Transitioning from Ag Land to Commercial NNN Leases
When we begin discussing commercial real estate with our clients, some of them tell us, “Look – I know ranching. I don’t know anything about commercial real estate”. And when we mention “triple-net” (NNN) leases, there may be further confusion.
This article will discuss what they are, what to look for, and the benefits and risks of investing in NNN commercial properties.
Commercial property leases specify whether the landlord or tenant is responsible for certain costs and responsibilities. On one end of the spectrum lies the pure gross lease, which requires that the landlord be responsible for all costs associated with the property. These costs are then factored into the lease rate charged to the tenant. The opposite of the gross lease is the absolute triple-net or "NNN" lease, which requires the tenant to pay for all operating (e.g., property taxes, insurance, utilities, repairs, etc.) and capital improvement (e.g., roof, structure, parking lot) costs of the property. Other leases will fall somewhere between the gross and NNN lease, and will be described by terms including modified gross, single net ("N") or double net ("NN").
NNN Ground Leases
One type of NNN lease is a ground lease. Whereas most leases encompass both the land and the building and improvements on the land, a ground lease encompasses only the land.
The tenant pays rent to lease the land from the land owner (the landlord), and the tenant then builds their own building upon the land. The tenant owns the building and is responsible for all costs and management responsibilities associated with it. At the end of the lease term, or earlier if the tenant were to terminate the lease prematurely, ownership of the building and improvements convey to the landlord at no cost.
When this conveyance occurs, the landlord now owns both the land and the building. Assuming the building is in good shape and a new tenant is found, the landlord will typically incur some tenant improvement costs to renovate the building to conform to the new tenant’s floor plan and business model. Now leasing out both the land and building, the landlord can expect to charge a higher rental rate to the new tenant – which increases both the property’s net operating income and value.
Effectively, the lease is backed by value of the building and improvements. Due to this added security, ground leases will generally trade at lower cap rates than land and building leases.
Examples of NNN Properties
Most absolute NNN properties with long-term leases (10 to 20 years, or more) are single-tenant properties. (Most multi-tenant properties, such as strip centers or multi-tenant office buildings, will have shorter term leases and a lease structure that is less than absolute NNN.)
The most common type of single-tenant NNN properties are quick service restaurants (McDonald’s, Taco Bell, Chick-fil-A, etc.). Other types include:
- Fast casual (Buffalo Wild Wings, Panera Bread, Starbucks)
- Dollar stores (Dollar General, Family Dollar, Dollar Tree)
- Drugstores (Walgreens, CVS)
- Convenience stores (Circle K, 7-Eleven)
- Vehicle repair (Jiffy Lube, Christian Brothers)
- Gas stations
- Communications (Verizon, AT&T, T-Mobile)
- Automotive parts (AutoZone, Advanced Auto, O’Reilly)
- Urgent care medical clinics
Capitalization Rates and Property Pricing
A capitalization rate, more commonly called a “cap rate”, is both a measure of return and a means to value a commercial property. The cap rate is calculated with the following formula:
Cap Rate = Net Operating Income/Purchase Price
(In this formula, net operating income is simply gross rental income minus operating expenses, and does not include items such as depreciation, debt service or income taxes.)
Let’s assume that a NNN property is priced at $2,000,000, and generates net operating income (NOI) of $100,000. That property is priced at a 5% cap rate, and would provide a 5% cash-on-cash return if you paid all cash for the property. The property price and the cap rate have an inverse relationship – as the cap rate increases, the price decreases, and vice versa.
Cap rates, and thereby property prices, will be influenced by a variety of factors, including:
- NOI from the property
- Type of lease (e.g., absolute NNN, gross, etc.)
- Amount of lease term remaining
- Tenant strength and credit worthiness
- Strength of location
- Market demographics (population growth, poverty rate, unemployment rate, household incomes)
- Age and condition of the building and improvements
- Economic fundamentals such as supply and demand
One of the basic fundamentals of any investment is that risk and return are related. Accordingly, the stronger these factors are, the lower the risk (at least in theory) and the lower the cap rate (i.e., the higher the price). The opposite is also true.
As an example, let’s look at two different properties in the same industry that represent different risk profiles. Both provide the landlord with NOI of $125,000/year.
- Property A is characterized by a new, 20-year, absolute NNN lease guaranteed by a large, successful and financially strong corporate tenant with very little debt. This tenant is the leader in its market segment, and properties occupied by the tenant are in high demand. Its average sales per store lead the industry. The lease specifies rent increases of 10% every 5 years. The building and related improvements are brand new. The location is strong – sited on a hard, signalized corner with superior access, visibility and traffic counts, ample parking, and surrounded by national, brand-name retailers. The market enjoys a significant population base, rapid growth, low unemployment, low poverty rates and high median household income.
- Property B is characterized by a NNN lease that has only 3 years remaining on its primary term, with rent increases of 5% every 5 years. The operator and lease guarantor is a small, 4-unit franchisee of a company that has been experiencing financial difficulties in recent years. There is little investor demand for properties leased by the parent company or its franchisees. The franchisee’s average sales per store are below the franchisor’s system-wide averages. The building is 35 years old, and the location is marginal, sited well off a commercial corridor with limited access and visibility, and in an older section of town that has seen better days. The market is declining in population with poor demographics.
Based on the factors above, Property A is priced at a 5% cap rate, or $2,500,000. Property B is priced at a 10% cap rate, or $1,250,000. While this may be an extreme example, it should be clear why there are significant cap rate differences between the two.
What to Look for in NNN Properties
There are generally three critical components that will have a significant and direct impact on the quality and success of your triple-net real estate investment: the lease, the tenant and the location.
Having a thorough understanding of what is and isn’t in the lease is critical. Accordingly, the lease, all supplements, amendments and exhibits should be read thoroughly by you, your broker and your attorney. Be sure to retain an attorney who has significant knowledge and experience in commercial leases.
Some of the relevant items to look for in the lease include:
- Lease type: What is the lease structure? NNN? NN? Gross? You should confirm both the landlord’s and the tenant’s responsibilities assigned by the lease. An absolute NNN lease should not have any landlord responsibilities.
- Lease term: What is the primary lease term and what are the renewal options? Long-term leases (15 to 20 years) may be preferable to the investor who wishes to sell the property after holding it a few years, as leases with significant primary term remaining are generally attractive to more buyers and tend to hold their value better.
- Termination clause: Some, but not many, NNN leases may have an early termination clause that allows the tenant a one-time option to terminate the lease prior to the expiration of the primary lease term. This can effectively turn a long-term lease into a short-term lease.
- Rent increases: Periodic rent increases throughout the lease term can offset inflation, and help the investment maintain its value. Rent increases will typically be a certain percentage (e.g., 12%, 10% or less) every 5 years, but occasionally a lease will contain annual rent increases. From a time value of money perspective, annual increases are more desirable.
- Rights of landlord and tenant: Under what conditions can the lease be terminated by the tenant? By the landlord? A lease will contain many other landlord and tenant rights that need to be understood.
- Financial reporting: Ideally, as a landlord, you want a lease that requires your tenant to disclose their financial information to you periodically. This allows you to monitor the success of their operation. Many franchisee leases will require this reporting. However, many parent companies or franchisors may not agree to reporting this information, due to competitive concerns and/or, if a publicly traded company, restrictions about disclosure of material inside information.
- Insurance: What type of insurance is the tenant required to carry, and are you named as an additional insured?
- Parking: Does the property have a dedicated or shared parking arrangement? If parking is limited, shared parking with other nearby businesses may be problematic.
- CCRs: Governing documents such as Covenants, Conditions and Restrictions may apply to the property if it’s part of a larger commercial development. You should review these as part of the lease review. These documents may lay out access and parking policies, as well as common area maintenance costs and obligations. Pay particular attention to whether you are responsible for any maintenance, and confirm that the lease addresses whether you or your tenant must fulfill these responsibilities. In an absolute NNN lease structure, the tenant should ultimately be responsible for common area maintenance costs.
Your investment’s success will largely depend on the success of your tenant. If you plan to depend on the income from this property, make sure the tenant is financially sound and that you can reasonably expect timely rent payments. Some of the tenant factors to examine include:
- Lease guarantor: The success and strength of the company standing behind the lease is crucial when it comes to the security of your property investment. Large parent companies, or franchisors, will typically provide greater security than small franchisee guarantors.
- Units: How many stores does the guarantor operate? Some large franchisors may operate several hundred, or even several thousand, stores. Franchisees may operate anywhere from a single store to hundreds of stores.
- Financial statements: It’s critical to review tenant financial statements as part of the due diligence process. If the guarantor is a public company, financial statements will be publicly available. If it’s a franchisee, request several years’ worth of financial statements as part of your due diligence process before purchasing a property. Review the financial statements for revenues, operating margins, debt and liquidity. Ideally, sales will show an upward trend, not downward. For franchisee guarantors, review both the financials for the subject property as well as the franchisee’s other stores, and compare the subject property’s results to the system-wide averages. Above-average results bode well for the subject property’s ongoing stability, while below-average can be a red flag.
- Credit ratings: If the lease guarantor has issued public debt, check its credit ratings from Moody’s, S&P and Fitch. A company’s credit rating is a measure of its ability to meet its obligations. Investment grade credit ratings are preferable to speculative grade ratings. Credit ratings can be reviewed at each rating agency’s website. Stock analyst reports can also provide valuable information.
- Operator experience: Review the backgrounds and experience of the operator and management team. An operator with significant industry experience is likely to have the necessary skills and understanding of what it takes to succeed in the industry, as opposed to a new franchisee just starting out.
You’ve heard it before: location, location, location. This age-old axiom still holds true. A good location is essential to the success of any business, particularly retail.
When purchasing a commercial property, you should consider whether the location meets the tenant’s needs now, and whether it will continue to meet future tenants’ needs well into the future. Things to consider when assessing a location include:
- Visibility: If customers have a difficult time finding a business because they can’t see it, that business is likely to suffer. Good visibility from multiple directions is a big advantage. Corner lots are a great example of this.
- Access: Can customers get to the building easily? Are there multiple access points?
- Traffic counts: Locations on major commercial corridors with high traffic counts may translate to higher customer counts for a business.
- Demographics: What are the local demographics for the property? Is population growing? Is there strong employment? What are the household incomes? Are poverty rates low? Strong demographics support sales at the property’s location.
- Parking: Is there adequate parking for customers and employees?
- Activity: Is there strong consumer activity in the area? Dense retail locations with nearby big box stores (Walmart, Home Depot) or shopping centers can generate significant consumer activity.
- Track record: A store that has been operating successfully at the same location for a long period of time may speak to the quality of the location. This can take a lot of the guesswork out of evaluating a location.
Risks of NNN Properties
Every investment comes with risk. Before making an investment, it’s important to understand what the risks are, and how you might mitigate them. Some of the risks of investing in NNN properties are outlined below.
Single vs. Multi-Tenant
While single and multi-tenant NNN properties have similarities, they differ when it comes to certain benefits and risks.
- Lease structure: Multi-tenant leases are typically not true NNN leases — they generally place some of the costs, management responsibilities and risks on the landlord.
- Tenant Quality and Turnover: Multi-tenant properties tend to attract smaller, franchisee-type operators with much less financial wherewithal, and there may be a much greater tenant turnover (and related cost). Single-tenant properties tend to attract high-quality, creditworthy corporate tenants that may be more likely to remain tenants for many years with very little turnover. Of course, it's more critical to have a strong tenant in a single-tenant property because if the tenant vacates, your income stops. If you have minimal or no debt on the property, and reasonable carrying costs (e.g., property taxes and insurance), your risk is much less than if you have substantial debt on the property and have to worry about making the loan payment every month. This reinforces the need to make sure your tenant and the property's location are both strong. If you lose a tenant in a multi-tenant property, your income drops but it does not go to zero.
- Length of Lease: Multi-tenant leases tend to be shorter term than single-tenant leases, which again tends to increase turnover and related costs. A typical multi-tenant lease term will range between 3 to 7 years, and occasionally up to 10 years. Single-tenant lease terms generally range from 10 years to 25 years and then offer multiple renewal options for another 20 years or longer.
- Cap Rates/Investment Returns: Due to the NNN lease structure, higher quality tenants and longer-term leases, single-tenant properties tend to trade at lower cap rates (i.e., higher prices) than multi-tenant properties.
Always compare the rental rates in a lease to the current local market rental rates. As previously discussed, commercial property values are determined in large part by the NOI the property generates, and lease rental rates drive NOI. So if a lease sets higher-than-market rental rates, that inflates both the NOI and the purchase price of the property. That may be fine, as long as the tenant remains in place and can afford the rent — but if the tenant vacates, you may have a hard time finding a new tenant willing to pay that higher-than-market rate. If the new rental rate is significantly less than the old rental rate, this could lower the value of your property. Conversely, if a lease sets rental rates below the market average, this may present a future opportunity — the landlord can increase the building’s net operating income and value by re-leasing it at market rates after the current lease expires and/or the tenant vacates.
Note: Federal government agency leases frequently have above-market rental rates, and thus, higher residual value risk.
Special purpose buildings such as gas stations, lube shops and some fast food buildings can pose a reuse risk to the landlord if the tenant vacates. For example, a gas station is designed to be just that – so if your tenant moves out, you likely will need to find another service station company to lease the property or you will need to significantly alter the premises (at your cost) to make it suitable for a new non-gas station tenant. General-purpose buildings, such as offices or box-type stores, are generally easier and cheaper to renovate for another tenant’s use than special purpose buildings.
Tenant Improvement Costs
When a tenant vacates, the landlord should expect to invest more money into the property to tailor it to a new tenant’s needs. How significant this cost may be depends upon the age and condition of the property, the multi-purpose nature of the property (i.e., the ease of adapting it to a new tenant), and so forth. Of course, the need for these funds coincides with the absence of any rent income from the property. Thus, at the start of a lease, the landlord may want to set aside a certain amount of annual rent income each year to build up a capital reserve fund for future tenant improvements. This is yet another reason to try to minimize turnover and instead obtain a strong tenant likely to remain in place for a long time.
Benefits of NNN Properties
Now that we’ve looked at some of the risks, let’s review some of the compelling benefits that NNN leases have to offer.
Long-Term, Stable Income
As we’ve said previously, single-tenant NNN leases can be for very long time periods – in some cases, 25 years or more of primary term, plus multiple renewal options. A lease of this duration, secured by a strong, profitable tenant and with regular rent increases, may provide you the security of stable income for decades.
Returns on equity (as measured by cash flow) vary for ranch operations, but generally seem to fall in the 1% to 2% range. Investing in high-quality investment real estate can provide cash flow returns of 4% to 6% in the current market. Thus, those who have decided to sell the ranch and reinvest into commercial real estate may earn significantly higher income.
If you’re selling a highly appreciated farm or ranch, the 1031 exchange provides you with an opportunity to take advantage of two compelling benefits of this valuable tool -- tax deferral and wealth accumulation. An exchange will allow you to preserve the equity you have built up in the ranch by deferring taxes on the sale. It’s possible to not only defer capital gain taxes, but eliminate them entirely by holding the replacement property (or continuing to exchange it into other properties) until death. Under current tax law, when such a property is inherited after you pass, your heirs get a stepped-up tax basis to the fair market value of the property. Conceivably, if they then chose to sell the property, they could sell it for little or no gain and avoid the capital gain tax entirely.
Additionally, not only are you saving taxes with an exchange, but by reinvesting the sale proceeds that would have gone to paying the capital gain tax, you are putting that saved capital to work, building more wealth and generating more income by purchasing more real estate.
Relief From Active Management
Our clients who are selling ranches and exchanging into NNN properties generally have much in common. Two of those things are that they want to slow down a bit and maybe pursue some other interests now that they’re not running their ranch operation, and they don’t want to manage rental properties. Absolute NNN leases require that the tenant assume all costs and management responsibilities of the property. This allows you to enjoy a passive real estate investment and simply collect your monthly rental check.
Most NNN leases provide for rent increases throughout the primary term of the lease and the renewal options. These rent increases can help hedge against the effects of an inflationary environment. Any future appreciation of the property can also be an effective hedge against inflation. Appreciation will largely be determined by overall commercial real estate market conditions.
Tax Shelter Through Depreciation
Based on the premise that buildings will not last forever and “wear out” over time, current tax law allows commercial building owners to “recover” the cost of their investment through depreciation deductions. Therefore, you can offset some of the rent income you receive with depreciation deductions.
Note, however, that if you are completing a 1031 exchange, the basis from your relinquished property (the property sold) will carry over to your replacement property (the property purchased). If you’re selling a farm or ranch that has been in the family for many years, you likely have very little tax basis in the property. In this case, your depreciation deductions can be limited. That said, increasing debt or contributing cash to the purchase transaction will create additional depreciable basis for deduction purposes.
Note: If you’re buying a ground lease property, you will receive no depreciation as land cannot be depreciated.
Real estate is tangible; it’s something you can see and touch. This may or may not be a true advantage in terms of the quality of an investment, but for some people it provides a certain peace of mind.
Although you may not think you know much about commercial real estate, you likely know more than you realize. If you are a farmer or rancher, and come from a generational agricultural family, the reality is that your family probably made their wealth in real estate – both from the income earned from the land and to a greater extent, the appreciation of that land’s value over time.
Owning commercial real estate is simply a different means of living off the land. Instead of you working the land, in commercial real estate the land (and building) works for you.
For agricultural families selling highly appreciated real estate and wanting long-term, steady income with no management responsibilities, NNN lease properties may make compelling sense.
We’ve provided the information in this Straight Talk guide for general educational purposes. It is not intended as specific tax or legal advice. Please consult a professional for specific advice regarding your particular situation.
© 2018 Jack Sauther & Diana Sauther