The NNN Lease, often just called the triple net lease, is a common lease structure used in commercial real estate. Despite the popularity of the NNN lease, the triple net lease structure is still commonly misunderstood by many commercial real estate professionals. In this article we’ll take a deep dive into the NNN lease, dispel some common misconceptions about the triple net lease, and then finally we’ll tie it all together with a clear and concise example.
What is a Triple Net (NNN) Lease?
First of all, what exactly is a triple net, or NNN, lease? A triple net (NNN) lease is defined as a lease structure where the tenant is responsible for paying all operating expenses associated with a property. The triple net or NNN lease is considered a “turnkey” investment since the landlord is not responsible for paying any operating expenses. With that said, in order to fully understand the NNN lease you must first understand the spectrum of commercial real estate leases.
The Spectrum of Commercial Real Estate Leases
All commercial real estate leases fall somewhere along a spectrum with absolute net leases on one end and absolute gross leases on the other end. Most leases fall somewhere in the middle and are considered to be a hybrid lease.
When most people talk about a triple net or NNN lease, they are usually thinking about an absolute net lease. However, just because a lease is called or labelled an NNN lease, does not mean it’s actually an absolute net lease. Often a lease will be called a “triple net lease” for convenience when in fact it is not.
For example, when a building is brand new the tenant may indeed be responsible for funding replacements such as the roof or HVAC systems as they wear out over time. However, on older buildings a lease can often be called triple net, but actually require the landlord to fund these capital expenditures over time, rather than the tenant.
The most important thing to remember when working with commercial real estate leases is to ALWAYS read the lease. The only way to truly understand the terms and conditions of a lease is to actually read the lease. Simple labels like triple net, full service, or modified gross, which are commonly used by brokers and landlords, will often conflict with the actual terms of the lease.
What the NNN Lease Does Not Include
Even if your lease is a true absolute net lease, a common misconception is that even a true absolute net lease covers ALL expenses associated with a property, which is not always the case. While a true absolute NNN lease with a strong tenant can be thought of as a turnkey commercial property from the landlord or investor’s perspective, even an absolute net lease has some expenses that won’t be covered by the tenant(s).
For example, it’s rare for an NNN lease to cover the accounting costs charged by the landlords CPA or legal costs charged by the landlord’s attorneys when drafting or reviewing documents. While these costs are usually small relative to the purchase price of a property, they are nonetheless not typically covered in a standard “NNN lease”.
Triple Net Lease Investment Risks
A common misconception with triple net lease investments is that they are almost risk-free. While triple net investments do offer several advantages, there are still several risks that should be taken into consideration. The primary advantages of triple net lease investments are that you get a predictable revenue stream due to the long-term leases and pass-throughs in place, and you also get a relatively hassle-free investment due to the low management requirements.
While these are compelling advantages, triple net leases also do come with several inherent risks. First, because most triple net lease investments are for single-tenant properties, tenant credit risk is important to understand. For example, not many today doubt the strength of a triple net Walgreens investment since the lease is guaranteed by the parent company, which is publicly traded and financially strong. On the other hand, it is very possible for financial strong and publicly traded tenant to fall out of favor over the term of the lease and ultimately go bankrupt. Since single tenant triple net properties are either 0% vacant or 100% vacant, this should be taken into consideration.
Another risk to consider is the risk of re-leasing. A lot of triple net investment properties are sold towards the end of a longer term lease, shifting the risk of re-leasing the property to the new owner. If the new owner does not have this skillset or a strong team to handle this, then this could present considerable tenant rollover risk.
Assessing Tenant Credit Risk in a Triple Net Lease
One important component to take into account when analyzing a triple net lease investment property is understanding the credit risk of the actual tenant(s). After all, a lease is only as strong as the tenant behind it, so analyzing the financial statements of the tenant on the other side of the NNN lease is critical in understanding downside risk.
Many single tenant triple net lease deals involve publicly traded companies such as Starbucks, Walgreens, or Arby’s. In this case it’s easy to pull up credit ratings on the companies bond issues and to also read stock analyst reports.
For private companies credit analysis requires some more effort, but analyzing financial statements and trends to better understand credit risk is a worthwhile endeavor. For these situations, here’s a primer on better understanding tenant credit analysis.
Triple Net Lease Example
Let’s take an example to see how a proforma is structured with a triple net lease in place. Suppose we have the following cash flows for a sample investment property:
The above proforma includes no expense reimbursements from the tenant. In other words, the above proforma assumes all of the leases are absolute gross leases, where the landlord pays all of the expenses for the property. Now, let’s take a look at how the proforma changes when the tenant reimburses the landlord for all of the property’s expenses:
As you can see on the second proforma, the triple net lease in place provides additional reimbursement income that cancels out all of the operating expenses. To be fair, a triple net lease rate will typically be significantly lower than an equivalent gross lease rate for the same property, which would make the bottom line cash flows under a gross lease and a net lease much closer together than in the above example.
However, what the NNN lease ultimately achieves is that it shifts the responsibility, and therefore the risk, of paying the operating expenses from the landlord to the tenant. For example, if property taxes increase one particular year at an unusually high rate, then the landlord’s bottom line cash flow will be protected under an NNN lease and the tenant will be the one responsible for bearing this increased expense. The above shows how a proforma would be structured with these reimbursements in place.
The NNN lease, often just called the “triple net lease” is a popular lease structure in commercial real estate. In this article we defined the triple net lease in the context of the overall spectrum of all commercial real estate leases. We also discussed some common misconceptions about the NNN lease, reviewed some of the major risks associated with triple net lease investment properties, and finally we walked through how a triple net lease proforma is structured.