As a major component of our core investment strategy, we seek to own and operate grocery store anchored shopping centers. Whether the property has one tenant or many, we invest a significant amount of time looking at the structure of the existing leases before committing to a deal.
Lease structure can vary significantly from one tenant to the next, but one of the first things we look for is to see whether the lease terms are “Gross” or “Net.” For simplicity’s sake, we like the “Net” structure.
Introduction to Net Lease Investing
A “Net” lease structure is one where the tenant pays a base monthly rental rate plus a proportionate share of one or more expenses associated with operating the property (e.g. Insurance or Taxes). This structure can be used with any tenant or property type, but single-tenant, net-leased properties are popular and could even be considered a specific type of investing model in and of itself.
Although each individual deal is unique, investors generally like single-tenant, net-leased deals for their:
- Long Term Leases – Up to 25 years.
- Strong Tenants – Including national, publicly traded companies that guarantee the lease (e.g. Walgreens or CVS)
- Favorable Debt Terms: Because of the long term leases and strong tenants, lenders are more likely to offer favorable debt terms.
For the reasons above, net leased properties tend to have a lower risk profile so it can be tempting to think that owning them just means collecting a rent check every month. While this may be true to an extent, a significant amount of due diligence must be completed on the front end of the deal to get comfortable with the tenant, the real estate, and the strength of the income stream.
Net Lease Investing – The Players
Net leased properties are popular with four groups of investors:
- Institutional Investors: Real Estate Investment Trusts (REITs) and Private Equity firms may allocate a portion of their capital to net lease investing.
- Merchant Builders: Individuals or firms that have a relationship with a tenant may work with them to select a site, construct a building, and execute a long term lease. In some cases, the Merchant Builder may keep the property as an investment for themselves, but in many cases they flip them to investors.
- Single Tenant Users: If a business owns their real estate, but needs capital, they may execute a “sale/leaseback” transaction where they sell the property to an investor and simultaneously lease it back from them. The result is that the business gets their needed capital and the investor gets a long term lease with a tenant.
- 1031 Exchange Buyers: Property owners with significant capital appreciation can face a big tax bill upon sale. But, the taxes can be deferred indefinitely through a process known as a “1031 Exchange” which allows them to use the sale proceeds to invest in another property that is of “like kind.” Net leased deals are a popular choice for their relative stability and long term leases.
For each of these participants, close attention must be paid to the lease to ensure that it is a good fit for their risk tolerance and time horizon.
Types of Net Leases
A net lease is distinguished from a “gross lease” by clarifying who is responsible for the property’s operating expenses. In a gross lease, the tenant pays one rental amount and nothing more. In a net lease, the tenant pays a “base” rent plus some portion of the operating expenses. There are four types of net leases:
- Single Net Lease: The tenant pays a base rent plus a proportionate share of the property taxes. For example, if the tenant leases 10% of the space, they may be responsible for 10% of the taxes.
- Double Net Lease: The tenant pays a base rent plus their share of the property taxes and insurance.
- Triple Net Lease: The tenant pays a base rent plus their share of the property taxes, insurance, and all maintenance (including structure and roof).
- Absolute Triple Net Lease / Bonded Lease: The tenant pays a base rent; plus all operating expenses.
While net lease investments are popular, they are not a “silver bullet.” For every deal that looks good, there is a downside and for every deal that looks bad, there is an upside.
Net Lease Pros and Cons
The major benefit to a net lease investment is the tenant(s). They are often widely known companies with a strong balance sheet like Walmart, McDonalds or CVS. As a result, there is a great deal of confidence that the lease payments will arrive on time every month. But, that isn’t the only benefit. Others include:
- Periodic Rental Increases: Many leases include “escalators” that call for periodic increases in the rental rate, which increases the property’s Net Operating Income (and value) over time. Such increases help the returns keep up with, or beat, inflation.
- Long Term Leases: Net lease tenants tend to sign long term leases up to 25 years in duration. As such, it is important to understand the lease term remaining at the time of purchase because it directly impacts the price. The less time remaining, the more risk, and the lower the price.
- Operating Expenses: In a triple net lease, the tenant bears the responsibility for all operating expenses, which makes ownership more of a passive endeavor.
But, like any investment, net leased properties have potential downsides as well:
- Price: Tenants like Walmart or Walgreens – and the stability that comes with them – can be expensive. The high up front cost can limit potential upside as the property becomes more of a cash flow play with little opportunity for capital appreciation.
- Fundamentals: Often, the value of the property is not determined by the fundamentals of the real estate, rather the strength of the tenant. For example, Dollar General is a strong tenant, but they tend to operate in rural locations. If they leave, the backfill options may be very limited.
- Tenant Concentration: Single-tenant properties are either 100% occupied or, if the tenant leaves, 0% occupied with no cash flow. Because retail spaces are often purpose-built for the tenants, it may take months – and many thousands of dollars – to repurpose the property for a new tenant.
While all investment properties come with some level of risk, we actively work to mitigate them as part of the business plan and strategy for each property.
Net Lease Investment Strategies
When evaluating a net lease investment opportunity, we drop the deal into one of two buckets: Core or Value Add.
The Core bucket is very straightforward. There are deals with long-term leases, tenants with excellent credit, stable cash flows, and periodic rent escalations. While we like core deals, we don’t always want to pay core prices, and one of the ways that we separate ourselves from other market participants is through our relationships. We have significant, long-standing relationships in the brokerage community and they know that we can close a deal. Because we can move quickly, and with certainty, we are able to get discounts of 50 or 100 basis points on the cap rate for core deals.
Value Add deals are less straightforward and may come with an elevated risk/return profile. Often they involve a motivated seller looking to divest the property because of the uncertainty around the tenant renewing their lease. These deals may have an unexpectedly high cap rate, but we can step in and add value right away by leveraging our relationships to get a lease extension.
Net Lease Returns
In return for stability, returns for net-leased properties tend to be lower than other investment types. But, one of the strategies we use to maximize return potential is to position the property as a turnkey investment so a core buyer can step in and pay a market price.
The rate of the return is a function of two key lease elements: the number of years remaining and how much the rent will rise over the remaining term. To position the property for a core buyer, we may give the tenant cash for building improvements in return for a lease extension or we could offer flat rent or smaller rental increases. Either way, the goal is to position the property to extract maximum value upon sale.
Summary & Conclusion
Net leased properties are a popular option for investors looking for stable cash flow and relatively passive involvement in the day to day management of the property. But, that doesn’t mean that investing in them is “easy.” Buyers need to invest a significant amount of time up front to evaluate the deal from all angles to ensure it meets their risk tolerance and time horizon. Best practices include:
- Do your homework on the tenant: Do they have good credit and a strong balance sheet?
- Do the homework on real estate fundamentals: Is the property in a strong market with good visibility from the road and high traffic counts?
- Focus on the lease term: How many years are remaining on the lease and what can be done to increase the term?
- Look for rental escalations to keep up with inflation: Leases should include periodic rent escalations to ensure that returns keep up with inflation.
- Avoid high rents that are irreplaceable: Should a tenant leave, you’ll want to be able to replace them at a rental rate that is the same or higher than the existing rent. Properties with high rents relative to the market should be avoided unless there is a significant amount of time left on the lease.
- Look at stability vs. other asset classes: Evaluate the stability of the property’s cash flows against other income producing assets, like bonds, to ensure that the return is commensurate with the risk.
With the proper amount of due diligence and proactive risk mitigation strategies, net leased properties are a worthy addition to any real estate investment portfolio.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
Whether you’re just getting started or searching for ways to diversify your portfolio, we’re here to help. If you’d like to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.