Are Triple Net (NNN) Leases the Holy Grail of Real Estate?

As soon as Real Estate investors learn about triple net (NNN) properties, a lot of us make it a goal to own one of these elusive properties. The marketing materials often state, “No Landlord Responsibilities”. Wait, what?  That sounds like 100% pure mailbox money! I made it my goal to acquire one of these gems and wondered why everyone didn’t shoot for this same goal?

There are NNN properties where the landlord truly has no responsibilities at all. This means you literally will never get a phone call from your tenant. You can purchase one of these NNN properties anywhere in the country because you are essentially purchasing a guaranteed stream of income.

The reality of the NNN lease

In reality, many NNN properties require the landlord to pay taxes, insurance, and take care of the exterior maintenance. All of these costs are charged back to the tenant in the form of CAM (common area maintenance) charges. CAM charges also have a 10-15% markup or management fee that you are allowed to tack on. Still doesn’t sound so bad; I’m in.

NNN properties are often comprised of long-term leases, corporate guarantees, and fixed renewals. Most of these are 10-year leases with multiple 5- to 10-year renewals and a 5-10% rent bump with each renewal. The leases are almost impossible to break because they are signed by the corporation.

What to look for when assessing a NNN lease

One important aspect to look at is how many years are left on the term of the lease. If there are two years left on a 10-year lease, it is not as attractive to most buyers. What if they don’t renew? A McDonalds that doesn’t renew can typically be repurposed to another fast-food chain. A larger footprint tenant like Walgreens or a Kroger can be more challenging to repurpose. A serious caveat to consider is that corporate-backed leases can be broken if the parent company declares bankruptcy. For example, few ever imagined that JCPenny would end its 120-year existence by filing bankruptcy, yet it happened.

The trade-off of the NNN lease

Over the 10+ years that I have been investing in real estate, I have looked at hundreds of NNN deals. The price you pay for having a guaranteed income with minimal responsibilities is a very low rate of return. Below is a typical single-tenant NNN or STNL (single tenant net lease) property for sale.

Let’s break down the numbers. To finance a property like this you are typically putting down 30% and amortizing the loan for 25 years. The typical interest rate in today’s climate would be 3.5% but we will be generous and use 3%. With these numbers, you can expect a 5.1% cash on cash return, as outlined below.

Now, let’s assume you are an experienced investor with a great track record, a great balance sheet, and have an established relationship with a lender. In this scenario, you may get away with 20% down. Below is what those numbers look like:

You can see that putting less money down increases your debt service and ultimately reduces your cash on cash returns.

In the final example, we will use an interest-only loan. Many investors rely on appreciation and will use this type of loan to increase their cash flow.

An 11% cash on cash return would appease many investors. In this scenario, you would likely run through the remaining years on your lease term. You would remain hopeful that your tenant’s business is thriving and they will exercise the renewal of their lease. If the lease is renewed you would get the highest sale price because of the freshly signed lease. There is the risk that the tenant has other options and they will attempt to negotiate a lower lease rate and threaten to relocate.

These examples below show typical cap rates for these STNL assets:

 

At the end of the day, I gave up on my dream of owning a multi-million dollar NNN property. The returns are simply too low for active real estate investors. Here are some other ideas for how to get started with commercial real estate investing.

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The Downsides of Triple Net (NNN) Leases

There is a feeling of safety when you purchase a property that has a Triple Net (NNN) lease from a giant corporation. Many investors flock to these NNN deals because there is little that can go wrong. What are the chances that Starbucks will go bankrupt? After all, they have almost $3 billion in cash on their books. Many thought the same about JCPenney who had a 120-year run until the pandemic. Brooks Brothers also met their demise after a 200+ year run. Chuck E. Cheese, Men’s Warehouse, Neiman Marcus, GNC, Hertz, Sears, and Toys R Us all met the same fate.

Imagine the investor who spent $10 million dollars on a JCPenney thinking they are set for life.  The result of the JCP bankruptcy is that their lease obligations were terminated. That $80,000/month rent will no longer be deposited into the landlord’s bank account but hey, their loan payments are still due.

To make matters worse, let’s assume you spent $20 million on a shopping center with JCPenney as the anchor.  One by one, these tenants will leave when their leases come due because they no longer have the overflow traffic that their anchor tenant supplied.  Think about that boutique store that you never would have gone to but, because it was next to a Kroger, JCP, or Lowes, you just stopped in. That stop-in traffic becomes a thing of the past when the anchor tenant goes dark. Repurposing a big-box-retailer is very difficult and often results in a lower-paying tenant.

 

Below is a photo of a former Walgreens. This property sold for $7m when it was occupied. Now that it has gone dark, it is for sale for $1.5m.

 

Let’s revisit the Starbucks example. They are one of the safest tenants around so the risk of bankruptcy is almost non-existent. In a May 5th letter to landlords, Starbucks Chief Operating Officer wrote:

“Effective June 1 and for at least a period of 12 consecutive months, Starbucks will require concessions to support modified operations and adjustments to lease terms and base rent structures.”

As a landlord, you want to be able to work with your tenants in good faith. In many cases, landlords were able to furlough mortgage payments as well. The Cheesecake Factory CEO sent a letter to all of its landlords and stated:

“Due to these extraordinary events, I am asking for your patience and, frankly, your help. Unfortunately, I must let you know that The Cheesecake Factory and its affiliated restaurant concepts will not make any of their rent payments for the month of April 2020.”

They did not ask for concessions, they just informed their landlords that they will not be paying rent. The pandemic is an extreme example so let’s identify another risk.

 

Risks of NNN leases outside of the COVID-19 Pandemic

At the end of the lease, the NNN tenant will have renewal terms of, say, 5 years with a 10% rent increase. There is nothing obligating them to those terms because they control all of the leverage. They can come back to you and say we want a 10% reduction in rent or we will move to a more favorable location. The landlord has little recourse other than to agree to those terms. Of course, reputation is critical in real estate so, this cannot be their standard operating procedure, but it does happen.

Here is another blog that breaks down a sight-unseen commercial real estate acquisition to give you another idea of the bumps in the road to acquiring commercial real estate investments.

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How to Evaluate a Self-Storage Deal

Last October my boss, Ryan Gibson, texted me on a Saturday. Frankly, it’s not uncommon for our whole Investor Relations team to be texting each other at any time during the weekend. Even though I am in my 50’s with two teenagers in high school, I feel like a kid in a candy store when it comes to work — and the whole team feels that way. (Nerds!) Anyway — Ryan had caught wind that Melinda & Bill Gates had put a truckload of cash into a self-storage investment. How much is a truckload? I’m not entirely sure. The Gates and a Sovereign Wealth Fund (SWF) invested in the privately held International Storage Company “StorageMart” that was started in 1999. The investment by the Gates and the SWF brought the current market value to a cool $2.7 billion as of October 2020. Suffice it to say, syndicating and investing in self-storage is a thing.

But, either as a passive investor or a syndicator, how do you know if a self-storage asset is worth purchasing? Allow me to throw a few ideas at the wall. Spartan Investment Group is a syndicator of self-storage assets. These are some of the items we keep an eye on and I hope they provide some perspective as you evaluate opportunities that may come across your desk.

Product Mix

Part of our process in deciding to buy an asset is product mix. What’s that? In storage, that is the available unit sizes and whether or not they make sense for a location. Late last year, we bought a 108,000 square-foot facility just outside Bentonville, AR where Walmart’s headquarters are located. Would you believe that of the 108,000 net rentable square feet, 48,000 was climate-controlled RV storage? What was really astounding was that the occupancy of the RV spaces was a whopping 20%! Not an ideal situation for the former owners, but what appears to be a sweet deal for Spartan’s investors.

In rural areas, we have found that typically you will find larger product mixes. Lots of 10 x 10s or 10 x 20s, and generally not a lot of 5 x 5s or 5 x 8s. Urban areas tend to be the opposite. Just make sure the product mix seems to make sense for the market. In your mystery shopping, try to get a feel for the overall product mix of your competitors and the availability of each type. If it’s a value-add opportunity you’re evaluating, be sure to understand the demand six different ways from Sunday, so you nail the execution.

Contribution to Total Revenue

Another piece to the puzzle is the contribution to total revenue for each product type. If you are looking at an asset in a warmer climate that has zero non-climate-controlled units available for rent, what does that tell you?

What if the competitors also have zero available non-climate-controlled units? Build, build, build!

Getting a little more granular, you may find that some of the competitors in any given market have zero units built for a given dimension. That’s a tell, as well. Saturation is one thing, but if there is no presence by your competition for a type of storage, that saturation number is soft and unreliable.

Saturation

Let’s talk a little about saturation and what it does and does not tell you. In general, it is critical to understand your assumptions, and then stress test your assumptions to make sure they are correct. You may feel like you understand your market but is there a nuance to your market that may have eluded you — hard to imagine? Here’s an example.

Imagine a market where there are two competitors, and one is for sale. Both competitors are at relative maximum occupancy; there is 3% population growth in the county and the completed parts of your due diligence metrics are firing green. When using three-minute, five-minute, and seven-minute drive times for your competitor, you may find that the three-minute drive time is too clouded by the competition to pass due diligence, and you may initially feel you should pass on the opportunity.

However, with both assets on the eastern side of the city and the not-for-sale competitor further to the east, the for-sale asset may control 75% of the market. In this situation, the topography of the location dictated that most of the residences were to the west and south of the city and potential tenants would have to drive past the for-sale asset to access the competition. While saturation gives you a piece to the puzzle, be sure you understand the characteristics of the market you are pulling from and what the capabilities of your competitors are. Most of the time, drive time is the determiner of who gets the tenant.

Expenses as a Percentage of Maximum Economic Occupancy

Let’s take it a step further. When evaluating an asset, where would you like to see the expenses as a percentage of maximum economic occupancy? Spartan likes to see less than 40%. Playing off this number, when evaluating an asset, if an asset has a net operating income of $120,000 and a loan payment of $100,000, your debt service coverage ratio is 1.2. That’s not bad, but the higher this number, the better.

 

Ted Greene is part of the Investor Relations team at Spartan Investment Group.  Spartan syndicates self-storage assets for investment. Ted has 24 years of experience in the financial services industry as an investment advisor and Chief Compliance Officer. Ted can be found on LinkedIn at www.linkedin.com/in/ted-greene-dontbeafraid or ted@spartan-investors.com.

 

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Joe Fairless