Absolute NNN Diligence Question

[Benjamin Aaker]

Questions for commercial investors out there:
1. When underwriting an building purchase with attached absolute NNN lease, what diligence items do you typically request?
2. Do these items change for you if the property was recently built and has a long-term lease vs an older property with a 'seasoned' lease?
3. Do these change based on the credit history of the tenant?
Thanks for your help!

[John McKee]

It's a long list of docs but I'll give you a couple I can think of from the top of my head. Here goes: recent appraisal, survey, Certificate of Occupancy, Phase 1 or 2 studies, Amendments to lease, personal guarantees, diagram specs of building, POA docs, HVAC maintenance, sprinkler maintenance, pest control, boiler, copy of rent receipt, list of vendors, flood elevation certificate, existing insurance, tax bill, copy of all warranties etc.

Most sellers don't have 1/2 this stuff, as the tenant should have some of this so it can be like pulling teeth to get the answers to see how well this property is taken care of.  

These docs should always be requested regardless of tenant

[Joseph Gozlan]

One of the most critical items to review is the lease. How many more years left, renewal options, responsibilities of maintenance, rent increases, etc. 

Another important thing is to evaluate the tenant’s financial strength. 

These are the basis to the NNN value in a deal like this.

The physical building should be inspected as of you would inspect it even if it's not a NNN deal.

[Al M.]

The items @John McKee mentioned are great.  The quality of the tenant will drive a lot of this stuff and can also override some of DD items.

[Ronald Rohde]

Quote from @Benjamin Aaker:
Questions for commercial investors out there:
1. When underwriting an building purchase with attached absolute NNN lease, what diligence items do you typically request?
2. Do these items change for you if the property was recently built and has a long-term lease vs an older property with a 'seasoned' lease?
3. Do these change based on the credit history of the tenant?
Thanks for your help!

 I only care about tax statements (to see rate of change), insurance premiums (again to see costs, claims) loss run, any correspondence from Tenant.

As absolute, you don't need more than that unless the lease calls for sales reporting, you need to guage the underlying credit of the tenant. is this a good location?

Not unless there's sub 5 years left on the lease and I plan on reletting.

Anything absolute should have a very high quality tenant. Most tenants don't want absolute...

[Ronald Rohde]

Quote from @John McKee:

It's a long list of docs but I'll give you a couple I can think of from the top of my head. Here goes: recent appraisal, survey, Certificate of Occupancy, Phase 1 or 2 studies, Amendments to lease, personal guarantees, diagram specs of building, POA docs, HVAC maintenance, sprinkler maintenance, pest control, boiler, copy of rent receipt, list of vendors, flood elevation certificate, existing insurance, tax bill, copy of all warranties etc.

Most sellers don't have 1/2 this stuff, as the tenant should have some of this so it can be like pulling teeth to get the answers to see how well this property is taken care of.  

These docs should always be requested regardless of tenant

 Hey John, I know you know your stuff, but what does a pest control invoice provide you? The seller doesn't care, seller doesn't pay, why would he want receipts? How does that change your underwriting if they have a $475 bill or $0 bills?

[Benjamin Aaker]

Quote from @John McKee:

It's a long list of docs but I'll give you a couple I can think of from the top of my head. Here goes: recent appraisal, survey, Certificate of Occupancy, Phase 1 or 2 studies, Amendments to lease, personal guarantees, diagram specs of building, POA docs, HVAC maintenance, sprinkler maintenance, pest control, boiler, copy of rent receipt, list of vendors, flood elevation certificate, existing insurance, tax bill, copy of all warranties etc.

Most sellers don't have 1/2 this stuff, as the tenant should have some of this so it can be like pulling teeth to get the answers to see how well this property is taken care of.  

These docs should always be requested regardless of tenant

Thanks for all the information. Would any of this be different for you if the lease was absolute NNN?

[Benjamin Aaker]

Quote from @Joseph Gozlan:

One of the most critical items to review is the lease. How many more years left, renewal options, responsibilities of maintenance, rent increases, etc. 

Another important thing is to evaluate the tenant’s financial strength. 

These are the basis to the NNN value in a deal like this.

The physical building should be inspected as of you would inspect it even if it's not a NNN deal.

It's interesting how the lease becomes so important in commercial properties. The lease has a huge impact on the value of the property, which is much more than in multifamily. It seems there is much less consideration for 'potential rent' in commercial.

[Benjamin Aaker]

Quote from @Ronald Rohde:

Quote from @Benjamin Aaker:
Questions for commercial investors out there:
1. When underwriting an building purchase with attached absolute NNN lease, what diligence items do you typically request?
2. Do these items change for you if the property was recently built and has a long-term lease vs an older property with a 'seasoned' lease?
3. Do these change based on the credit history of the tenant?
Thanks for your help!

 I only care about tax statements (to see rate of change), insurance premiums (again to see costs, claims) loss run, any correspondence from Tenant.

As absolute, you don't need more than that unless the lease calls for sales reporting, you need to guage the underlying credit of the tenant. is this a good location?

Not unless there's sub 5 years left on the lease and I plan on reletting.

Anything absolute should have a very high quality tenant. Most tenants don't want absolute...

Thanks for the reply. That's the crux of my question - if the tenant will pay all the expenses related to the property, except the owner's admin costs and debt service, I wonder if the 'physical' diligence might be less and the 'paper' diligence (tenant credit and lease scrutiny) might be more. Clearly there will be some variation so I'm grateful for everyone's info on this.

[Joseph Gozlan]

Quote from @Benjamin Aaker:

Quote from @Joseph Gozlan:

One of the most critical items to review is the lease. How many more years left, renewal options, responsibilities of maintenance, rent increases, etc. 

Another important thing is to evaluate the tenant’s financial strength. 

These are the basis to the NNN value in a deal like this.

The physical building should be inspected as of you would inspect it even if it's not a NNN deal.

It's interesting how the lease becomes so important in commercial properties. The lease has a huge impact on the value of the property, which is much more than in multifamily. It seems there is much less consideration for 'potential rent' in commercial.

 When you have 5-10 years lease with predetermined rent bumps, how would the "potential rent" be relevant? You only get it if the tenant defaults on the lease or chooses not to exercise an option to extend.

In the apartments world we use a standard lease form (usually the state's apartments association's form). In commercial, especially in NNN leases where there's a national grade tenant, it's a lot more common to see custom contracts which required deeper diligence and understanding.

[John McKee]

The information is always relevant. Even if it's an absolute NNN there can come a day when the tenant vacates the building and it is now your responsibility. It's in your best interest to know the building is being taken care of. Maybe you don't need to know the day to day, but make sure the operator is taking care of the asset. The biggest thing is to make sure your listed on their insurance policy as an additional insured.

[Benjamin Aaker]

Quote from @John McKee:

The information is always relevant. Even if it's an absolute NNN there can come a day when the tenant vacates the building and it is now your responsibility. It's in your best interest to know the building is being taken care of. Maybe you don't need to know the day to day, but make sure the operator is taking care of the asset. The biggest thing is to make sure your listed on their insurance policy as an additional insured.

Get on the insurance policy. Not something I considered. Thanks for that tip!

[Ronald Rohde]

Quote from @John McKee:

The information is always relevant. Even if it's an absolute NNN there can come a day when the tenant vacates the building and it is now your responsibility. It's in your best interest to know the building is being taken care of. Maybe you don't need to know the day to day, but make sure the operator is taking care of the asset. The biggest thing is to make sure your listed on their insurance policy as an additional insured.

 That's fair, just curious how important it is, certainly you can ask and still close if you don't receive a copy in time.

[John McKee]

I always put the pressure on the seller and the broker to produce documentation.  I don't really need all of it to close, but I never let them know that.  It also buys me some more time in the due dilligence process because the clock doesn't start ticking until I receive the documentation as requested in the contract.   If I have a 30 day due dilligence clause and they sent me a bunch of documents but are still missing the obvious ones like the CO, Insurance, proof of rent etc., then the clock hasn't started yet.    

[Cody J Leivas]

Quote from @Benjamin Aaker:

Quote from @Ronald Rohde:

Quote from @Benjamin Aaker:
Questions for commercial investors out there:
1. When underwriting an building purchase with attached absolute NNN lease, what diligence items do you typically request?
2. Do these items change for you if the property was recently built and has a long-term lease vs an older property with a 'seasoned' lease?
3. Do these change based on the credit history of the tenant?
Thanks for your help!

 I only care about tax statements (to see rate of change), insurance premiums (again to see costs, claims) loss run, any correspondence from Tenant.

As absolute, you don't need more than that unless the lease calls for sales reporting, you need to guage the underlying credit of the tenant. is this a good location?

Not unless there's sub 5 years left on the lease and I plan on reletting.

Anything absolute should have a very high quality tenant. Most tenants don't want absolute...

Thanks for the reply. That's the crux of my question - if the tenant will pay all the expenses related to the property, except the owner's admin costs and debt service, I wonder if the 'physical' diligence might be less and the 'paper' diligence (tenant credit and lease scrutiny) might be more. Clearly there will be some variation so I'm grateful for everyone's info on this.

Both are important. When doing your DD, you need to assume that this building could go vacant, and if it did, could you get rents similar to or above your current lease. Even if it is NNN or Abs NNN, you will want to do a property condition report to determine all the deficiencies in the property (it's a couple hundred dollars). If it's the tenant's responsibility, you can and should notify them of the problem and have them fix it. It should say in the lease that they are required to maintain x in working order. Some tenants will be better about keeping the building up to date than others. At the end of the day, they could leave and not maintain the building (and you may not have a security deposit), so it's best to know what is wrong with the building and get it fixed, especially if it's the tenant's responsibility. 

[Benjamin Aaker]

@Cody J Leivas Thanks for the reply. I'll look into getting a property condition report. Thanks for the tip.

[Mark H. Porter]

I see that you mentioned a single NNN lease. If it's occupied by an A-class tenant, like Walgreens, Starbucks, etc.. make sure to read the lease and its amendments carefully. These guys are very good at writing these contracts. For instance, I bought one of these majors who had signed a 5 year extension after the landlord cut a check to their "incentive" program for $400k.

If multiple tenants it gets more complicated.  My experience has been that if major national(s) anchor the property they will have far different leases across the board.

[John McKee]

Let me add something of note here about Insurance.  A lot of landlords are added as an additional insured on the tenant's  policy, but if the lease contract doesn't mention this as a responsibility of the tenant then the insurance company may not cover the landlord.  I recommend getting your own liability policy in addition to being listed on the tenants policy as well.  It won't cost a lot and you can bill it to the tenant anyway because they should cover all landlord costs.

[Joseph Gozlan]

Quote from @Mark H. Porter:

I see that you mentioned a single NNN lease. If it's occupied by an A-class tenant, like Walgreens, Starbucks, etc.. make sure to read the lease and its amendments carefully. These guys are very good at writing these contracts. For instance, I bought one of these majors who had signed a 5 year extension after the landlord cut a check to their "incentive" program for $400k.

If multiple tenants it gets more complicated.  My experience has been that if major national(s) anchor the property they will have far different leases across the board.

Here's a worse example: Walgreen/CVS has in many of their leases a "rent holiday" which means they don't pay rent in the last 3 years of the main period. If you don't read the lease you can be in serious trouble...