What are NNN Properties?
NNN Properties are typically free-standing buildings that are leased to tenants for a 10-to-25-year term. NNN Properties offer the benefit of little or no management responsibilities as the tenant pays for all, if not most of the expenses. The investor receives their rent with little to no other involvement.
Tenants in NNN Properties are divided by both quality and type of businesses they are in. Qualitatively NNN Properties have either credit or noncredit tenants. The most desirable (least risk) NNN Properties have investment grade (rated BBB- and better) credit tenants.
Noncredit tenant NNN Properties have tenants that are not credit rated. These tenants frequently are regional or local businesses or companies that are unrated. Some tenants are considered credit worthy yet are unrated because they carry no debt on their books. Click Tenant Ratings for list of tenants for NNN Properties.
Who Buys NNN Properties?
NNN Properties are appealing to those who wish to have outright ownership of their commercial real estate investments and have little to no management responsibility. The alternative ways of owning non-management commercial real estate would be to own a security in the form of a mutual fund or REIT or invest in fractional ownership Tenant in Common properties.
A major advantage of 100% direct ownership is control and the ability to defer future capital gains by doing a 1031 exchange when the property is sold. For many investors the lack of immediate liquidity inherent in NNN Properties is offset by the lack of volatility NNN Properties offer when compared to a securitized investment. Investors should carefully consider their need for liquidity when considering investing in NNN Properties.
How are NNN Properties Valued?
NNN Properties typically are valued using their Capitalization Rate also referred to as Cap Rate. NNN Properties cap rates reflect the value of a stream of economic benefits discounted for time and risk. Generally, this is computed as a pretax cap rate using the Net Operating Income (NOI) for NNN Properties.
NOI is income less all expenses before debt service. The Cap Rate is the NOI divided by the purchase price for NNN Properties. Conversely the NOI divided by the Cap Rate will equal the purchase or selling price.
Example of Cap Rates for NNN Properties:
NOI = $100,000/10%=$1,000,000 Purchase or Selling Price
NOI = $100,000/$1,000,000=10% Cap Rate
How are Cap Rates Determined for NNN Properties?
Some of the major considerations when calculating Cap Rates for NNN Properties are:
The more positive the above factors for NNN Properties, the lower the Cap Rate or the higher the value of the property related to its income stream. Conversely if the above factors for NNN Properties are weak the Cap Rate will be higher and the resulting value will be lower reflecting the greater risk of the investment.
It is important to remember that markets are not perfect and low Cap Rate NNN Properties are not necessarily a lower risk investment, they could simply be a bad investment that is overpriced. Astute investors seek NNN Properties that are mispriced in their favor, namely a higher Cap Rate for a property that has lower risk factors.
What is Build-to-Suit?
In a build-to-suit the landlord builds the improvements for the tenant and the tenant leases them back typically on a Net Lease. The Net Lease rent payable by the tenant is a function of the construction and financing costs of the project. This arrangement allows the tenant to move in and occupy the property with zero initial cost.
The Net Lease rent is fully deductible over the lease term, making the tenant’s after-tax cost less than with alternative forms of asset-based financing.
What is a Ground Lease?
A ground lease is a method for separating ownership of the improvements (building) from the ownership of the underlying fee (ground). Typically ground leases are long term Net Leases where the tenant pays all expenses except debt service. Any financing for the improvements are paid for by the tenant. In some cases, the ground lease is subordinated to the debt on the improvements.
On unsubordinated ground lease, no lien is placed against the fee simple title to the land. Instead, the leasehold estate is the primary security for any debt on the improvements. There is no depreciation with the ownership of a ground lease.
Many investors favor ground leases because they don’t need to use their own funds to build the improvements yet end up owning the improvements on termination of the lease. When the Net Lease ends the improvements revert to the owner of the ground lease the owner benefits from the full rent for both the land and the improvements.
Tenants like ground leases because they reduce the tenant’s cost of development by eliminating land acquisition costs. A long-term Net Lease provides predictable rent payments that are deductible by the tenant for federal and state income tax purposes.
Typically ground leases are long term Net Leases and include set rent escalations, foreclosure rights and reversionary right (improvements revert to owner of ground lease at termination of the lease).
What is a Sale Leaseback?
A Real estate sale leaseback is when a business sells its commercial property for current market value and then leases it back typically using a Net Lease. The seller retains the use of their real estate and frees up capital which can be used to invest back into the business. Real estate sale leasebacks are popular because they generate capital for immediate use within the business.
A long-term Net Lease on a sale leaseback create a predictable rent that is deductible for federal and state income tax purposes Some businesses do sale and leaseback transactions for equipment as well. Types Net Leases.
NNN Properties are generally categorized as either true triple net (NNN) or double net (NN). The distinction between NNN and NN leases is an important one as can be seen in the following definitions.
Absolute Triple Net (NNN)
The tenant pays operating expenses such as maintenance, repairs, taxes and replacement for the entire property, without limitation. The owners pay the mortgage only. This is the type of lease that most investors expect when purchasing NNN Properties.
Bond Lease (NNN)
A bond lease is a slight variation on the true triple NNN lease because the tenant is required to absolutely comply with their rent and operating expense obligations regardless of extenuating circumstances affecting the property (i.e., Even if the property is under eminent domain proceedings).
Double Net Lease (NN)
Similar to NNN leases but with additional owner responsibilities. The owner is generally liable for the structural components of the building such as the roof, foundation, load-bearing walls and parking. Leases will vary so they should be carefully read.
Net Lease Alternative
For investors considering NNN Properties but who would like to invest less capital (cash) and still have little to no management responsibilities Tenants in Common (TICs) are a good option to consider.
Advantages of Tenant in Common are the lower minimum investment (starting at $50,000); prepackaged financing (if any) and due diligence material. Because Tenant in Common is a deeded interest in real estate and not a security like a mutual fund or REIT they qualify for 1031 exchanges providing they follow IRS Rev Proc 2002-22.
The most frequent objection to Tenant in Common ownership is that Tenant in Common owners have a proportionate vote on major ownership issues as opposed to 100% owned NNN Properties.
Tenant in Common investors can invest in fractional ownership in NNN Properties and other multi-tenant real estate. A major advantage of Tenant in Common ownership is the ability to reduce overall risk by diversifying into a number of investment properties.