Investment real estate owners often hear about “NNN”, or “triple net” properties. Real estate brokers or other advisors may recommend NNN properties as an alternative to apartments for 1031 exchanges or direct investments which include:
- Hands-free management
- Name brand tenants.
- Long-term leases
Pinch me, I must be dreaming! But what are NNNs, exactly? What follows is a quick primer on what NNNs are, and perhaps more importantly, what they are not.
What are NNN Properties?
NNN properties can be different types of real estate properties but the property’s tenants have a special type of lease, a “NNN lease”. NNN stands for “net, net, net”. In addition to the agreed-upon rent, the NNN tenant is responsible for the net property taxes, net insurance costs, and net of some building maintenance expenses.
Generally, these tenants (who can lease anything from retail, to office, to industrial properties) sign longer term leases in exchange for lower rental rates. Investors love NNN lease properties because they do not have to deal with traditional property management responsibilities. Tenants love them because they can lock in generally lower rents for a longer term than a traditional lease. They are very popular investments for a number of reasons.
Why Invest in Real Estate?
There are two primary reasons people invest in real estate to begin with:
1. Current cash flow income and
2. Future appreciation in value
Tax sheltering benefits, 1031 exchangeability, pride of ownership, and other reasons also factor in. Many real estate investors look to single-tenant, NNN properties because they believe such investments will achieve these goals, and they are attracted to the lack of day-to-day, hands-on property management. Also, these properties are often leased to publicly traded, “name-brand” companies with strong balance sheets, giving the property owner confidence that the rent due will be paid each month, even if the tenant vacates the property during the term of the lease.
So, what’s wrong with NNN properties? There are several issues that investors should consider before purchasing a NNN property.
First, while a long-term lease is attractive, the most important question is how much of that long- term is remaining at the time of purchase. A 20-year lease with 10 or fewer years remaining could be a disaster if the tenant doesn’t renew or extend the lease at the end of that 20-year term, just 10 years later. The shorter the term remaining on the lease, the lower the actual and/or perceived value of the property.
Second, while a 6%+ cash-on-cash return certainly seems attractive during the first few years of an investment, what happens in the later years? In nearly all NNN property leases, the rental rate increases are fairly few and far between. Often, you will see a 10% increase in rent only once every five years. Whatever the rental rate increases are, it is highly unlikely they will keep up with inflation, which many experts believe will increase even more over the coming decade. If the dollar buys less in five or ten years than it does today, then that average 2% a year increase could mean little. And if the local market is doing well, the NNN property could fall far behind local market rents, decreasing the return and potential value of the property. Also, because the tenant is responsible for so many of the property expenses, landlords lose many valuable tax deductions against the income that they would otherwise be able to claim.
Third, investment real estate is valued based upon its Net Operating Income (NOI). A lack of NOI growth means the property may be worth less every year, as opposed to more. As the rent will either be flat or only slightly increased when the time comes to sell years later, the only hope of appreciation in value is a lowering of capitalization rates, a phenomenon called “CAP rate compression”. The CAP rate is used to determine value, and is simply a multiple of the NOI for a property. In other words, it means the investor is betting that in the future, buyers will pay more for a property that generates nearly the same income as it does now. Generally, this is a poor bet. Add to this, if a property has only five years remaining on a lease, would a buyer pay more than if it had 10+ years remaining? Most likely they will not.
Last, what about the “Toys R Us Factor” or the “Blockbuster Video Factor”, if you prefer? Name your long gone bankrupted store, office or fast food tenant who used to fill shopping centers and commercial buildings. Needless to say, things change. A tenant who looks solid and attractive today may be outdated and worthless tomorrow. If an investor loses a NNN tenant, they will be on the hook to not only find a replacement, but possibly to pay for all of the tenant improvements required to secure that new tenant. If the NNN property is located in a smaller market (as so many of the available offerings are), it may be very difficult and very expensive to find that replacement tenant. An investment property that once seemed like a homerun can suddenly be a strikeout.
Of course, not all deals are created equal, and there are some good quality NNN investments available, in good locations, with solid tenants and 15+ years remaining on the lease. But while a NNN property may seem like an attractive, hands-free investment for a 1031 exchange or direct investment, a closer look is required to determine if it truly meets your investment goals and objectives.
Adam Bryan is with H&S Wealth Management, a wealth management and 1031 investment advisory firm. He is a licensed Series 7 investment advisor and also a licensed real estate sales agent with 17 years of experience working with 1031 exchange investors. Contact: (310) 903-6757 or [email protected].
Investment advisory services offered through McDermott Investment Advisors, LLC, an SEC registered investment advisor. Securities offered through McDermott Investment Services, LLC, a registered broker dealer member of FINRA/SIPC/MSRB.