Triple Net Lease Investing (NNN): The “No Toilet” Method to Real Estate Investing

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Have you heard Brandon Turner’s toilet story?

No? Then read the following excerpt, taken from the article “Top 100 Ways to Make Money in Real Estate,” especially if you are looking to become a buy and hold investor:

“Have you heard my “toilet story?”

Let’s just say it involves a plugged toilet, three college-aged tenants, three weeks of procrastination (with continual use of that plugged toilet), and my bad mistake of not hiring a plumber.  It was a low point in my investing career but a turning point as well. I realized the type of investor I wanted to be and the type of investor I did not want to be. I no longer work on toilets.

It’s been years since that event, but I still think of it when I hear people say, “I would never want to invest in real estate because I don’t want to fix toilets!” It’s a valid concern.”

Brandon came to a great conclusion after a few years of landlording: he was tired of toilets!

This story gave me the inspiration for this article: No More Toilets! I am going to write the next few articles about real estate asset classes (direct or indirect) that have one common theme in common: No More Toilets!

What is a Triple Net Lease? No More Toilet Investing

Triple Net Lease investing (NNN) involves buying free standing buildings that are leased to credit-worthy tenants. Tenants can be everything from a Walgreen Drug Store to a dollar store such as Family Dollar and Dollar General. Other net lease properties include bank building such as Bank of America, food such as McDonalds, Burger King or Taco Bell or auto service and part stores like Bridgestone/Firestone or an Advance Auto. NNN properties  are typically leased to tenants for a 10 to 25 year term.

If you are a value oriented non-flip investor, then the lease is the second most important piece of information that you need to complete as you invest into No Toilet Oriented NNN Investments.  (Hint: the first important piece of analysis is the location of asset ). First, it is important to understand what the different types of leases are and what makes NNN special?

There are five different types of leases (in order from most passive to most active for a landlord):

Bond Lease:The tenant is fully responsible for operating expenses, maintenance, repairs, and replacements for the entire building and site, without limitation. This is a very rare lease to put together but if you can find a real estate asset that is backed with this type of a lease. These types of leases will typically yield the lowest return on investment out the different types of leases.

NNN Lease:These leases follow the bond lease definition except that capital expenditures are limited, usually in the final months of the lease. The lessee is liable for all of the property’s expenses, both fixed and operating.

NN Lease: This lease follows the NNN, except the landlord is responsible for structural components, such as the roof, bearing walls, and foundation.

Modified Net (or Modified Gross) Lease:The tenant pays its own utilities, interior maintenance and repairs, and insurance. The landlord pays everything else, including real estate property taxes.

Gross Lease:  The tenants pay one set cost for their rent and the landlord pays everything else including real estate property taxes, insurance, repairs and interior maintenance.

As you can tell from the list above, the NNN lease investments offer the benefit of little or no management responsibilities as the tenant pays for all (or most) of the expenses. The investor receives their rent with little-to-no other involvement. Hence this is a No More Toilet Investment!

Analyzing Triple Net Lease Investments

If you see the value of a NNN Investment as a No More Toilet Investment then you need to develop an investment analysis framework. The Analysis Framework involves a “three prong” analysis:
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Prong I:  Evaluate the Real Estate 

The purpose of this prong is to complete an initial evaluation of the asset utilizing the following steps:

A. Site Property Visit: NNN can make you lazier given the bond nature of the investment. This is still a piece of real estate so it is important to physically vist the asset and get a feel for the area and the site itself.

B. Legal Analysis : Easements, Restrictions, and Encroachments can impact the value of the real estate site by restricting what you can and cannot do with the site in the future. The terminal value of a NNN investment is the piece of real estate itself. Hence you want to be sure that you can use the site to its highest and best use potential when the tenant does eventually vacate out of the asset.

Pront II:  Evaluate the Tenant

In NNN investments, 50% of the value of the asset is driven by the location of the real estate while the other 50% is driven by the credit quality of the long term tenant in my personal opinion. This is where NNN investing really drew my interest as it a real estate asset class wherein I can utilize Corporate Finance and Financial Statement analysis (courses taken during my MBA days) and real estate analysis together. From a real estate investor’s perspective, a triple-net-leased property’s investment value should reflect the tenant’s ability to meet the terms of the lease. The capitalization rate indicates this variable risk factor, because it directly represents the relationship of the stipulated net income to the price a knowledgeable investor is willing to pay. The higher the risk that a tenant may not be solvent over the long term, the higher the cap rate should be.

How can you underwrite tenant risk?

If the tentant is a public company, the credit rating is fairly easy to determine through a number of sources, including sites available on the Internet such as S&P, Moody’s, and Zacks.com. 

If the tenant is private then you need to request and analyze the following pieces of information:

  1. Tenant Credit Report: Request and review Tenant credit profiles from one or more of these types of reporting agencie   D&B, Equifax Small Business Enterprise, Accurint Business, and ClientChecker.
  2. Tenant Business Plan
  3. Tenant Recent Sales History
  4. Tenant Annual Financial Reports and Tax Returns

If you feel overwhelmed and cannot do the tenant underwriting analysis yourself then you contact a fee-based tenant underwriting service for added assistance.

Prong III: Evaluate the Lease

As was stated earlier, the lease is the second most important piece of information associated with buy and hold investment analysis. Lease is your source of gross income document so you must make sure that two things are for certain with a lease:

  1. Clear Language: Make certain that the lease is written in clear language so that there is no ambiguity to its terms. Hence it is important to read every word of the lease document and request your attorney to do the same independently from each other. Once the review has been completed, it is vital to compare notes to make sure that you understand what you as the landlord need to cover, what are the rental increases agreed upon and when, and under what conditions can a tenant get out of this lease. 
  2. Inflated Rent Analysis: An inflated rent that may not reflect current market rents. Inflated rents may make the investment return appear desirable but they are surely to drop upon renewal especially if current market rent is cheaper. The drop in rental income will directly resale value which may be less than what the investor paid for the property and the actual yield probably will be lower than other alternative opportunities in the marketplace. Hence it is important to read the lease to understand what the annual rental rates will be on a per square foot basis and compare that to current market rents.

Triple Net Investments (NNN) investments that have been carefully structured and underwritten can become a No Toilet Investment. However, these are highly long term investments and before you commit capital to such a long-term investment vehicle it is vital to further study this asset class and complete a thorough pre-acquisition due diligence.

Share your favorite “No Toilet Investments” in the comments below and I look forward to covering another asset class next week.

Until Next Week Happy Investing!

Photo:jacreative, FreeDigitalPhotos.net/

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About Author

Ankit Duggal(G+) is the Investment Director of a New Jersey Income Operating & Consulting Company . Ankit is a seasoned value investor who enjoys achieving a zen through surfing, hot yoga, and snowboarding.

15 Comments

  1. I had NNN properties, cvs (before) and now walgreens drug store. cap rate in 2010 at 7.35% and interest CTL loan at 6.11% for 25 yrs. COC only 4.35%, and can’t refinance, but can sell with 1 pt fee. cvs was nn, headache roof etc, so sold it to buy walgreens.
    At that time they were giving 1.05 DCR, but negative cash flow. So put dn 18% to get above COC. Good for long term estate and financial planning, and for grand kids!!!, up to 75 yrs lease option, but same rent!!!! Have not seen property,new bld’s, walgreens pick their site after thorough reviews!!!

    • Kris

      Thanks for some numbers behind the NNN investment asset. You are correct that this is good asset class for long term real estate. You can achieve high COC returns by not buying credit worthy tenants like Walgreens. The higher up the risk stack you go the higher your returns will become.

      Ankit

  2. @Ankit Duggal This is an outstanding discussion of one of my favorite types of real estate investment. I couldn’t agree more in regard to some of your key points: The financial strength of the tenant is critically important to the success of a NNN deal — otherwise your entire anticipated cash flow may go right down that toilet you thought would never haunt you again!

    Also, the language of a NNN lease with a credit tenant can be very convoluted. It’s fine to negotiate the terms, but you shouldn’t try to negotiate the language of a NNN lease on your own. That credit tenant didn’t get to be a major retail player without having a top law firm on retainer, so you should hire your own top gun to parse and negotiate the language.

    In reading your article I also realized that I, and many with whom I discuss such deals, are guilty of lazy language. We often erroneously refer to deals as “triple-net” when really they are NN. Thanks for the reminder!

    • Frank

      It is truly an honor having you comment and read my article. I read your book when I started down cash flow investments “What Every Investor needs to know about cashflow”. It is part of my reference library that I refer to whenever I cannot remember how to calculate a cash flow ratio.

      Great point on negotiating the terms but not the language of the lease.

  3. I as newbie, I have to say you are very knowledgeable. I just heard you on the BiggerPockets podcast @Frank Gallinelli, and I need to get your book. @Ankit Duggal, I just went your website, and the blog is SOooooo informative. Since we are both in North NJ, I would love to make a connection! Thank you both!

  4. Nice article, I came across it googling NNN cap rates, I have a NNN building in a A1 location in Beachwood OH, anchor tenant is a bank been there 20 yrs we are about to exercise a 5 year extension net rents are $220,000 what would a reasonable sale price be based of average cap rates for this type of lease? Thanks in advance.

    • Dave, As a single-tenant broker I suggest you also understand the market conditions surrounding your investment. If the centers around it have dark anchors or the demographics have started to shift this too should be of concern to you or if the area has experienced a positive change in demographics then the bank renewing their lease might not be the best investment decision for you.

  5. Hi, I am new to NNN investment and from what I’ve read about NNN properties they are good investments. I would like to invest to in NNN properties but not sure about how to get started with investing in NNN properties. What do you suggest I do first? Are there any investment clubs that I can get involved for properties like these?
    Thanks,
    Emory

  6. I am new in NNN investing and have been searching for the last 4 months. I am not sure what to buy. From my point of view the agents just want to sell and get the commission but I will be left holding the bag if the choice is not good. For now I am looking at Dollar Generals and Applebee’s but I am not sure what Dollar General will look like 15 years from now. If they decide not to renew or who/how/how fast would I be able to re-lease the property? I am looking for 6 to 6.5% Cap. If there are better NNN investment opportunities than Dollar General, I would appreciate knowing.

  7. Thanks for the article. I’m looking at walgreens but don’t understand why anyone would be happy with 75 years of no change in rent. Towards the end you can only be getting 1/4 of the value in real money assuming a very modest 2% inflation.

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