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
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 tenant is private then you need to request and analyze the following pieces of information:
- 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.
- Tenant Business Plan
- Tenant Recent Sales History
- 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:
- 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.
- 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!Triple Net Lease Investing (NNN): The "No Toilet" Method to Real Estate Investing by Ankit Duggal