If you’re considering a 1031 exchange then you may be attracted to NNN properties because of the perceived stability and ease of management. However, you should be aware that there are at least six significant hazards associated with exchanging into a NNN property.
The 1031 exchange has been used by savvy real estate investors for a century. 1031 exchange investors can defer capital gains taxes by exchanging one property for another “like kind” piece of property. The general idea behind the 1031 exchange is based upon the presumption that, when a property owner reinvests the sale proceeds and retired debt into a like-kind property, his or her economic situation goes unchanged. However, if the replacement property is sold, and the owner cashes out instead of initiating another, and all of the original deferred gains plus any additional realized gains on the replacement property would become taxable.
In a recent interview with Wealth Management, Alex Madden, Vice President with Kay Properties believes that more than 30 percent of all commercial and multifamily property sales in the United States involve some kind of like-kind 1031 exchange, and many of those investors will consider NNN properties as one of their exchange options.
Think Twice Before Investing Into a NNN Property
Real estate investors have 45 days to identify a property to 1031 exchange into. Many investors are attracted to NNN properties that are leased to well-known brands under long term triple net leases (NNN).
NNN refers to the three areas the tenant is responsible for paying (in addition to rent) which include property taxes, insurance, and maintenance on the property.
Real estate investors are drawn toward NNN properties because they require limited ongoing landlord responsibilities, and can potentially provide the owner with long-term, predictable streams of rental income.
However, investors should also be aware that these NNN properties can come with significant hazards, as well, including “Black Swan” events like COVID-19. Below are six of the most common “watch-outs” that can occur with NNN properties.
Watch-Out #1: Vacancy Dangers and Lack of Diversification
Unlike multifamily, self-storage, and mixed-use retail, single tenant net leased properties have the unique situation of being either 100 percent occupied or 100 percent vacant. Shrewd real estate investors understand this “single tenant” moniker is just another way to say “undiversified”. If a tenant goes out of business or breaks the lease prematurely, the rent could go to zero and the owner could be stuck paying the taxes, insurance, and maintenance, not to mention the mortgage (if any) all while not collecting any rental income.
A great example of when this situation hit landlords hard was during the recent COVID-19 pandemic when the United States saw a wave of bankruptcies wash over the NNN retail sector, forcing many name-brand stores like JCPenney, Guitar Center, Stein Mart, Neiman Marcus, Pier 1 and more to shutter locations. Other examples of failed brands and risky tenants include Blockbuster Video building that only get two-months of rent a year when the Halloween Store rents them!
What does an investor do with a vacant, former Blockbuster Video or Big Lots? Lease it to another similar tenant, right? However, in many cases, this is much easier said than done. While re-tenanting a property is not impossible, it does require a lot of work, and chances are rental income will be absent for some time. All real estate investments pose certain risks, and having a vacant building is one of many potential risks investors need to weigh.
Watch-Out #2: Bad Locations will Impact Both Landlord and Tenant
Many people get sucked into the idea of NNN properties because they like the idea of a high- profile tenant, or the “better than average returns” their real estate broker promises the property will generate. But many of these buildings are located in C+ or B – locations that can be incredibly difficult to re-lease at the same rent level in the event of a vacancy. NNN properties are easy to buy with rents way over market, and if things don’t go right, the investor could be looking at some real trouble. Even if a property is located in a decent area within a large metropolitan district, it might be very hard to sell in eight years when the current tenant only has two-years left on the lease.
Watch-Out #3 Specialized Buildings
Many single tenant net leased properties have floor plans that are designed to meet the unique requirements of a specific tenant. Fast food restaurants or bank branch locations commonly have unique architectural or functional aspects to the building design. Re-leasing these buildings to a different type of tenant can take a long time and can cost the landlord a significant amount of money.
Even if a building is in a good location, marketing and tenant negotiations can sometimes mean no rent for anywhere from 6 to12 months. This can be especially challenging for an investor who doesn’t live in the market, or doesn’t have discretionary funds to aggressively market the empty building for good tenants.
Watch-Out #4: Just Because It’s a Name Brand Doesn’t Make It Bulletproof
Many net lease retail businesses were struggling before the COVID-19 pandemic hit, so when the public health crisis arrived, it was not surprising to see many long-term brands file for bankruptcy. J. Crew Group, Neiman Marcus, and JCPenney all filed for bankruptcy within a few weeks of each other. Even outside the retail sector, brands like Blockbuster Video, Borders books, Pier 1 Imports, Sports Authority and Solyndra all suddenly went out of business, and many investors were left holding the bag. The economic factors underlying these bankruptcies are varied and complex, but make no doubt about it, major tectonic shifts are taking place across the brick-and-mortar landscape including changing demographics and related buying habits of shoppers, and the dramatic rise of ecommerce businesses replacing traditional retail locations.
Watch-Out #5: Dig Deep to Find out Who is the Responsible Party
The truth is, a fair number of single tenant net lease properties are leased to individual franchisees rather than the corporate entity on the building’s signage “eyebrow.” This is not a bad thing per se as franchisees can be very creditworthy. Sometimes, a local franchisee will have multiple stores in an area, and it’s not uncommon for regional franchisees to operate 50 or more stores across multiple states. Most franchisees of this level set up a limited liability company (LLC) with a similar sounding name for the sole purpose of signing a net lease property. This is because an LLC is a corporate entity that has no assets and can shield even the largest company from having to honor a lease agreement.
All of this means that single tenant net lease tenants can be hard to challenge in the event of rental non-payment.
Watch-Out #6: STNL Properties Are Not Really 100% Passive Management
Many people who invest in single tenant net properties are seeking an investment asset that requires less active management and maintenance than say a 12-unit multifamily building. However, while single tenant net leased properties are considered one of the most passive real estate investments available, many investors find that they are far from a zero-management proposition. For example, someone still has to be responsible for calculating unpaid tenant taxes, collecting reimbursements, refinancing paperwork, lease burn off and value erosion issues, lease renewal and negotiations, legal and insurance issues and more! Or how about if there is a sudden roof leak?
Delaware Statutory Trust Exchanges Are Designed to
Help Investors Avoid These Same “Watch-Outs”
Instead of exchanging directly into a single tenant net leased building, more and more real estate investors are opting to leverage the power of the Delaware Statutory Trust (DST) properties. There are several reasons why DST 1031 experts advise clients to strongly consider exchanging into a DST 1031 exchange rather than single tenant net lease real estate investment, including:
Access to the Same Type of NNN Leased Real Estate and Tenants – Tenants such as CVS, BJ’s Wholesale Club, Walgreens, Bridgestone/Firestone, Advance Auto Parts, Sherwin Williams, FedEx, 7 Eleven, Starbucks and Dunkin’ Donuts have been structured and used as DST 1031 properties in the past. Many investors are drawn to the appeal of owning a building occupied by a Fortune 500 firm and love the idea that DST properties are 100% passive investments that can deliver the potential for monthly income.
Diversification – Many 1031 investors realize that placing a large portion of their net worth into a single net lease property is just plain risky. The DST 1031 property provides a potential solution to investors wanting net leased properties and national tenants but with the ability to build a diversified portfolio of them. This is in contrast to “putting all your eggs in one basket” on a single piece of net leased property. Unlike a single NNN property with a single tenant that could suddenly vacate the property, DSTs have multiple businesses, which makes it much less likely that all of these businesses will go out of business.
It is important to note that diversification does not guarantee against losses or guarantee profits. Investors should speak with their CPAs and attorneys for guidance as to if a DST 1031 property investment is suitable for their particular situation prior to considering a 1031 exchange.
Inflation Protection Potential
Anyone with a basic understanding of economics can realize that the way the federal government has been spending money, inflation may soon be raising its ugly head. For example, the United States passed the CARES Act in March 2020, which was justified as the U.S. would have faced a very dark economic period, some even say a depression. Regardless, federal spending has created the largest government deficit in U.S. history (a $3.129 trillion budget shortfall). A year after the CARES Act, Congress passed, and President Biden signed, the American Rescue Plan Act of 2021, with a hefty $1.9 trillion price tag. Then on August 11, Senate Democrats approved a budget resolution, paving the way for an additional $3.5 trillion spending bill, just hours after passing a bipartisan $1.2 trillion infrastructure plan. All of this spending could spell real inflation, and trouble for NNN leased properties. Why?
The problem with most net leased properties is the flat to minuscule rental increases that will occur, potentially causing values to suffer. For example, Walgreens and CVS often have leases with primary terms that are from 20-25 years. During this 20-25 year-period, the rent that they pay to the landlord will stay the same for the duration of the lease. Inflation could potentially wreak havoc on a static income stream such as this.
DST 1031 properties allow 1031 investors access to asset classes that historically have shorter lease terms than most net leased properties, such as multifamily apartments and self-storage properties, without the burden of active management. Asset classes with shorter lease terms can potentially be attractive to investors because when the leases are reset, the tenants are theoretically paying a greater amount than the year before, allowing the landlord to pass along any potential inflationary pressures to his or her tenants.
DST 1031 Properties Are “Pre-Packaged” for
1031 Investors to Be Able to Close on Immediately
For an investor in a 1031-time crunch, a DST property that has been pre-packaged can be a potential solution to a very real capital gains tax burden. The 45-day identification period of a 1031 exchange moves very quickly, and investors wanting to purchase a single net property have very real risks, such as financing not coming through, issues with third-party reports such as appraisals and environmental reports and sellers not disclosing material items in the property’s lease, such as early termination clauses or co-tenancy clauses, which can change the economics of the previously agreed upon purchase price.
Much can go wrong with trying to purchase a net property, potentially resulting in a failed 1031 exchange of a NNN property. The DST 1031 provides a truly passive solution to investors not wanting to be burdened with such a painful headache
Chay Lapin is President of Kay Properties & Investments where he helps advise clients nationwide about Delaware Statutory Trust 1031 exchange investments including multifamily, commercial, and fractional NNN properties. Additionally, Chay has sponsored and co-sponsored the syndication of over two million square feet of DST properties in the multifamily, net lease, industrial and office sectors as well as invested in and operated multiple net lease assets and residential properties throughout the United States.
Kay Properties & Investments is a national Delaware Statutory Trust (DST) investment firm. The www.kpi1031.com platform provides access to the marketplace of DSTs from over 25 different sponsor companies, custom DSTs only available to Kay clients, independent advice on DST sponsor companies, full due diligence and vetting on each DST (typically 20-40 DSTs) and a DST secondary market. Kay Properties team members collectively have over 115 years of real estate experience, are licensed in all 50 states, and have participated in over $21 Billion of DST 1031 investments.
* Past performance does not guarantee or indicate the likelihood of future results. Diversification does not guarantee profits or protect against losses. All real estate investments provide no guarantees for cash flow, distributions or appreciation as well as could result in a full loss of invested principal. Please read the entire Private Placement Memorandum (PPM) prior to making an investment. This case study may not be representative of the outcome of past or future offerings. Please speak with your attorney and CPA before considering an investment.
* No representation is made that any DST investment will or is likely to achieve profits or losses similar to those achieved in the past or that losses will not be incurred on future offerings.
Diversification does not guarantee profits or protect against losses. All real estate investments provide no guarantees for cash flow, distributions or appreciation as well as could result in a full loss of invested principal. Please read the entire Private Placement Memorandum (PPM) prior to making an investment. This case study may not be representative of the outcome of past or future offerings. Please speak with your attorney and CPA before considering an investment.
There are material risks associated with investing in real estate, Delaware Statutory Trust (DST) properties and real estate securities including illiquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multifamily properties, financing risks, potential adverse tax consequences, general economic risks, development risks and long hold periods. All offerings discussed are Regulation D, Rule 506c offerings. There is a risk of loss of the entire investment principal. Past performance is not a guarantee of future results. Potential distributions, potential returns and potential appreciation are not guaranteed. For an investor to qualify for any type of investment, there are both financial requirements and suitability requirements that must match specific objectives, goals, and risk tolerances. Securities offered through Growth Capital Services, member FINRA, SIPC Office of Supervisory Jurisdiction located at 2093 Philadelphia Pike Suite 4196 Claymont, DE 19703.