January 04, 2016

Understanding and Evaluating Net Leased Investments

What is a Net Leased Investment?

A net leased investment is one in which the tenant pays expenses in addition to rent. The three nets are taxes, maintenance, and insurance. In an absolute net leased property, the tenant is also responsible for roof and structural repairs. Net Leased properties are so attractive because they offer a real property investment vehicle that can be completely passive. With no management responsibilities, investors can own properties across the country and can easily diversify by market and tenant.

Most national companies are tenants under net leases. Some examples are Walmart, Burger King, Advanced Auto Parts, CVS, Starbucks and Dollar General. Typically tenants will sign very long leases with structured rent increases throughout. These leases often have corporate guarantees giving the investor security in the income stream.

Before you can effectively evaluate a net leased investment you need to understand the basic terms.

Key Terms in Net Leased Investing

1031 Exchange

A tax benefit that allows an investor to sell an investment property and buy another investment property using the proceeds from the sale. This provision allows capital gains taxes on the sale to be deferred indefinitely.

Cap Rate

Annual Net Operating Income (NOI)  / Purchase Price. Also equal to the unleveraged return in year one.

Double Net (NN)

There is some level of management responsibility. Typically the  property owner is responsible for roof and structural repairs along with some other expense sharing.

Fee Simple

Standard property ownership of both the land and the building.

Ground Lease

Investor owns the land only. The building is built and maintained by the tenant. The building reverts to the owner of the ground lease at the end of the lease term.

Leverage

The use of various financial instruments or borrowed capital to increase the potential return on an investment.

NOI

Net Operating Income. A property’s annual gross income, less operating expenses, before the cost of financing and income tax. In a NNN investment NOI equals the lease payments.

Rent Escalations

Increases in the rent or NOI as per the lease which are also called Rent Bumps. Escalations can be represented as a dollar amount (ex. $3 per square foot) or a percentage of the base rent the previous year.

Triple Net (NNN)  

The tenant is responsible for all expenses including taxes, maintenance, insurance, and repairs.

How to Evaluate a Net Leased Investment

There are many considerations when evaluating a potential net leased investment above and beyond the actual real estate. The factors below are some of the most important things to review.

Guarantor

Who is guaranteeing the lease? Corporate guarantees are preferred followed by franchisee guarantees. Leases guaranteed by individuals are seen as the most risky. If the tenant chooses to vacate, the remaining lease payments are guaranteed by the entity behind the lease which could be an LLC that runs three Wendy’s businesses or a national company like Walmart. This is one of the main factors in evaluating the risk of the net leased investment.

Lease Structure

Is the lease structure NN, NNN, or a Ground Lease (GL)? What, if any, are the management responsibilities? Ground leases command the greatest premium because they are considered the most hands off. NNN or Absolute Net Leased deals are a close second with NN deals fetching higher cap rates. The more potential landlord responsibility the higher the cap rate.

Lease Term

How long is the base term of the lease? Are there option terms? Longer lease terms command cap rate premiums. If the tenants were the same, a 20 year lease will always be more desirable than a 5 year lease. It’s also important to note how long and how many options the tenant has. If the tenant is near the end of their lease and there are no options you will have to renegotiate the lease if the tenant wants to stay. Typically longer base terms and longer option periods are preferred.

Location

Is the property re-leasable should the tenant leave? Fast Food is considered one of the easiest tenant categories to release because the buildings are often similar in size and are more or less interchangeable. A Burger King can become a McDonalds etc. Simple structures called “vanilla boxes” are often seen as a positive as well. Larger spaces such as a FedEx distribution facility may be harder to release. Second, does the tenant match the market? Dollar General may not do as well in a highly affluent area as it would in a middle market. Finally, are the current rents in line with the market? Many national net leased tenants pay above market rent to get the best locations. However, if a tenant is paying at or below market rent it may be easier to replace the rent if the tenant should vacate.

Market

What is your exit strategy for the investment? You always want to be able to answer, how you get in the deal, how you make money, and how you get out of the deal. Your strategy will vary based on your investment goals however it’s important to have an idea of your ideal hold period. You will also want to understand the resale market for your investment. You may love XYZ pizza but the brand may be meaningless to out of area investors, which will limit the buyer pool when you go to sell.

Rent Escalations

Are there rent escalations in the base term? In the option term(s)? What is the percentage and how frequent are the escalations? Certain tenant categories are more likely to offer rent escalations than others.  Fast food leases typically offer increases which can be annual, biannual or occur over a longer time period. Some common percentages are 1.5% annually, 10% every 5 years etc. Certain tenant categories such as drug stores do not often offer rent escalations in the base term. These leases are considered “flat” because the NOI or rent does not change throughout the entire base term.

Return

What is unleveraged return on equity in year one (Cap Rate). What is the leveraged return over a 5 or 10 year hold period?  Leveraging your investment often gives you a greater return on your equity. The greater the spread between the cap rate and the current interest rate the more adding leverage will improve your return.

Tenant

How long has the tenant been in business? How many locations do they have?  How are they doing as a company? Are they expanding or closing locations? You want to get a sense of the stability, size, and future growth potential for the tenant. It’s also important to review the tenant’s credit rating if available. Tenants are divided into investment grade and non-investment grade based on their credit ratings. However, it’s important to note that there is great variation within each of these categories. A local flower shop would be considered non-investment grade as would Rite Aid and Dunkin Donuts. Some companies such as Chick Fil A are privately held and do not have a public credit rating.

The members of the Iacono Retail Group are experts at evaluating and advising on net leased investments. We look forward to helping you find the right property to meet your investment goals.