There are several options when looking to diversify your investment portfolio, especially in the commercial real estate asset class. A borrower’s risk tolerance, passive or active investment activity, long-term goals, location, and current equity and capital position can make finding the right investment property a unique experience. Options for commercial financing are available from several lenders and the types of loans depend on the property type, location, tenancy, and borrower financial profile. For those looking for more passive real estate income opportunities, triple-net (NNN) leased properties and the type of financing available can be a great option to explore.
What is a Triple-Net (NNN) Lease?
Triple Net Lease, or NNN, is a type of commercial real estate lease agreement where the operating costs of maintaining or owning the property is paid directly by the tenant. Circumstances vary, but it’s common for tenants under a NNN lease to cover maintenance costs, insurance, property taxes, utilities, repairs, and other fees in addition to their monthly rent.
Under a NNN lease agreement, the tenant contracts to pay an agreed upon base rent plus a pro-rated cost of the property’s operating expenses. These are often referred to as CAM or NNN charges. Compared to gross leases, a NNN lease agreement typically carries very little to no landlord responsibilities or costs. Under a NNN lease agreement, the tenants are not required to pay any portion of the mortgage payment should the landlord have any debt secured to the property.
NNN leases are a good consideration when investors are searching for a passive real estate investment. The degree of risk depends on tenancy, location and capital allocation. Typically, NNN leases are perceived to be lower in risk due the credit nature of the tenancy and term of the base lease periods. As a result, these types of properties will have lower cap rates.
What is Triple-Net (NNN) Financing?
Net lease financing is when a lender relies upon the repayment capability or “credit” of the tenant to make the lease payment to the landlord; which in turn will assist in making the subject mortgage payment. The lender will cite the base rent income as well as the recoupment of taxes, insurance, and management expenses in their underwriting analysis. NNN financing is something that not all lenders are willing to participate in. Finding the best lending partner given the property type, location, and tenancy are essential to maximizing a NNN investment.
Acquiring NNN financing requires more specific eligibility. For example, interested investors should have a net worth close or equal to the requested loan amount. Because of this, NNN investments are usually attractive to more sophisticated investors or real estate owners that are in 1031 exchanges that using leveraging larger down payments to grow their portfolio.
Lender Considerations for NNN Financing
While the benefits for NNN leasing are attractive to high-level investors, there are still other factors that lenders will consider. NNN leases allow for long-term occupancy, low-risk investments, a consistent income stream, increased equity, reduced landlord duties, and tax benefits. However, there are also earning caps on rent ceilings, which can limit the property’s overall earning potential, especially if the property’s located in an area with increasing value. There are risks of vacancy if the tenant were to default, which leads to loss in profit and a requirement to cover the costs during vacancy themselves. Since tenants will be running a business, they may need financing of their own to cover the rent, operating costs, and any problems that occur along the way. This can create complexities in the finances of a building, which may lead to a more hands-on approach from the investor. Thus, lenders focus their attention to the creditworthiness of the tenants due to the primary reliance of those lease payments to the landlord.
To better weigh these pros and cons, there are certain considerations that a lender and investor need to review. Due to the volatility of the market, working with a professional can help you weigh your options and determine if a property will make a good NNN investment.
Credit vs. Non-Credit Tenant
Credit tenants, and often referred to as national tenants, have strong balance sheets and are known across the country—think Walgreens, Dollar General, or Starbucks. They have highly rated investment-grades from places like Fitch, Moody’s, or S&P and therefore considered to be lower-risk. Due to their overall financial standings across the nation, NNN financing for credit tenants are strong, stable, and safe. As with any investment, there are still risks, so landlords should not view them as 100% risk-free. When a NNN property is occupied with credit tenants, you should expect to pay for the convenience of stability. Your overall return on investment will be lower, but it will also be more guaranteed. The higher the investment grade tenancy, the lower the cap rate.
Non-credit tenants can be small or private businesses that do not operate on a national level. These mom-and-pop shops often have more volatile financial stability than credit tenants and rely on local economies for support, but that does not mean that they should not be considered. While non-credit tenants usually pay at or just below market rents, they too include paying their pro-rata share of the buildings operating expenses through a CAM or NNN charge in addition to their base rent. While the financial strength may be less than that of a nationally acclaimed credit tenant, their leases still hold value to investors seeking more passive commercial real estate holdings. As a result, smaller, more local or regional tenants with NNN lease agreements will still command a strong cap rate, but they may not be perceived to be as strong as a national credit tenant such as Drugstore, Grocer . Because of this, the number of different lenders that may be interested extended such loans can become very limited and localized to the subject market.
The benefit of purchasing Net-leased properties is they are already occupied and paying the contracted rent. In a purchase transaction, the existing lease agreement is transferred to the new buyer so it is important to take the time to fully understand the in-place lease agreement as there can be joint-tenancy agreements with larger anchor tenants, go-dark periods, rent holidays, and what extensions are available. Most NNN leases with credit tenants will have an initial lease term at a minimum of 10-15 years with periods for larger, national credit tenants extending up to 25 or even 30 years. The longer a credit-tenants lease, the more attractive the investment is for the prospective purchaser or existing landlord.
While national credit tenant net-leased properties with long term leases command a premium, there can also be hidden value for properties with strong tenants with shorter terms remaining on their leases. It is not uncommon for certain lenders to pass on financing properties with shorter term leases, as they view this as potential vacancy risk, but these can be great opportunities to uncover opportunity by restructuring the lease with the tenants.
Traditionally, lenders like to match financing; in other words, make loans for fixed periods that coincide with the remaining term of the lease. Of course, the longer the lease term, past the fixed loan term, the better. This is commonly referred to as “lease tail” and is highly scrutinized in the world of Net Lease finance and with CMBS lending. Lenders will also request and want to review tenant estoppels and SNDA’s, which are typically available to new buyers per contracted lease agreements.
For NNN leased properties with short and long term leases in place, it is important to work with industry professionals that can secure competitive loan terms which offer flexible and long term options.
Type of Tenant
Prior to securing NNN financing, investors should take the time to get to know the type of tenant occupying the building. Researching the credit rating of your tenant will help you determine how your lease terms will be in the future since lenders understand that your repayment is largely determined by a tenant’s financial stability. To better assess tenant strength, explore the number of stores they own and operate, what their debt-to-equity ratio is, the stability of their management, what their operating margins are, and the likelihood of them staying in business. COVID-19 brought a lot of attention to NNN leased properties. While some single-tenant restaurants with drive-thru’s fared quite well, many indoor dinning tenants were hit specifically hard and requested rent concessions. In today’s world, it is vital to ensure tenancy can be both internet resistant and considered an essential business should anything like a global pandemic occur again.
Property and Market Conditions
Even if you secure a credit tenant with impeccable finances, NNN properties are not immune from the nuances of commercial real estate.
In 2020, COVID-19 know around the world as the global pandemic, caused many credit tenants to push pause and re-evaluate their current real estate obligations. The concept of force majeure was used across the US with some tenants trying to evade their lease obligations due to unexpected government mandated closures. In these instances, landlords with loans on properties will need to be liquid enough to cover any short payments to stay current on their loans.
Local market conditions and location can change the value of a property over time, which will affect your investment in one way or another. If you secure a property with 5 years remaining, but it is in an inferior or deteriorating location or poor market, it may be hard to re-lease.
Trends in demographics of a surrounding population will affect your NNN property’s competitive position in a market as well. The type of tenant that is currently occupying the space can indicate future problems or growth opportunity. Businesses that specialize in one thing—oil changes—can be difficult to refurbish for use if they decide to move after their lease. Taking the time to fully consider each property is essential in the long-term success of NNN investments.
For the most competitive NNN financing terms, investors should know their options when selecting a lender. Federally insured institutions, such as banks and credit unions, are attracted to NNN leased properties, but they’re not the only financing option.
PACT Capital is a national commercial mortgage banking firm who specializes in offering the most competitive NNN financing across the United States. As experienced capital advisors, we provide clients with strong industry knowledge to accurately assess the risks associated with NNN investments while providing best-in-class financing solutions to maximize return on investments with the most flexible and lowest cost of capital. To learn more about how PACT can help with your NNN financing, email info@PACTCap.com, or call 213-799-PACT (7228) today.