What is a Triple Net Lease?
A triple net lease, a type of commercial leasing agreement, is a lease where the tenant pays the insurance, maintenance, taxes and rent. There are pros and cons associated with a triple net lease for both the tenant and the landlord.
Prior to making a decision, individuals should carry out extensive research about the triple net lease. Often times, a triple net lease is referred to as a true net lease as usually the landlord has no responsibilities related to the upkeep of the building. This is the reason why a majority of commercial landlords prefer triple net leases over any other type of lease. The terms of a triple net lease agreement are individualized to the lessor and the tenant. These may include stipulations and restrictions to protect both the parties involved in the agreement.
Benefits and Risks
With a triple net lease agreement, both the tenant and the landlord benefit in one way or the other. Under this agreement, the tenant has to pay three additional payments other than rent. These three payments cover the building maintenance, property taxes and insurance. However, with such an agreement, the rent is usually lower. This lower rent is beneficial for both the parties; it makes it easier to find tenants and the landlord is less likely to have a vacant building.
Under a triple net lease agreement, tenants are liable to carry out the insurance on the building or property. Moreover, they may also be required to pay for any uninsured damage or for any policy deductibles.
When deciding on a suitable rate to charge, insurance companies consider a number of factors. The tenant may choose not to file a claim or may let the policy come to an end if he/she cannot afford the expense of insurance. If, however, there are severe damages to the building/property and the tenant files for bankruptcy, the landlord may not have any other alternative for payment.
If the leased building is not in a bad condition, the maintenance expenses will be minimal and the tenant will be able to benefit with the lower rent. If, however, the building needs a new roof, for example, the landlord will be in a better off position as he/she is not liable for any maintenance expenses on the building and instead the tenant will have to cover for them. However, such a scenario depends on the tenant whether he/she is maintaining the property in a good condition. There may be situations where the tenant does not disclose any potential damage to the building to avoid making maintenance payments, which in turn will leave the landlord with a building in a weakened condition. He may then, however, pay for the repairs by using up the profits generated from the rent payments of the tenants.
Under NNN lease agreement, the tenant is responsible to make payments relevant to the property taxes of the leased building. This is a disadvantage for the tenant. Various communities increase the tax rate on commercial properties yearly, which eventually results in an increased tax bill. Here, it is the responsibility of the landlord to contest the new appraisal, who may not be willing to invest the time and money for a private appraisal as he is not the one making the property taxes payments. This may rebound on the landlord if the tenant decides to leave the building once the lease ends. The landlord will then be responsible for paying the higher tax bill until a new tenant is located, which may then become difficult as it is highly unlikely that anyone would be willing to pay the higher property taxes. Even worse, if similar properties have a lower price, then the landlord would be left with a vacant building.
How to Analyze a Triple Net Lease?
Before signing up for a triple net lease agreement, it is important to carry out a detailed analysis, which mainly consists of three steps; analyzing the property, analyzing the tenant and analyzing the lease. Each of these three steps is discussed in detail below:
Analyzing the Property
This is the initial evaluation of the building or property under consideration. This initial evaluation is carried out in two steps:
- Visit to the property site: It is important to physically visit the location of the property and get an initial understanding of the site and the area itself.
- Legal Analysis: There are many factors that can have an impact on the real estate’s value including; encroachments, easements and restrictions. These factors restrict what you can do or cannot do with the building in the future.
Analyzing the Tenant
From the perspective of the real estate investor, the investment value of a NNN leased property should reflect the ability of the tenant to meet the lease terms. For this purpose, it is important to analyze the credit rating of the tenant. If the tenant is a public company, their credit rating can easily be determined through various sources including online websites such as S&P. However, if the tenant is an individual, then the following information needs to be analyzed:
- Credit Report: Request and review the credit report of the tenant from the respective reporting agencies.
- Review their business plan
- Evaluate their recent sales history
- Appraise their annual tax returns and financial reports.
Analyzing the Lease
Analyzing the lease is essential as it is the source of your gross income document. Therefore, make sure that the following two things are definite with the lease:
- Clear Language: The lease should be written in a clear language so that its terms are clear and understandable to both the tenant and the landlord, and there is no uncertainty. Therefore, before signing up the agreement it is important to read out the lease on your own, and also ask your attorney to do the same. Once this is done, compare the notes to ensure that you are well aware of what you, the landlord, need to cover and what are the conditions agreed upon.
- Inflated Rent Analysis: Inflated rent is higher than the prevailing market rents. Though, this may make the return on investment desirable, but upon renewal they are likely to drop, particularly if the prevailing market rent is cheaper. This drop in the rental income will directly affect the resale value of the property, which may even drop down to a value less than what the investor had paid for it. Therefore, it is vital to understand from the lease what the rental rates on an annual basis would be, and that should be compared to the prevailing market rents to assess the profitability of the agreement.
Cap rate, or capitalization rate, is the ratio of the capital cost of an asset and its net operating income. This capital cost is the original price that is paid to acquire the asset. As an alternative to the capital cost, its prevailing market value can also be used for the calculation of the cap rate. The formula used for this calculation is as follows:
Capitalization Rate = Annual Net Operating Income
Cost (or value)
This is an overview of the due diligence process when identifying NNN lease real estate investments. To learn more about the same, please contact iFunding directly.