Due diligence is key
Properties with triple net leases offer investors several advantages, but the primary one is the opportunity to receive a steady stream of income with minimal management responsibilities for the property. This is because the tenant is responsible for paying real estate taxes, insurance and property maintenance.
Every triple net property is different, however. So thorough due diligence is essential before investing. Several areas in particular call for close examination.
Bad tenants can cause problems for most types of real estate investments. But triple net leases are especially vulnerable because they typically involve only one larger tenant. If the tenant defaults, the property’s revenue stream ceases altogether.
The first step in evaluating tenant quality typically involves looking at the tenant’s credit rating with Standard & Poor’s, Moody’s or Fitch. Bear in mind, though, that properties with tenants boasting the highest credit ratings usually offer investors the lowest returns because they expect more favorable rental rates and terms. Conversely, properties with lower-rated tenants are at a higher risk, although they offer the possibility of greater returns to compensate for risk.
Also look at tenants’ financial statements to determine, for example, the amount of cash on hand, future liabilities, debt levels and revenue stability. Additional research should be done regarding the ongoing viability of the tenant’s business. For instance, could it be threatened by obsolescence, increased competition or regulation?
Consider, too, the type of tenant. A local or regional store (as opposed to a national store) may be riskier because it will likely have a shorter lease term and limited cash reserves and financial backing.
Before investing, you’ll need up-to-date information on the property’s condition, age and improvements. If the property has improvements, are they special-use and designed specifically for the current tenant, or could they be used by other tenants in the future with little conversion cost and work required? Has the current tenant invested a significant amount of expense and effort in making improvements? If so, the tenant is more likely to renew its lease.
In addition to conducting a property inspection, obtain valuations of the land, building and improvements. It’s possible that the property has little value without a tenant.
As with most real estate investments, don’t overlook your location. You shouldn’t take for granted that the tenant that sought out a neighborhood years ago is still satisfied with it. Does the location continue to provide sufficient demand for the tenant’s products or services? If it’s a retail business, how is the retail traffic? If the tenant is part of a national company, how is that location performing compared with other locations? Among other things, due diligence requires a look at the area’s employment rate, median income and population density.
If the tenant might not renew, zoning also can come into play. For example, will zoning regulations make it difficult to get a new tenant into the space? And if a new tenant is necessary, what are the market expectations in the area regarding landlord and tenant responsibilities? It’s possible the market might not bear the current arrangements, cutting into investors’ profits.
Last but not least
Not every property advertised as “triple net” truly qualifies. For example, according to the fine print of the lease agreement, a landlord may be responsible for things like snow removal, roof maintenance and replacement, or parking lot resurfacing. So, always obtain and scrutinize the lease contract itself.