By: Sebastian Moya, Associate- Kay Properties and Investments, LLC
The Great Recession probably resulted in a seismic shift in many real estate investor’s risk profiles. In 2007, the primary investment strategy was aimed at residential properties with large amounts of market speculation. These properties were largely financed with debt and when the market collapsed, well we all know the story. In 2019 we are experiencing a 1) very peaky market with 2) compressed cap rates on residential properties 3) throughout secondary markets that are assigned values relative to 4) large growth in that market. This all sounds a little too familiar. There is no need to be Chicken Little in this market as the imminent correction (and it is imminent) will probably not strike investors as starkly as it did in 2008. Multi- family and singlefamily homes can be worthwhile investments with the right placement of capital. However, there are lessons to be learned about other investment strategies that were pervasive in the years following the recent economic downturn.
Many investors that held onto their real estate or invested in the price-trough from 2008 until now are considering what to do with their properties considering the price peak we are currently experiencing. It is an excellent time to sell, but with cap rate compression across the board it is a difficult time to find the right placement of capital. Investors that are looking for lucrative IRRs may go towards the residential route, which is fair but potentially risky. Other investors that want to weather the ensuing market slowdown have looked towards a less speculative route. Triple Net properties have skyrocketed in the last ten years as a result of this investor desire
Triple Net Leased Property
A piece of property that is usually being leased by a single tenant (i.e., single-tenant net-leased or STNL). The building on that property is typically built to their needs and business model. The tenant typically has contractual obligations in their lease to make monthly rent payments to the property owner over the life of the lease. Higher quality tenants would usually be of a high credit grade, large in scale, and/or is financially robust in a way that will assure they pay their rent consistently.
Why would a company do this?
In an effort for companies to reduce the amount of liabilities on their balance sheet, they choose not to purchase the real estate on which they conduct business. Instead, the companies decide to rent it from real investors who own said properties.
What does Triple Net mean?
“Net” helps describes the responsibilities attributed to either the tenant or the landlord. A “single Net” lease hands over more costs and responsibilities to the landlord in exchange for higher rent. The rent may be higher in a Single Net, but the costs vary much more and affect cash flow.
“Triple Net” is a type of lease structure wherein little to no responsibilities are given to the landlord and the variable costs of the property (taxes, insurance, maintenance, etc.) are handled by the tenant.
Triple Net properties have emerged as a pervasive investment strategy over the last decade for many reasons.
Consistent Cash Flow
The lease structure described for NNN properties should allow for dependable cash flow that passes through to investors on a monthly basis. These cash distributions are effective income, and yours to keep. There are little to no costs that bite into your bottom line. This is ideal for the retirement or passive income profile investor.
More often than not, the tenant will guarantee payment of rent throughout an established period of time. A typical rent period exists between seven and fifteen years. In shorter leases, tenants will incentivize investors with “rent bumps” that could increase their net operating income by 1- 2% each year. If a tenant vacates the building, or “goes dark,” they would be liable to pay the remaining term. The tenants are varying degrees of credit quality as ranked by the large ratings agencies or backed by large franchisees. This is not a total guarantee, however. Any business can go bankrupt or fail to meet its obligations for any number of reasons. It is important to understand your tenants’ profile and backing before entering into a contract with them. Triple Net Properties provide the opportunity to invest money into real estate and benefit from potential appreciation on property, while playing it relatively safe with a consistent cash flow from their asset. But at the end of the day, this is still real estate we are talking about. There are
many risks and obstacles and investor should we weary about.
Triple Net buildings can act as a sort of “one-trick pony.” You know what you are getting for how long and how much, but your property could end up being stagnant in cash flow or relative value. The longer the lease that is negotiated with a tenant, the less they are willing to pay. This means the likelihood of “rent bumps” goes down or does not exist. You are effectively trading a longer “guaranteed” income for less cash to your bottom line. If inflation increase on average one percent a year, then without significant cash flow escalations you may be losing money on your cash investment. This is why it is important to analyze a lease structure when you are looking for a tenant and negotiate rents and lease terms appropriately.
Although a tenant may be guaranteed on the lease, there is always the possibility that they default on their payments or go dark. If they default on their payments this is really the worstcase scenario. Your cash flow stops completely, and the value of your building potentially decreases immensely. With Triple Net leases, the value is inherently tied to the tenant filling the property and paying rent. The cash flow is what would entice potential investors to buy the property from you. Even if the building goes dark and cash flows are rolling in, there is no exit strategy when the lease terminates. Again, the building’s value is inherently tied to the tenant that provides cash flow to it.
The leases on these properties are structured for extensions, or “options.” This means tenants can exercise a clause in the lease that would add more time to their rental period. However, this usually involves a lot of negotiation with a large company that has many units across the country. Since your property value is tied to the tenant, and the tenant knows this all too well, they will try to strong arm you into paying tenant improvements or adjusting the lease to their benefit. If you don’t play ball, there is a chance they will relocate or simply vacate upon termination of the lease. In reality, a lot of these large companies don’t care to negotiate at all and may move before the lease is up. Then it is potentially the job of the investor to commit capital towards finding a new tenant through brokerage, advertising, attorney fees when negotiating the lease, and other costs.
Although this property is a relatively cost-free venture, you are still in charge of managing the property. If there is a power outage, you are in charge of finding a solution. If it hails, you may have to repair the roof. The tenant might reimburse you for the costs, but ultimately it is the investor’s obligation to take care of the building. Those looking for a completely hands-off investment may be turned off by this.
The ultimate risk in investing in Triple Net properties is that you are investing in a venture that costs hundreds of thousands of dollars, if not millions, into one investment. As any person that has remote financial knowledge will tell you, diversification is key when investing. Putting all your eggs in one basket is scary It is a large risk in any real estate venture, but with triple-net properties it is nonetheless a substantial factor to recognize. So, there are many ways to look at triple net properties. The benefits are unique to most real estate assets. The risks are also diverse and require astute attention when considering them as an investment opportunity. It seems that the risks can outweigh the benefits in many ways. How would someone who is looking to exercise passive investments mitigate the risks mentioned above. Let’s talk about Delaware Statutory Trusts. The tools that a Delaware Statutory Trust can give you to smooth out some of the obstacles you would encounter when investing in triple net properties while emphasizing the positive points.
Delaware Statutory Trust (DST)
DSTs are a financial structure that allows for investors who are looking to invest in real estate to diversify their opportunities into different properties. It is a shared ownership structure wherein an investor puts in a piece of capital for a property instead of the entire backing. DSTs are passive investments, which means that all management responsibilities are removed from investors and income is passed through. This is meant to be a refresher on DSTs and if you are interested in learning more we recommend you visit our website www.kpi1031.com or speak to one of our representatives. In a DST structure, your eggs are not all in one basket. Chunks of capital can be distributed to different assets. Amongst the types of properties that can utilized in this structure are triple net properties. There are several advantages to investing in triple nets through DSTs that help absorb some of the risks you may encounter when investing in one on your own.
Sponsor Companies – an important concept to understand when it comes to DSTs are their sponsor companies. Sponsor companies are the entities that underwrite, acquire, and manage properties for investors. These large entities manage billions of dollars in real estate and have years of experience under their belt that help investors make educated DST investments. They are a huge advantage when it comes to investing as will be demonstrated.
One of the primary ways to mitigate risks when investing in triple net properties is the way in which the lease between the tenant and the investor is negotiated. In a situation wherein an investor is investing in a property on their own or perhaps in a small group of investors (such as an LLC, LP), negotiating a lease will be difficult. Large tenants that are creditworthy and therefore increase the value of a potential property also have more negotiating leverage. These large companies negotiate leases all the time in ways that may affect rent bumps, which means an investor could be exposed to inflation risks. The tenant improvements they require in order to stay, or their capacity to leave overnight are also pieces of a lease that can be negotiated and need to be considered. DST properties are managed and negotiated by sponsor companies that have years of experience and immense deal flow that allows them to get more at the negotiating table than the average investor could.
In a DST structure, investors will experience a more realized passive investment. Instead of worrying about management of the property or fretting about tenant demands, sponsor companies take care of all operations and management concerns. Investors are given monthly or quarterly updates about any changes to the properties, but there are no hands-on requirements asked of anyone participating in a DST. Diversification Of the benefits offered by DSTs, arguably the most helpful is the diversification that they can provide. When you are investing into DSTs, it is possible to split a chunk of capital into pieces and distribute said capital amongst several properties. For example, you can invest one hundred thousand in a FedEx property in Seattle, and three hundred thousand in a triple net Walgreens in Phoenix. The point is that you are not placing all of your capital into one place. If your property in Seattle “goes dark,” for some reason, you are not at a total loss because you still have your investment in Phoenix. Hedging your investment and receiving a blended return on those investments protects you from more risks. This is especially useful in triple net properties where tenants can be finicky. Protecting yourself from risk is something rarely afforded in the world of real estate.
Through DSTs, the benefits of triple net properties are realized while spreading the risks out through negotiation, operation, and diversification advantages. At the end of the day, we are talking about real estate. Any property can have a bad run or sail smoothly throughout an ownership period. Anyone interested in DSTS should consult their CPA or attorney about their specific situation. DSTs are not for everyone, but they can provide an alternative way to invest in triple net properties if that is your interest.