Have you ever driven past a free-standing McDonald's or Burger King and wondered who owned the building?
Well, wonder no more because there's a pretty good chance that it is just a regular person like you. They just happen to be leasing that building out to the mega corporation (or its franchisee) under a triple net lease.
Triple net properties offer an impressive list of benefits. The biggest draw though is that most triple net leases require the tenant to cover everything, so it's about as passive as you can get in rental real estate.
But, like every investment, these properties come with their own set of pros and cons, and the prudent investor should evaluate and be prepared to mitigate them.
In this article, we will explore what triple net leases are, as well as the benefits and drawbacks to investing in a triple net property.
Let's get started!
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The information contained in this post is for informational purposes only. It is not a recommendation to buy or invest, and it is not financial, investment, legal, or tax advice. You should seek the advice of a qualified professional before making any investment or other decisions relating to the topics covered by this article.
What is a Triple Net Lease?
A triple net property has a triple net lease.
A triple net lease is a type of commercial lease where the landlord typically has very few responsibilities or costs associated with the property. The three “nets” represent three areas that the tenant is generally responsible for covering. They are (i) property taxes; (ii) insurance premiums; and (iii) maintenance.
Of course in all of these leases, the tenant is usually responsible for costs that are typically expected to be covered by tenants such as rent and utilities.
Triple net leases are often used by large drug store chains, like CVS and Walgreens. As mentioned earlier, many fast-food chains also use triple net leases, like McDonald's Burger King, Wendy's, Taco Bell, and Chick-fil-A, But really, these types of leases can be used throughout the commercial leasing sector, including office buildings, shopping malls and industrial parks.
Pros of Triple Net Properties
As we stated at the top of the article, there are many advantages to owing a triple net property.
The main benefits of a triple net property are highly passive income, strong tenant quality, long-term leases with automatic rent escalators, leveraged returns through financing, and tax advantages that are common to real estate investments.
We will cover each of these benefits in more detail.
A triple net property is essentially a completely passive investment because the tenant usually pays for and handles everything. This is why many retirees and others looking to decompress from owning assets that require far more maintenance and attention like rental homes or apartment buildings exchange into this option.
In many ways, you can look at this type of investment as similar to a bond.
Strong Tenant Quality
Tenants of triple net properties are typically companies with strong cash flow and significant resources. In some cases, the lease is backed by a very large and well-known corporation (remember the impressive list of fast food and other huge chains that I referenced earlier).
That being said, you still need to pay attention to tenant creditworthiness because many times, the entity that signs the lease is not the corporation, it is the franchisee. That's not to say that all franchisees are not creditworthy. In fact, some may be extraordinarily strong and owns dozens or even hundreds of franchise locations.
Lease terms for triple net properties are usually very long, with the initial terms often running well over 10 years.
Some extend much further than that. They also come with multiple options to renew. Each of these renewal terms is also in long-term increments, like five years.
As a result, it is not unusual to see a McDonald’s, for example, that has been in the same location for multiple decades under a triple net lease.
If you have ever invested in residential real estate before, you recognize the tremendous financial and psychological benefit of not having to worry about upcoming vacancies every year. The ability to consistently receive rent month over month and year over year for potentially decades is an immense benefit.
Automatic Rent Escalators
One feature that I like about triple net leases is that they ordinarily come with automatic rent escalators. They increase the rent without negotiation or argument during every set number of years (usually five). This feature contributes further to the passive nature of the investment and also acts as protection against inflation.
Triple net properties can be financed, just like other forms of commercial property. Given the stability, tenant strength, and other positive features of this type of investment, lenders are willing to offer attractive terms for the loans.
Rates are changing all of the time, but I recently saw a lender advertising financing terms for a triple net property. As of the date of this article, they advertised a 3% interest rate with a loan to value ratio of 75% (which means you put 25% down), and up to 30-year terms and amortizations.
Now you probably will have to experience some trade-offs depending on the type of loan you want to get (longer terms may require higher rates, etc.), but on balance, it looks like you can get decent financing terms on these types of properties in the current market.
Because triple net properties can be leveraged, you can enjoy magnified returns on your investment. If you would like a more detailed discussion of leverage and how it can enhance your return, please see my article discussing the various benefits of rental property investing.
Triple net properties may also grant certain tax advantages, such as no state income tax, depending on the location of the property, and an opportunity to defer your gains on an existing property through a 1031 exchange.
In fact, a 1031 exchange into a triple net property is a common tactic.
As mentioned before many investors who own apartments or other real estate that require active management find the passive nature of a triple net property very attractive. Given this, swapping their existing property for a triple net property in a tax-advantaged way through a 1031 exchange makes a lot of sense.
I admit I am no tax expert and much of the information referenced above can be found in this article which goes into more detail on these and other tax benefits.
As with any tax-related issue, please check with your tax advisor to ensure you are getting comprehensive and accurate tax advice.
If you are curious or have questions about what a 1031 exchange is, this article seems to provide a solid explanation.
Cons of Triple Net Properties
There are of course drawbacks to investing in triple net properties.
The main drawbacks of investing in triple net properties are high purchase price, complete loss of cash flow if tenant defaults, a highly customized building, declining property value as lease term nears expiration, and deferred maintenance by tenant.
Investing in triple net properties is expensive. Many of these properties are worth millions of dollars. Even with financing available to help with the cost of purchasing, they require a significant down payment.
Single Tenant Risk
One of the strengths of a triple net lease is that the tenant is typically much stronger financially than a residential property tenant. However, there is no diversification in the tenant base for a triple net property, which means that if your tenant fails or does not fulfill its obligations, there is no other tenant who will help mitigate that loss.
By contrast, in an apartment, you may have dozens or even hundreds of individual tenants who will be paying their rent, even if a handful do not.
This risk of loss can be mitigated by having a very strong tenant occupy the property. For example, it is highly unlikely that McDonald’s (with its deep pockets) will default on its lease obligations. But a tenant who is less established and financially stable may expose you to the risk of default.
That’s why it is essential to conduct thorough due diligence on your tenant.
Contributing factors to whether a tenant may default are (i) the strength of the store in that location; and (ii) the demographics of that area. If the profitability of that location is not great or if the area is declining, you should pay attention to those red flags.
Many triple net leased properties have been designed (or modified) specifically to meet the needs of the tenant.
That means that if a property becomes vacant, either through default or because the tenant chooses not to renew, it may be a challenge to find a new tenant quickly (even if you find another tenant that is in a similar industry and generally uses the same equipment and features offered by your property).
Make sure you negotiate plenty of time for your tenant to give you notice if they do not plan on renewing the lease because it might take you a long time to find a suitable replacement tenant.
In any event, you should be prudent and build up significant reserves in case this happens, especially as you get closer to the expiration date of the lease.
Value of Property Declines as Expiration of Lease Nears
Investors understand that a large part of the value of a triple net leased property is the long lease term. If your triple net lease expires in 20 years, you are able to get top dollar for the property if you want to sell it because buyers are going to be delighted that they can enjoy the benefits of that lease for at least 20 years.
But if you have only a couple of years remaining on the lease, your property value will be discounted accordingly.
As mentioned above, the tenant is typically responsible for maintenance on the property. But some tenants may feel that a repair is not necessary (or may simply not want to pay for it).
This could lead to deferred maintenance over the years and result in a big shock (and expense) when the tenant leaves. To prevent this from happening, you should make sure you have the right to conduct periodic inspections of the property.
Triple net properties have some very attractive benefits and are a popular choice for many real estate investors, especially as they mature in their investing cycle. But these investments are far from risk-free and must be carefully evaluated with the goal of avoiding or at least mitigating against the risks outlined above.
In short, these types of properties are better suited for sophisticated investors.
Given some of the risks associated with owning triple net properties, some investors choose to invest in Delaware Statutory Trusts, which may include a portfolio of triple net properties. This diversification can offer additional protection to the investor seeking a long term, passive investment without some of the single-tenant risk of a triple net investment.
If you do not have the funds to purchase a triple net property or are worried about some of the risks involved, you may want to consider online crowdfunding, which is also a maintenance-free option that some consider to be a safer investment than investing in individual properties.
DiversyFund, for example, lets you invest in a diversified basket of real estate investments with an initial investment of as low as $500.