By Dwight Kay and the Kay Properties Team
Purchasing a Triple Net Lease Property (NNN) provides many benefits to investors. They’re usually single tenant retail, medical or industrial properties where the tenant is responsible for the majority of if not all of the expenses including insurance and maintenance costs. They also provide a potentially steady cash flow to the investor as leases are often 10-15 years in length with multiple renewal options. For this reason, many potential investors look for single tenant NNN properties for sale with the goal of securing a steady cash flow. However, just like any investment, there are risks involved in triple (NNN), properties, which we examine below:
However, just like any investment, there are risks involved.
Triple Net Lease Properties (NNNs) are typically either fully occupied or totally vacant. Since they only have one tenant, if the company goes out of business, then you have no rent coming in. That means you’re responsible for any debt service, maintenance, insurance and taxes. When purchasing a NNN investors must be very cautious when it comes to the tenants business model and industry and the potential for disruption that future changes in technology could bring – think Blockbuster Video and Borders Books.
Lack of Diversification
The problem for many 1031 exchange investors is that they often have only between 500k and 3 million of equity to purchase a NNN property and this equity amount comprises a large portion of the investors net worth. Oftentimes, the most desirable triple net properties start at a 2 million dollar purchase price. This can be problematic because the 1031 exchange investor is placing a large amount of his or her net worth into one building, with one tenant and that is in one location. This often causes investors to over concentrate their net worth into a triple net property and if things don’t go exactly right with the property or tenant, the consequences could be disastrous.
Single Location Risk
Naturally, the location of your property can determine the level of potential risk. Any real estate investment, including triple net lease properties are subject to risk of location. How well-trafficked is the area? Is it blessed with a large population with a relatively high spending power?
When researching the triple net lease property for sale, it’s easy to focus on the high returns it has been generating. However, what will happen when the tenant leaves the property due to some unforeseen reason? At that point, the location will mostly drive the ability of the property to attract a promising long-term tenant with good credit. Is the location favorable enough to easily attract tenants from various types of businesses so that the property is never vacant? Or is the property situated in an unfavorable area that would draw very few businesses? Besides occupancy, location will also influence the rental rate.
A long-term lease contract guarantees a rental income for a period of 10 years or more. Therefore the length of the lease is a crucial factor that can help determine the value of triple net investments. It’s only natural that as the lease of a triple net property is about to expire, its value may reduce.
If a tenant is nearing end of the lease and is not open to renewing the lease, they should let the landlord know ahead of time about their plans so the latter has the benefit of a reasonable notice period within which to look for another tenant.
A Potential Solution
Many 1031 exchange investors are opting to purchase fractional interests in triple net lease properties to build themselves a diversified real estate portfolio instead of purchasing just one NNN property with a large portion of their net worth. As an illustrative example, consider this: instead of buying just one Walgreens for 4 million dollars, because of lower investment minimums, investors are purchasing 500k in a Walgreens, 500k in a CVS, 500k in a Fresenius, 500k in a FedEx industrial facility, 500k in an Amazon distribution facility, 500k in a Costco, 500k in a Starbucks and 500k in a US Government Leased building.
This diversified real estate portfolio of triple net lease properties allows investors to potentially mitigate concentration risk and reliance on one tenant and potentially losing their entire principal if that one tenant goes bankrupt. Of course there is still a risk of losing the entire investment, but is will be spread across multiple tenants. Investors are doing this through what is called a Delaware Statutory Trust or DST. The DST has been blessed by the IRS as like kind for the purposes of a 1031 exchange via IRC Revenue Ruling 2004-86. Diversification does not guarantee profits or protect against losses.