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THE PITFALLS OF TRIPLE-NET COMMERCIAL LEASES

What are retirement investors missing about triple-net?

The Case for Private Equity Investment. Twenty years ago, I was the COO for a private equity group that invested mainly in NNN properties. We had over 250 NNN properties in our portfolio. We did sale leasebacks, build to suits, reverse build to suits, acquiring or selling NNN in just about every way imaginable. It was a great business, a wealth-generating machine.

NNN is presumably an attractive personal investment for Individual investors due to the absence of landlord responsibilities, steady cash flow, and opportunity to defer to capital gain. Aging individuals who formerly owned and operated multitenant properties have traded into NNN to preserve an income while retiring from active management. For these reasons, NNN is generally thought to be the ideal 1031 investment.

Sounds like a great deal. But maybe investors, particularly those who are investing to provide a reliable source of retirement income, should consider alternatives.

What are retirement investors missing about NNN?

Less sophisticated investors don’t understand the risks.

All NNN Is Not Created Equal.  When it comes to NNN investing, less sophisticated investors don’t understand that “NNN” is not a legal term or guaranty. There are material differences among so-called “NNN” leases. Few NNN leases place all property-related burdens on tenants for any reason whatsoever. Most NNN leases either expressly, or subtle ways, place material obligations on owners.

More than anything, NNN investors may mistakenly assume that a NNN lease means owners have no reason to their properties, tenants, and general market conditions.

Difficulty Buying Properties. Popularity and conventional wisdom have driven individuals to the NNN market. The popularity of NNN properties has created a seller’s market and the existence of a seller’s market should be a warning to exercise caution.

NNN tenants, particularly the well-known tenants, are aware of the demand for net-leased properties. This allows tenants to negotiate favorable lease terms which may, one day, become problematic for owners.

While one may think that real estate developers will be tough about lease negotiations, the developers themselves generally do not hold newly constructed properties for any length of time. Due to strong buying interest, they can sell many of these properties before construction is even completed (which introduces yet another set of risks). Since developers believe they can flip out of properties quickly, they do not bear the risks of long-term ownership. In addition, the desire to get repeat business from net-leased tenants, has encouraged developers to go easy on lease negotiations.

There are so many buyers flooding the market, developers and other sellers of NNN properties are very tough about purchase and sale contracts. These contracts are very light on seller obligations and warranties, they are heavy on forcing buyers to close. They give little time for buyers to perform due diligence and understand property conditions.

Tenant-friendly leases, seller-friendly purchase contracts, limited due diligence, and buyer competition are factors that can lead to costly mistakes.

Lease Compliance Risks.  EEven if a lease provides landlords with broad protection, many NNN investors incorrectly assume that by having no “performance” obligations, there is no reason to monitor a tenant’s lease compliance. But a tenant’s obligation to maintain insurance does not mean that a tenant will buy the right insurance, a tenant’s obligation to maintain the premises does not mean that a tenant will repair property damage property, if at all. Since a NNN lease generally places operating control in a tenant’s hands, owners need to ensure that tenants are exercising that control responsibility.

Liability Risks.  Many NNN investors think that a tenant’s insurance protects them from liability. They don’t understand the importance of having multiple liability shields such as a special purpose entity or backstop insurance to cover potential gaps in tenant policies. Tenants may try to shift liability to landlords based on a theory that the liability-triggering event was caused by a construction or design defect that was the original owner’s responsibility. And owners get sued even when tenants are purportedly responsible for claims. Special purpose entities may not shield individuals from liability, the law can be compassionate towards injured parties, allowing plaintiffs to “pierce the corporate veil.”

Moreover, insurance is a complicated. Any investor who does not understand the difference between “all risk” and “broad coverage” or between “loss payee” and “additional insured”, the relationship between “indemnity” and “insurance,” or the reliability of an ACORD form has no business buying NNN.

Credit.  NNN is a credit transaction, in some ways similar to buying a bond. The NN advantage is that the bond is secured by real estate. If the tenant goes out of business, the underlying real estate has some value. Most corporate bonds are unsecured, they represent only an issuer’s promise of repayment. If the issuer goes out of business, the bonds could be worthless.

However, sophisticated tenants may “buy” the credit. An investment grade tenant may lease real estate through a subsidiary that is substantially less than investment grade. Sometimes the lease is not with the corporate brand’s organization but is tied to a small and less creditworthy franchisee. And even if tenants have credit, investors should never discount the risk of credit downgrades.

Bankruptcy laws favor tenants. There may be ten years remaining on a tenant’s lease, but bankruptcy law may reduce a landlord’s claim to a fraction of the remaining rent. Moreover, owners may not have the right to use cash security deposits or letters of credit that are supposed to collateralize the lease.

“Big” Tenants, Bullies, and Negotiating Leverage.  NNN investors like leases with corporate brands and “big” tenants because large organizations inspire confidence in an owner’s mind. But owners overlook the reality that big tenants have lots of lawyers. Some big tenants are bullies. Institutional quality owners have the muscle to arm wrestle with big tenants, especially when those tenants are being unreasonable. Small owners, particularly those who depend on the income, may be at the mercy of a heartless corporate bureaucracy. During this pandemic, many large, financially solvent, and profitable tenants threatened they would not pay rent. Buyer beware.

Vacancy.  Even credit NNN properties become vacant. Vacancy arises because credit tenants can face financial failure (Boston Market, Hollywood Video), or tenants voluntarily because the location is underperforming. Even an owner is lucky enough to have a tenant that pays rent on a closed location, the absence of an operating tenant-or even the mere threat of vacancy-can materially reduce the property’s value.

Even when a tenant’s business is performing well, there is no guaranty that a tenant will exercise a renewal option. Options are not mandatory; the option only commits the owner. “Fair market value” renewals are a myth; tenants can use these options to pressure less sophisticated landlords. Tenants will use the threat of nonrenewal to renegotiate rents, especially if they perceive their landlord is weak or their rents are above market.

Remember than real estate is a depreciating asset. Have you ever been in a Dollar Store or QSR that has been open for 10 years? These properties get worn down and accumulate deferred maintenance. NNN tenants frequently update buildings and equipment rendering older properties obsolete. Tenants can demand sizeable allowances as a condition to renewing a lease.

Residual, or Unoccupied, Value. The financial math underlying NNN assumes that the rental payments are an annuity, tenants will always renew and the rent will continue forever. This assumption departs from reality. There are many reasons why a NNN property could become vacant. The market values vacant properties based upon the property’s residual value – a function of leasing potential and re-tenanting expense.

Think about it. An investor might buy a name-brand oil change property for $1,000 psf. The building is useful for not much more than an oil change facility. The building sits on a post-stamp sized 10,000 square foot lot. If that tenant goes out of business, what could an investor do to replace that value? Walgreen’s may trade at $400 to $500 per square foot. NNN investors are generally buying income streams, they are not buying real estate.

For this reason, investors must understand that they could be purchasing NNN properties at prices that far exceed land and building costs. Those costs may not be justified for a different tenant or use. And to the extent a building is specialized to meet specific needs, the building may have prohibitive re-tenanting costs. Due to difference in the kitchen line and trade dress, a McDonald’s will not use a Burger King box. And if you can get a smaller restaurant operator who is willing to adapt to specialized property (as opposed to changing the building to meet its needs), there’s a likelihood that this tenant will not pay the same rent, and the building will not trade at a comparable cap rate on sale.

Don’t forget too that title or zoning restrictions may limit the types of alternate uses available for re-tenanting a vacant property. A smaller universe of tenant prospects makes the re-tenanting task more difficult.

Generally, vacant NNN properties have a residual value that is much lower than its leased value. With this dynamic, even a small loss can wipe out profits and invade capital. It could take take years to recover lost capital and the investor may never replace the income stream.

Tax. The tax code is constantly changing. New IRS section 199A, may reduce the type of deductions available to NNN owners. And it’s a greater concern that legislators have debated terminating like kind exchanges under section 1031 (or reducing the amount of gain that can be deferred) for several years. Note that the “Tax Cut and Jobs Act” repealed the ability to defer gain on exchanges of personal property. What would happen if Congress repealed 1031 for real property exchanges? Tax-deferred exchanges is an important tool for the NNN industry, repealing that right could change NNN investment economic, triggering a systematic rise in cap rates. Rising cap rates result in a corresponding reduction in value for owners.

Never let the “tax tail” wag the dog. 1031 buyers should note that sometimes it’s better to sell a property, pay taxes, and then consider reinvestment alternatives.

Investment Economics. This may be the least understood aspect of NNN investing. The relationship between cap rate and debt constant can be overlooked. While it’s generally assumed that leveraging real estate investments will produce a higher return on equity, in some cases (particularly when purchasing low cap rate NNN), debt will actually reduce current cash returns.

There is also a bias towards thinking that once you purchase NNN, you can just leave it alone, that NNN is a completely passive investment. That’s just not true. A NNN lease with a 15-year original term may start to lose value after the 7th or 8th year. To preserve capital value, it may be wise to look for opportunities to dispose of (or exchange) a NNN property starting around the 5th year of the term. Holding on too long exposes NNN owners to value reductions due to the possibility of lease nonrenewal. Moreover, market conditions, credit issues, and industry trends may warrant selling a NNN property at any time.

Alternatives to Triple-Net Properties

This article points out that NNN investing is not a “be all, end all” solution for creating retirement income. Most NNN investors overlook material risks. Investors should therefore consider alternatives to NNN investment. For example:

Retirement investors can hedge the risks of NNN investing through REITs. Publicly traded NNN REITS, for example, protect less sophisticated investors by providing professional management who know how to play the game, a diversified portfolio to hedge geographic and credit risks, and the financial strength to play hard ball with even the largest tenants. There is an added advantage because public REITs offer liquidity that direct real estate investment does not provide. However, there is a cost associated with investing in REITS. REITS have a lot of overhead, which means that dividend yields could be a couple of points lower than what is available through direct investments. Also, REIT stocks are subject to stock market volatility and other matters unrelated to the underlying real estate.

Private equity investing is another alternative to direct investment. By investing in properties other than NNN, private equity sponsors can pay internal overhead and still provide yields that are substantially above NNN. Moreover, private equity sponsors may invest in properties like apartments, office and retail properties that avoid NNN residual value and re-tenanting issues. Private equity may also offer these investments in the form of DSTs (Delaware Statutory Trusts) that preserve the ability to 1031 exchange (real property cannot be exchanged for shares in a REIT’s stock). Private equity sponsors may be equally capable as REIT managers and, due to their smaller size, may give their investors greater attention and more personalized service. The greatest risks in private equity investing lie with the sponsor. Investors are placing their faith in a sponsor’s judgment, integrity and financial conservatism.

ndividuals investing for retirement income should not take a knee-jerk approach by investing in NNN. Any investment in real estate involves special risks. Understand the risks in the context of your personal needs and decide accordingly. If you need help in analyzing risks, seek the assistance of a trusted advisor.

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