins with the options.

5. Length of Lease

As a general rule, the longer the lease, the better. Especially if there are rental increases during the primary term of the lease to help offset any inflationary pressures. Many tenants are now moving to “flat leases” during the initial 10-year or 15-year primary term, which can become problematic during periods of high inflation.

The remaining term on a lease will be a significant factor in determining the overall value of the property. Given other similar characteristics, a property with a 20-year lease-term remaining will be worth more than a property with a 10-year lease-term remaining. Once we get below 5-years remaining, the value begins to eradicate even more due to the uncertainty of the tenant remaining at the location at the expiration of the lease term.

6. Price Per Square Foot (PSF) of the Property

This metric is driven by the annual lease rate paid by the tenant and the size of the building. It is important to consider what other similar properties are selling for on a PSF pricing basis and to evaluate what a similar property could be constructed for in today’s market. There have been many instances of properties selling for over $1,000 PSF (in a market that construction costs would be less than $300 PSF) that have gone dark (tenant filed for bankruptcy) within a couple of years.

This metric is very much related to metric #3 (Rent Paid by Tenant) and can leave an investor in a very vulnerable position if the tenant vacates.

7. Termination Options

While not found in the majority of leases, these provisions do surface enough to make this a very important factor to consider. Termination options give the tenant the right to terminate the lease (generally without penalty) at a specified point in time. Some government leases give the tenant an annual right to terminate if the particular governmental agency loses funding for the fiscal year.

Other provisions give the tenant the right to terminate the lease early……think a 10-year lease that gives the tenant a one-time right to terminate at the end of year 5. In this case, an investor purchasing an asset with a 10-year lease really needs to underwrite it as if it were only a 5-year lease.

8. Debt on the Property

There are some properties in the market that have long-term debt on them that cannot be paid off early without significant penalties. Sometimes this is CMBS (commercial mortgage-backed security) debt and sometimes it is debt issued by life insurance companies. In either case, the penalties (otherwise known as defeasance) are stiff. Sometimes there are assumption clauses that allow a new borrower to assume the existing debt (subject to credit approval of the borrower).

In this case, the investor must evaluate the debt terms, the required equity, and any assumption fees to determine if the property meets the investor’s acquisition requirements.

9. Building Re-Use Adaptability / Specialty Buildings

Certain buildings are very easy to convert to alternate uses. Dollar stores, auto parts stores, and many fast food restaurant properties are excellent examples of easily converted properties. Certain specialty buildings can get very expensive to re-purpose.

Banks (with vaults), certain restaurants (multi-level buildings), and specialty medical clinics (MRI, CT scans, cancer centers, ER clinics) are a few examples that would require a much larger investment to convert the facility to an alternate use. This is just one more factor to consider when evaluating NNN investment properties.

10. Size of Lot / Land

Having an appropriate sized parcel of land impacts three major areas.

  1. Accessibility (discussed above in #2 Location of the Property)
  2. Parking Ratio
  3. Expansion

Many tenants require a minimum parking ratio before they will consider a location. Certain retail, restaurant and medical tenants have needs that far exceed minimum standards established by city code. Excess land gives the investor options to either expand the current building or to subdivide the land and construct an additional building or sell off the excess parcel.

Final Thoughts

It is important to take time and get very comfortable with the metrics that are important to YOU as an investor. Some folks are very comfortable investing in small markets with credit tenants. Others like short-term deals with upside in re-leasing the properties. While others want major market assets with long-term tenants and very little (to ZERO) management responsibilities.

Start looking at the market and getting familiar with what is out there before you are under the gun to purchase (1031 timeline). We would welcome the opportunity to show you what we are seeing in the market. We are connected with all of the major NNN brokerage players in the industry. We have deep relationships with developers, subscribe to the major database services, and are active in the CCIM (Certified Commercial Investment Member) network.

Working with investors in the NNN asset class is one of the most enjoyable things I get to do. I would welcome a meeting or phone call to visit about your particular investment goals.

With Gratitude and Respect,

Ken Wimberly, CCIM

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