What is a Triple Net Lease in Real Estate Investing?
A triple net lease is a commercial real estate lease agreement in which the tenant is responsible for paying all operating expenses associated with the property. This includes property taxes, insurance, and maintenance costs, in addition to the rent. Essentially, the tenant assumes all of the financial risk associated with owning the property, while the landlord collects a fixed rental income.
Triple net leases are commonly used in commercial real estate transactions, particularly for properties with long-term tenants such as retail stores, office buildings, and industrial warehouses. Because the tenant is responsible for all expenses associated with the property, the landlord can be more hands-off and simply collect rental income each month.
Commercial real estate lease structures may vary considerably depending on the property, tenant profile, and business model of both the tenant(s) and the property operator. The Benefits of Investing in Triple Net Lease Property
Investor Benefits
- Steady income stream: Because the tenant is responsible for paying all operating expenses, including property taxes and maintenance costs, you as the landlord have a predictable, steady income stream.
- Passive investment: With a triple net lease, the tenant takes care of most of the property’s day-to-day operations, making it a potentially more stable investment, a simple business plan, and a more reliable source of passive income. In other words, fewer expense items on the pro forma for the sponsor, therefore less potential risk in terms of net cash flow.
- Long-term tenant relationships: Triple net lease agreements tend to be longer-term, often spanning 10 years or more. This allows for the opportunity to establish long-term relationships with tenants and ensures a stable income stream for an extended period of time. With a solid, creditworthy tenant in place and owning day-to-day operations, sponsors may also be able to attract more buyers and achieve a desirable exit scenario.
The NNN Lease — What to Know
Triple net leases—often abbreviated as NNN or Net-Net-Net—are most often found in the office, industrial, and retail sectors. The structure is most popular with single-tenant properties where one tenant occupies the entire leasable space of the property. Generally, the NNN lease structure leads to lower contractual rent payments as the tenant reimburses the landlord or pays directly for all operating expenses. The three “N”s typically refer to common area maintenance (CAM), real estate taxes, and property insurance expenses. Some lease structures also require tenants to be responsible for roof and structural maintenance. These are often referred to as Absolute NNN Leases.
NNN vs. Other Lease Structures
The more traditional lease is often referred to as a Gross Lease where the tenant simply pays an agreed-upon rent amount and the landlord is responsible for all operating expenses. Within the net lease space, modified structures can also include Single-Net (N) and Double-Net (NN) leases as well. Under these structures which are also referred to as Modified Gross Leases, operating expenses are split between the landlord and tenant.
Considering tenants pay for major operating expenses, the triple-net lease generally entails the lowest rents of any lease structure, all else being equal. More importantly for the property owner and corresponding investors, it shifts the burden to maintain the property onto the tenant and offers a more passive asset management plan.
Single-tenant net lease terms can range from 1-2 years to 15+ years, with 10-year terms being the most common. The long-term lease structure allows the property to produce bond-like cash flow over a long time period. When structuring a triple-net lease, the property owner seeks to include frequent rent escalations (e.g. annually, or every 5 years). The contractual rent escalation can also be linked to the Consumer Purchase Index (CPI) to keep up with inflation.
Considering the long duration and payment responsibilities, NNN structures are best suited for industrial, warehouse, self-storage, and retail properties. They may also be a fit for credit tenants who have demonstrated financial strength and sound business operations.
Key Considerations for NNN Lease Investing
Triple net lease structures potentially bring unique benefits for real estate investors. However, this type of business plan also carries specific risks and considerations for investors. Here are some aspects of a NNN lease investment to look at:
- Location: As with any real estate investment, location is crucial. Look for properties in areas with high demand and strong economic growth potential. Triple net lease properties are often located in commercial areas, so consider the local business environment and the property’s proximity to major highways, airports, and other transportation hubs.
- Tenant creditworthiness: With a triple net lease, the tenant is responsible for paying all operating expenses, so it’s important to evaluate the tenant’s creditworthiness before investing. Look for tenants with strong financials and a proven track record of success in their industry.
- Lease terms: Triple net lease agreements can vary widely in terms of length and the tenant’s responsibilities. It’s important to carefully review the lease agreement to ensure that it aligns with your investment goals and that the terms are favorable.
Investors should carefully consider the lease term’s merits in relation to the investment’s return and risk profile. Compared to other lease types, the triple net lease can lower operating expenses but also temper the property’s revenue potential. Triple net leases may have a zero-sum effect on the net operating income; however, in transferring the responsibility to pay operating expenses, the property owner also transfers the risks of increasing operating cost. In the event of unforeseen circumstances—such as a natural disaster, change in tax policy, or damages—the tenant will be liable to cover the increased cost on top of the rent.
As previously noted, the tenant is also solely responsible for maintenance and all necessary repairs and/or replacements to the property. This includes the roof, landscaping, exterior and structural portions, foundations, and parking lot. Because the tenant pays for their own maintenance, insurance, and taxes, the property owner has fewer managerial responsibilities. Thus, investors can benefit from decreased property management-related fees.
When combined with a strong credit tenant, the triple-net lease can help investors secure attractive long-term debt financing with low-interest rates, further boosting bottom-line returns to equity investors. NNN transactions are often levered conservatively with long-term debt in the 50-65% Loan To Value range. The low debt service mitigates default risk and creates an opportunity for investors to capture enhanced current yield. NNN investments may be most appealing to investors who are relatively risk-averse but still seeking current yield.
Considerations for Triple Net Lease Investments — 2024 and beyond
Triple net lease investments may be attractive at any phase of the business cycle. Heading into 2024, triple net lease investments may be timely for several reasons:
- Inflation — while price increases have moderated some, inflation remains persistent, affecting (among other things) construction materials, utilities, and unskilled labor. Triple net leases may shift some inflation risk from the sponsor (and LP investors) to the tenant. On the flip side, triple net leases offer less opportunity to “mark to market,” as opposed to properties with a larger number of tenants and leases turning over more frequently.
- A “Flight to Safety”? — with uncertainty over the timing or severity of a potential recession, stability is at a premium. Sponsors who are able to negotiate NNN leases with highly creditworthy, well-capitalized tenants may be able to achieve more predictable cash flow and attractive downside protection.
- Sectoral Factors — If a recession does hit, certain types of NNN lease tenants and properties may be timely. Grocery-anchored retail and last-mile industrial could both benefit.
For triple net lease investments, especially when you participate passively, the credit-worthiness of tenants is critical. Sound financing and the ability to cover cost and rent are critical. Typically these properties have fewer tenants and fewer leases, which also makes the creditworthiness of each more critical (as a smaller number of tenants means higher vacancy rates should a tenant renege). Since triple net lease tenants are responsible for most or all operating expenses, creditworthiness and strong financials are even more critical, as unforeseen changes in operating cost could stress the borrower’s ability to service debt.
In 2024 and beyond, it may be worth taking an extra close look at the operating plan and financials of tenants for triple net worth properties. Inflation has abetted some as of late 2023, but it appears both inflation and interest rates will remain elevated for some time. The ability of a tenant to thrive in a higher rate, higher inflation environment is therefore critical. In the years ahead, it may be worth looking deeper into the financials and business operations of tenants.
Certain sectors within the NNN market may offer more resilience or growth potential. For example, medical facilities, data centers, essential services, and certain retail segments (like grocery stores) have shown robust performance even during economic downturns. While we can be optimistic that a major recession can be avoided, nothing is certain. The intersect of NNN leases and durable sectoral trends may offer attractive investment opportunities for investors taking a more defensive mindset.
Triple Net Lease Investment — The Bottom Line
When evaluating a NNN lease investment, tenant creditworthiness is crucial. Since triple-net lease terms can be long, investors must discern the tenant’s ability to meet obligations throughout the investment hold period. Reviewing the tenant’s corporate credit rating is a good starting point for understanding the tenant’s credit quality. Credit rating agencies, such as Standard and Poors (S&P), Fitch, and Moody’s assign letter grades to indicate the creditworthiness of public companies and reflect the tenant’s ability to meet financial obligations. Beyond credit ratings, investors can look into financial statements to ensure the tenant has sufficient liquidity under distressed situations. It may also help to examine the capital structure to ensure conservative leverage.
Investors should consider the relationship between the property and the tenant’s business operations, particularly for single tenants. Tenants are incentivized to continue the tenancy even amid a tough economic environment when the property is mission-critical to business operations, located in a valuable location, or in the case of retail, has demonstrated sales performance.
Finally, investors should consider the lease term and lease rate of the existing tenants. To avoid or minimize lease-up risks, the remaining lease terms on average should be longer than the investment hold period. Lease rates should also be in-line with the market.