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ABC's of NNN

ABC's of NNN

Single tenant, net lease real estate investments are currently, and have been historically in high demand. Also know as a “triple-net” or “NNN”, the market for these types of triple net commercial properties remains quite active in today's unstable marketplace.

Whether called a triple net lease, a bond-style investment or a coupon-clipper, these terms all refer to owning property leased to a single tenant on a long term basis. New net lease terms are generally 10 years or longer, during which time the tenant is both financially and physically responsible for maintaining the premises. This latter feature is quite significant in that it not only allows investors who are less experienced in the operation of commercial real estate to participate in the marketplace, but to also successfully remove buyers' geographical boundaries. In other words, people often invest in property which is physically far away because it is not necessary to have anyone on-site to manage the NNN real estate. As a result, these deals are primarily credit driven, likened to an investment in a corporate bond but with the tax and appreciation benefits of real estate ownership. What follows are the "ABC's of NNN Investment".

The Sellers

Although sellers of NNN real estate range from individual investors to lender REO departments, the seller is usually a commercial developer who has already, or will be soon, completing a build-to-suit for delivery on a long-term net lease. Since the developer has maximized his near-term upside at the time the lease is signed, he is generally interested in realizing his profit immediately through a sale an NNN sale opposed to a finance-and-hold strategy.

The other major source of NNN real estate is the largest landlord / owner in the country, the corporation. Companies regularly elect to sell and leaseback their buildings and land as triple net real estate.

The Buyers

Buyers for triple net properties are more numerous than ever before. It is arguable that during real estate downturns, the demand for NNN properties increases. Not only are net leased properties pursued by 1031 tax exchange (individual) investors, but also today's institutional investors and their advisors have become bigger buyers of these triple net leases due to the general "flight to quality".

However, in the $20 million and under range, individual investors, motivated by the tax-deferred exchange, will continue to outpace institutional investors in playing the major buying role in the marketplace. Whereas the institution is motivated by desire for a particular IRR, the individual is motivated to avoid the financial pain of paying capital gains taxes. In the majority of transactions, this desire to avoid the tax bite motivates a trade buyer who has sold a management-intensive property to justify paying more for what he really wants--a credit-worthy tenant in a long term passive investment

The Properties

Property types found in net lease investments include: free-standing or in-line retail buildings or restaurants, industrial buildings (ranging from bulk warehouse to manufacturing plants), office buildings (varying from local or regional offices to corporate headquarters), and land (either unimproved or land under existing improvements owned by others). Although industrial NNN real estate is in marginally greater demand the key feature affecting cap rates, with regard to the improvements, is the potential for future use. A generic commercial building will always command significantly higher price than one built for a special purpose, all other factors considered equal. This element of an opportunity should be of significant concern to the investors as many commercial net lease buildings are created due to specific requirements of a particular business.

The Locations

Many investors would rather buy a triple net property that they can reach by car, and for this convenience most will generally pay a premium. However, this premium is quantifiable and for the appropriate return, the net lease investor will consider NNN for sale outside of his immediate area. For example due to the intense intra-California competition for assets, a property inside the state generally carries a 50 to 100 basis point premium as compared to similar NNN leases available elsewhere in the U.S.

The Tenants

Another important factor in determining the price at which a net lease will trade is the credit-worthiness of the tenant. Investors categorize tenants as national, regional or local credits and adjust their cap rates accordingly for this security element.

1. A national credit is usually considered to be a publicly traded company that is making money and has stockholders' equity or net worth of at least $500 million. These include the Fortune 500 firms, and investors can expect to pay as much as a 100 basis point premium over other deals for credits of this quality.
2. Regional companies may or may not be publicly traded, but are expected to be financially strong with accompanying net worth in the $75 million and up range. These tenants make up the mainstream of the available triple net real estate.
3. Local companies are expected to be privately held with no significant net worth and are therefore considered to be a substantial credit risk. In these commercial properties, the investor expects greater yields and the evaluation of the real estate portion of the deal becomes increasingly more important.

Investment Grade Tenants

With the larger national tenants, that are rated, the security associated with an investment-grade rating is highly sought after in the marketplace. Not all of the national tenants are rated, and overall the majority of properties available in the market are leased to non-rated tenants

Investment-grade ratings are defined by the ratings agencies - Standard & Poor’s and Moody’s. The ratings range from B- to AAA for Standard & Poor’s and B3 to AAA for Moody’s. Anything above BBB- for S&P and Baa3 for Moody’s is considered investment grade (please see ratings chart below).

As one might speculate, the stronger the tenant, the less likelihood of default or bankruptcy (see chart below). The credit of the tenant affects many different aspects of an investment, including long-term lease security, possible financing, and asset liquidity.

	Credit Rating	Credit Rating
Credit Quality	Standard & Poor's	Moody's
Investment Grade	AAA	AAA
	AA+	AA1
	AA	AA2
	AA-	AA3
	A+	A1
	A	A2
	A-	A3
	BBB+	Baa1
	BBB	Baa2
	BBB-	Baa3
Non- Investment Grade	BB+	Baa1
	BB	Baa2
	BB-	Baa3
	B+	Ba1
	B	Ba2
	B-	Ba3

The Leases

A critical factor affecting the selling price of a net lease investment opportunity is the lease itself. Of primary importance is the lease term, and as a general rule, the longer the better. Investors today are looking for 10- to 15-year primary terms. Investors will generally pay a 50 basis point premium for each additional five years on the primary term beyond a minimum ten-year requirement. Terms for new restaurant and drugstore properties can range up to 20 or 25 years. The next major quantifiable issue with regard to the lease is its relative "net" nature. Most deals today are called “triple net”, but may be “double net” because the roof and structural maintenance remains the financial responsibility of the landlord. This means the investment is not truly net to the buyer since reserves must be set aside to provide for repairs (equated with potential headaches). “True Triple Net” also called “Absolute Net” Leases are the most desirable lease type from an investor standpoint. Management, maintenance, repairs, capital, condemnation, and casualty responsibility belongs to the tenant.

In any transaction, the tenant’s responsibility level can vary from deal to deal and should be carefully analyzed. The value of an asset is affected by the nature of the net lease structure. As the tenant’s responsibility goes up and the landlord’s goes down the value of the property should go up.

The final significant item regarding the NNN lease and its effect on price is the upside or inflation protection. Office and industrial buildings and land deals usually offer stepped-up rent in the form of pre-negotiated fixed increases or increases determined by a formula tied to the Consumer Price Index. Retail deals often have a flat (non-increasing) base rental, but may provide inflation protection through a percentage of sales clauses, which may or may not be realistic or achievable. In any case, the cap rate going into the triple net property will be inversely proportional to the size and regularity of the rental increases over the life of the lease.

The Financing

Also of important consideration is available financing. Cash-on-cash yields are important in this marketplace due to the comparative available yields on corporate bonds and treasury bills. Since the market for these deals is permeated with exchange buyers who have sold a property on which they carried debt, most transactions require a financing element in order to perfect the exchange. Numerous lenders exist for these deals in today's financing marketplace.

There is a positive correlation between the credit of the tenant and the loan terms achieved. Typically, interest rates are based on the U.S. Treasury rates plus a “spread,” which is based on a premium above the trading of a company’s corporate debentures. The higher the quality of tenant, the lower the spread will be, thereby, producing a more desirable interest rate.

The financial standing will affect the loan-to-value debt service coverage ratio (DSCR) and amortization of the loan, as well. Many lenders will not require as much equity from the borrower, nor expect a low DSCR, if the tenant has a good credit rating. A borrower may also be able to attain a longer amortization period with an investment grade tenant. The lower equity requirement will allow the owner to acquire the property with fewer dollars up front, while the higher DSCR and long amortization will increase the net cash flow over the life of the lease/loan.

The Future

The market for triple net investments will continue to be robust as the demand for stable commercial NNN real estate continues to be important in today's volatile economic environment.