Doing the Due Diligence
In our last blog post introducing triple net leases (NNN), we discussed how investors benefit from a stream of income without any of the day-to-day management responsibilities for the property. To catch up readers who have not had a chance to view that post, a triple net lease is one whereby the tenant is responsible for the monthly rent in addition to the property taxes, utilities and maintenance and upkeep expenses.
Like all real estate investments, investors should conduct thorough due diligence for triple net lease properties.
What are the top 2 diligence considerations when investing in NNN properties?
1. Quality of Tenant
Similar to any non-owner occupied investment in real estate, renting to the wrong tenant can create problems, but this issue is further exacerbating in NNN investing as there is only one tenant. Whereas in a multi-family building with many units a single tenant should not significantly impact cash flow, in a triple net lease there is typically only one tenant on the lease. Accordingly, one bad tenant in a triple net lease may result in the investor having a completely vacant property without any revenue stream to cover expenses.
One way to understand the quality of a tenant is to use the credit rating of the business. Although even the most profitable company is not a guarantee for future success, the credit rating is one way to indicate the health of the company. For example, many companies are qualified by the three top credit rating agencies (Standard & Poor’s, Moody’s and Fitch) and are classified with a rating of ‘BBB’ or better as “Investment Grade” and ‘AAA’ signifying the highest level of credit quality.
Examples of top credit rating tenants include CVS (‘A’ grade) and Home Depot (‘AA’ grade). It follows that due to their low perceived risk levels, these properties are typically sold at the lowest CAP rates, offering investors the lowest cash-on-cash returns. Alternatively, companies with lower credit ratings present more risk of default but provide higher CAP rates and higher cash-on-cash returns.
2. Unit Level Economics
In addition to looking at the credit rating of the tenant, doing an analysis on unit level economics is advised when doing due diligence on NNN properties. The unit level economics will change depending on the tenant. For example, for a restaurant like Carl’s Jr. or Jack in the Box, the analysis would center on food sales, historic revenues and profits. It is also helpful to compare store performance compared to other stores in neighboring vicinities. Understanding unit level economics can also help investors to predict the likelihood that the tenant will renew the lease when the lease term is up.
Some real estate investment companies focus on acquiring NNN properties with shorter lease terms, typically 5 years or less, that they believe have a high likelihood to renew based on unit level economics. Once the tenant reviews, these real estate investment companies can turn around and re-sell the property at a profit as there is a new long term lease agreed to by the tenant.
What else should investors consider when investing in triple net properties?
While tenant quality and unit economics drive a lot of the decision making behind NNN investing, there are other considerations investors can use to determine the strength of a triple net lease investment including:
Length of the existing lease
- Type and frequency of increases in rent
- Are these on an annual basis?
- Are rent increases tied to inflation?
- Strength of the demographics in the location, including things like:
- employment rate
- median income
- population density
- Property improvements
- What kinds of improvements are built into the property: are they specifically single-use improvements or are they representative of a generic tenant with little specialization?
- Generic improvements are easily convertible to a new tenant’s needs and are typically more desirable than special use improvements. From an investor standpoint, special purpose improvements may require large capital expenditures to convert the property in case there is a need for a new tenant.
- Condition, age of the property and when improvements were last made
As with most commercial real estate investments, every triple net property is unique, but there are a number of considerations investors want to address and understand before making the decision to contribute capital to an investment. As triple net properties have concentration risk with a single tenant, this analysis is all the more important. Done right, triple net leases can produce a steady, consistent income streams for investors.