Single Tenant Net Lease 101
Who, What Where, Why – A Single Tenant Net Lease Overview
A single tenant net lease (STNL) property is rented by a single specific tenant and the net lease refers to the responsibility of the tenant to pay one or more than one of property taxes, insurance and operating expenses. The terminology “triple net” is derived as we remove the three (nets) expenses together reducing the landlords responsibilities to zero. A single tenant net lease property can include a number of lease structures such as a single net lease, double net lease (NN), triple net lease (NNN), or ground lease depending on the number of landlord responsibilities.
Single net lease – In a single net lease the tenant pays one of the nets, which is usually property tax, while the responsibility to pay remaining property expenses and maintenance lies with the investor (landlord).
Double net lease (NN) – In a double net lease the tenant, typically, pays for property tax and insurance while the responsibility to pay for operating expenses and maintenance lies with the investor. Typically, the landlord responsibilities for a double-net lease are roof and structure, and in colder climates include snow removal.
Triple net lease (NNN) – In a triple net lease the tenant pays for all the three nets and there are no landlord responsibilities. These are the highest sough after lease structure and offer the lowest risk and hence the lowest return.
Single Tenant Net Leave Vs. Other Lease Structures
Net leases are different from gross leases. In a gross lease a tenant pays pre specified amount as rent and the landlord is responsible for all expenses, maintenance, and taxes of the property. Whereas in a net lease structure, the tenant takes the responsibility of the property liabilities such as property taxes, insurance and operating expense. Most rental agreements for non-commercial properties are gross leases.
- ✔ Triple-Net (NNN) properties usually have long-term leases. They often have new lease terms of 10 to 25 years and typically provide multiple lease renewal options and rent increases.
- ✔ The landlord does not have to collect rent from multiple tenants but just one. Hence, managing rent collection and risk management is easier. Most STNLs are designed to give landlord minimal responsibilities.
- ✔ STNL tenants are usually credit worthy and have a third party credit rating assigned to them, which enables the investor to make better risk analysis.
- ✔ In traditional real estate, the loan is backed by property value and personal guarantees; but in STNL is the lease is guaranteed by credit worthy tenants making refi/financing STNL acquisitions making it one of the easiest/fastest asset classes to underwrite by lenders.
- ✔ 1031 Tax Deferred Exchanges allow investors to defer their capital gains while receiving monthly income.
- ✔ STNLs have a very high vacancy risk. As there is one tenant and if that tenant leaves or goes bankrupt the income suddenly drops to zero.
- ✔ Usually, STNL buildings are “built-to-suite” and designed and fitted with a specific tenants use in mind. If the landlord wants to rent the building to a different tenant then they will incur expenses refurbishing and taking the time to release the building.
- ✔ High cap rate STNL deals can be misleading to investors not familiar with the corporate versus franchisee lease guarantee and lease language such as early out clauses which can surprise investors new to the space.
Double-Net (NN) Vs. Triple Net (NNN) Lease
The principal concern comparing NN to NNN leases is the level of involvement the investor wants to have in the property. An active investor will prefer NN lease where the tenant only pays property taxes and insurance premiums but the investor looks after the maintenance of the property. A passive investor will prefer a triple-net lease where the tenant is responsible for all taxes, insurance, and maintenance of the property. As NNN leases are usually long term and the tenant’s have a credit rating, it provides a high quality stream of predictable income over a long period of time. In NNN leases, if the maintenance expenditure is more than expected the tenant has to bear the additional cost. The cap rate of NN lease is higher than that of NNN lease (for the same property) because of additional expense exposure incurred by the landlord.
Depreciation gives an advantage to NNN lease
NNN lease and bonds are quite similar in risk and returns from an investor point of view. NNN leases with rent increases perform like an inflation protected bond guaranteed by a National, Credit and/or Fortune 500 tenant rather than a government or municipality. Triple-Net leases are real estate investments and not paper securities where taxes advantages from depreciation offer more compelling risk adjusted returns. The investor will have to pay back the depreciation when he sells the property. However, this capital gain can be deferred by using a 1031 tax deferred exchange.
Sector Trends – Supply, Demand, Cap Rates, Flows
Over the last 10 years the demand for US single tenant net lease properties have increased as interest rates dropped to historic lows and investors sought yield. Cap rates are expected to gradually increase as interest rates rise. With interest rate hikes in 2018 and further expected, the spread between cap rates and US 10-year treasuries compressed to its lowest point since recession. Additional factors to consider impacting supply and demand are the new FASB accounting standard for capital leases. New accounting regulation requires leases longer than a year to be recorded on a company’s balance sheet representing more risk. It is expected to reduce tenant demand for long-term leases, and consequently impact supply, demand and cap rates in the market.
Auto parts stores
The average sales price per transaction in auto parts stores fell an average of 13.8% to $1.73 million last year. All chains reported a lower average sales price compared to 2017. Based on a two-quarter moving average, auto store cap rates rose 46 bps to 6.5% in Q4 2018 versus a year ago. While, sector sales price per square foot dropped 7.9% year over year. According to IBISWorld industry revenue is forecast to increase at an average annual rate of 1.3% through 2023.
Dollar store sales transactions and volumes both fell roughly 25% versus 2017. The average cap rates for the dollar sector increased 29 bps to 7% versus a year ago. According to IBISWorld, due to external competition, industry revenue is forecasted to slow to an annualized increase of 1.1% into 2024, down from a 2013-2019 average of 3.9%.
In 2018, drug store sector sales volume fell 23% and the number of transactions declined 14%. Though average cap rates for the sector remained nearly unchanged on Y-O-Y basis, but Cap rates on CVS stores down by 13 bps to 6% also Rite Aid fell 89 bps to 7.2%, whereas Walgreens cap rates rose 14 bps to 6.4% keeping the overall cap rate of the sector relatively stable . According to IBISWorld, industry revenue is forecast to increase at an average annual rate of 2.4% through 2023. Drug stores are facing immense competition from mass merchandisers (i.e. discount stores, supercenters and warehouse clubs), mail-order prescription providers, online pharmacies, convenience stores, wholesalers and health clinics. Though the increase in per capita disposable income likely to have a positive impact on this sector.
Quick service restaurant
QSR transactions and volumes in 2018 were almost similar to that of 2017. Sector average cap rates increased just 4 bps year over year to 5.6%. According to IBISWorld, fast food industry revenue is forecast to annually increase an average of 1.2% from 2019-2023. Successful QSRs will drive profit through healthy and interesting menu options.