Net Leased Real Estate and the Well Rounded Portfolio

by : James McCarthy



Income-producing real estate is an essential component of a well-rounded investment portfolio, providing both income and enormous potential appreciation. There are many different ways to add a real estate component to a portfolio, however, often investors must choose between limiting potential capital appreciation by investing in managed funds, usually with high expenses, or purchasing income properties such as apartment and office buildings, together with all of their associated maintenance and management problems. Fortunately, there is a third alternative - net leased investment properties, commonly refered to as triple net or by the acronym NNN.

What is a net leased investment?

There are several types of net leases but for this article we will consider one called a triple net lease, or absolute net lease. In a triple net lease, the tenant agrees to be responsible for all expenses, eliminating the need to hire a property manager and to continuously shell out money for repairs and maintenance. The tenant usually pays the rent, plus taxes, maintenance and insurance. It is common to see this type of lease used by retail chain stores and restaurants during an expansion phase. The retailer can quickly open new stores without having to purchase real estate and can put all of their capital to work immediately without having to tie any up in real estate equity. This capital retention comes with a price - which is paid to the owner of the real estate in the form of generous lease terms.

From an investor's standpoint, purchasing a net leased investment property affords many benefits. The primary advantage of net leased investment is the ability to retain any appreciation in the property while, at the same time, avoiding expenses and management responsibilities. Essentially, a net leased property cherry-picks the advantages of other forms of real estate investment and bundles them up into an easy-to-own-and-operate, income property with a steady income stream for many years. As a 1031 exchange vehicle, net leased investments are unmatched due to the ease of identification and transfer. Since management and maintenance issues are minimal, investors may focus almost entirely on return on the capital and the credit worthiness of the tenant when comparing and selecting properties.

What are the risks of owning a net leased property?

Many of the risks of net leased ownership are the same as any real estate investment. The property value can depreciate in down markets, although given the long term nature of net leases, the likelyhood of this happening over the life of the lease is usually minimal. It is likely, however, that the cost of literally everything will appreciate over the life of the lease. This is also known as inflation, and must be factored in when considering a net leased investment property. The best way to mitigate inflation is to build rent increases into the lease and to tie any renewal options to market rates or an inflation-adjusted index. This can be a tricky negotiation since neither the tenant nor the owner rally knows what the inflation rate will be over the life of the lease.

Another consideration is the tenant's track record and credit-worthiness. Obviously, leases signed by large corporate chains can be a safer investment, but may come with a lower return. An investor may be willing to take on a little more risk to gain a higher return. A good candidate for this tactic is a franchisee owner operating several locations of a large chain. Look for a tenant who can demonstrate successful operation of multiple locations for five years or more.

Fortunately, in most net leased investments these negotiations have already been handled by qualified real estate professionals. Before purchasing a net leased investment property, be sure to have your advisor review the terms of the lease to make sure that the lease rate is at or near market rates and will remain at market over the life of the lease. Even if the lease rate is above market, which may seem to be an attractive investment, be aware that this could make it difficult to renew at the current rate after the lease expires. It is also possible that some improvements have been built into the lease rate - improvements which will have fully depreciated by the time the lease expires or which may not be desirable to the next tenant.

Where to go from here?

Think of net leased investment more as purchasing the lease, rather than the property itself. The property has already been selected by the tenant as a good location for their business. Now you must select both the property and the tenant - and they come as a package, inseparable for many years. The advice of a net leased real estate expert will be invaluable in making this selection. Don't rely on a local real estate agent. The pool of available net leased investments is large and the target geographic area consists of the entire country. Contact a professional with the resources to compare properties in multiple cities and states. You will not have to drive out to your property to fix any leaks, so don't limit yourself to nearby areas.

A net leased property is a long-term investment with many factors to consider. You must thoroughly understand the terms of the lease on your property and I can help you do just that. If you would like more information, or need help finding a property, contact me by email at david.perduk@cbre.com or call 760-438-8549 for a free consultation.