Emily’s Notes: Triple-Net Properties
This last election was only the latest battle of a seemingly endless war, but Emily was at least temporarily relieved when Proposition 10, the “Local Rent Control Initiative” failed by a vote of 60% to 40%. That rent control measure would have allowed localities to layer new burdens on residential landlords, including the owners of single family residences (SFRs) and condos. These are the properties many aging seniors hope to rent out after retirement, and perhaps to eventually leave to their children. The threat of ever more government intrusion into their private affairs did not appeal to them, and they voted as one would expect.
California being 54% homeowners and 46% renters, it’s clear that no state-wide rent control measure could pass without homeowner support and Emily was pretty sure that extending rent control to SFRs and condos was the inflection point for many homeowners. It’s okay, apparently, for multi-unit investors to be subject to rent controls, but not SFR or condo owners. If that’s the case, she feared, it’s only a matter of time before Prop 10 reappears with the SFR/condo threat redacted. When that happens, she believed Ma and Pa homeowner would think they no longer had skin in the game and the revised Proposition would likely pass.
Emily began to consider getting out of the apartment business and perhaps shifting to something else, maybe NNN properties. She had made no decision, but she was giving it thought and the following are a summary of her notes.
General Description: A single-net investment (N) is one where the tenant is responsible for real estate taxes. A double-net investment (NN) makes the tenant (the lessee) responsible for taxes and insurance. And a triple-net (NNN) includes taxes, insurance and adds maintenance.
These leases are typically associated with special purpose free-standing buildings on dedicated sites. This sort of investment attracts investors whose primary interest is income stability and no maintenance, so the most desirable tenants are those that provide the greatest certainty of uninterrupted payments to the owner (the lessor). As a general rule, these tenants are usually S&P 500 corporations who will provide a corporate rent guarantee.
There’s no free lunch. In exchange for that rental assurance, the corporation will often require a long term (30+ years) flat lease, perhaps with one or two optional (optional to the tenant, not the landlord) 10 year extensions. The sum of (a) the initial lease term plus (b) extensions can run to 50 years or more. These are flat leases and do not provide for annual inflation increases. Sometimes, there may be token increases at wide intervals, like 5% every five years, which pencils out to less than 1% per year (compounded). But it’s common to have no rent increases during the initial term (usually 30 years) of tenancy. No CPI increases does not mean there’s no inflation. It means the landlord absorbs the inflationary losses.
Example Offerings: Triple net investments run from things a prudent investor wouldn’t touch (ex: the processing plant of an unrated chicken farm, with not even a personal guarantee on the lease) to NNNs that are nearly certain to make their lease payments (ex: a “AAA” credit S&P 500 listed chain of drug stores with a corporate guarantee). Most are somewhere in between. Cap rates vary with the expected reliability of the lease payments.
Appeal: The allure of this sort of investment is threefold: (a) regular checks, (b) minimal management, and (c) less political jeopardy. Depending on the investor, these beneficia may not be enough to offset the risks (see following) associated with NNN properties.
Investment Risk – Credit: Noted only as a matter of completeness, there are rating agencies that will provide a professional opinion of the credit soundness of a potential lessee during negotiations. That’s not a risk Emily gave much thought to, because it’s usually handled for a fee by a third party during the normal due-diligence process.
Investment Risk – Asymmetry: Emily liked to think that an example of an asymmetrical relationship is when buyer and seller had dissimilar strength at the bargaining table. If one party had significantly more negotiating power than the other, the weaker party may ultimately have to simply accept whatever terms the stronger party offered. There would be no real negotiation because the prospective tenant could choose to lease another property from a different owner. This take-it-or-leave-it “negotiation”, where one party holds most of the cards, is the common relationship between a non-institutional investor and an S&P 500 potential lessee. Basically, the credit-worthy corporation offers rent and terms that are favorable to the corporation. The non-institutional owner either accepts the final corporate offer or mails the keys back to the bank.
Asymmetry is most acute during lease negotiations while the building is empty. For that reason Emily did not want to buy an empty building, even if she could possibly get it for a better price. If she bought a NNN building with an established lessee already in place the terms of the lease would no longer be a matter for discussion. Negotiations would be between putative equals, existing property owner to potential property owner. And that, in turn, made it possible to restrict the price discussion largely to the new owner’s capitalization rate.
Investment Risk – Principal: In some ways, the purchase of a NNN property mirrors owning a long-term bond. At maturity, the owner expects to reacquire the right to occupy the property (or to receive the face value of the bond). Between now and then he reasonably anticipates receiving a stream of income: rent from the property or interest from the bond.
The thing is – the value of the property (or bond) varies not only with time to maturity, but also with interest rates.
The guideline is this: as interest rates go up, the value of the property goes down. And vice versa: as rates go down, the value of the property goes up. As an illustration, to determine the value of a (hypothetical) perpetual bond, we need to know only two things: (a) the annual net income to the lessor and (b) the market interest rate at the time of purchase. Assume the market interest rate at time of purchase is 10%.
Knowing only the annual stream of net income and the market interest rate, can we compute the market value of the bond / NNN property? The answer is “yes”. The bond is worth $1,000. The math is simple: annual income divided by interest rate (in decimals) equals value.
A simple calculation indeed, but its corollary is that even small changes in the market interest rate could have big effects on the bond’s value. Following the purchase of the bond, imagine that interest rates go down for the next couple of years. One year after the bond is issued, market rates are 9%. What is the new value of the bond? $100 divided by 0.09 equals $1,111. Because rates went down, the value of the investment went up. Twelve months after that the owner checks rates and finds that they continued to drop and are now at 8%. He does the math and discovers that his perpetual bond is now worth $1,250. So far, that’s not a bad investment. He invested $1,000 and his principal has grown 11.8% per year (compounded). And on top of that he got the contractual interest payments. Not bad, huh?
But the lower rates caused the economy to overheat. To shortstop inflation the Federal Reserve ran interest rates back up. At the end of the third year of ownership rates were 12.5%. The value of the bond dropped to $800, and the owner learned an important lesson: the value of any stream of income can vary enormously during the holding period, regardless of its assumed safety, whether with bonds or NNN investments. Returning to NNN purchases and resuming the example of the 50 year lease (includes option periods), it is interesting to note that interest rates have cycled widely over the last 50 years. The 10 Year Treasury note was at 1.45% in July, 2016. At that time a $100 annual stream of income would have been worth $6,896. This was down from 15.82% in Sept 1981, when the stream of income would have been worth $632. Before you say, “Buy at $632 and sell at $6,896? I’ll take it!” remember that there were an equal number of parties on the other side of those transactions. For every person who bought at $632 there was someone who sold at that figure. And for every seller at $6,896 there was a buyer.
One element of successful investing in fixed income (NNN buildings or bonds) is to be on the right side of the interest rate curve. Half the people who have played that game have discovered that sometimes it’s not as easy as it looks.
Investment Risk – Purchasing Power: As noted earlier, a common characteristic of NNN leases that is often inadequately considered is that, while exceptions sometimes apply as noted above, the rent is fixed for the initial lease period. This means the landlord (lessor) bears the burden of inflation. That could be onerous for two reasons: (a) inflation will always be with us, and (b) inflation has a compounding effect.
Example: Presume a property with an original lease period of 50 years (30 plus two 10 year options). It’s a flat lease, with no bumps. In 1967, the owner paid $1,000,000 cash for the property, which at that time generated a contractual net income of $100,000 per year. At the time of purchase in 1967 a 10% cap rate for properties of this sort was common.
Before you know it, thirty years go by. It’s now 1997, and the rent is still $100,000. But inflation averaged 5.44% over those three decades. A basket of goods that cost $100,000 in 1967 cost $490,000 in 1997.
But there’s always a pony in the room, somewhere. Looked at from another way, the tenant is getting $490,000 (1997 value) of leased space for $100,000 1967 dollars. And, if the options are exercised, that lease could continue in eroding in value due to inflation for another 20 years. There may indeed be a pony in the room, but it belongs to the tenant. https://www.bls.gov/data/inflation_calculator.htm
Lease Termination: The owner recovers his “occupancy” rights at the end of the lease (plus extensions) which, as we’ve seen, may be fifty years on. At that point, the asset probably amounts to an old, empty, building that could well be unrentable due to market changes and / or accumulated deferred maintenance. The tenant, with no incentive to improve (nor even properly maintain) the building, over the last several years of the lease may leave the building needing a new roof, or electrical service, or even plumbing. The building as a whole may no longer meet market expectations, and thus be unrentable in its (then) current condition.
As the moment of lease termination approaches the owner will have two obvious options.
Alternative # 01: The owner keeps the property to lease’s end . . . But it’s possible (not assured, but possible) that after the lease ends, the residual land value could be pretty significant. Hypothetically, a NNN refrigerated warehouse might have been built in 1970 on 10 or 15 acres just outside Barstow. That is not an unrealistic location, being at the intersection of the 40 and 15 Freeways, and “convenient” (in trucking terms) to San Diego and Los Angeles.
The population of Barstow in 1970 was 17,442. In 2018 it had grown to 23,916. That’s not much. It comes to a less than 1% annual growth rate (actually, 0.66%). So we’re not talking runaway growth here. But the NNN leased property is right off the intersection of the 40 and 15 Freeways and is visible (not at the same time) from all four directions. When the lease expires and the lessee moves, that land will be available for redevelopment. There might be value in the land, not because Barstow is overpopulated, but because Interstate 15 (North) is the way to Las Vegas. Interstate 15 (S) passes reasonably close to Disneyland. Huge numbers of travelers pass that 15/40 junction every day, and more on weekends. Those ten acres might accommodate a food / gas complex. Maybe even add a humble motel. “Ok, kids, we’re gonna spend the night here because it’s cheap and Disneyland is expensive. If we skip breakfast tomorrow we might only need to leave one of you in the car”. Indeed, if the owner keeps the property past lease expiration, the site might be very sellable.
Alternative # 02: The owner sells the property late in the lease term . . . The original owner or his heirs may not wish to deal with an empty property that generates no income, especially if they lack the funds necessary to repair the structure. They might be very amiable to selling before the lease expires. If it’s not too long before the building becomes vacant, that probably means the transaction price would reasonably start by determining the NNN income not at historical 1967 levels, but at current market lease rates. Then there would be a deduction for necessary repairs. There would also be a deduction for the anticipated vacancy period before receiving lease checks from the new lessee. If the new buyer restores and re-leases the property, he’s back to the same point the original lessor was in half a century ago. Or, after the purchase, the new buyer may change his mind and make no effort to re-lease the property. He might simply sell the plot for land value (see above). That could work out very nicely for him.
This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional. Klarise Yahya is a Commercial Mortgage Broker specializing in difficult-to-place mortgages for any kind of property. If you are thinking of refinancing or purchasing real estate Klarise Yahya can help. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email info@KlariseYahya.com.