From: 1031 DST Solution
Date: January 27, 2021

NNN Leases: Why Long-term Is Not Always a Good Term

Triple Net Property leases, commonly known as NNN leases or net-net-net investments, are a well-known favorite amongst experienced investors. However, many of the significant benefits that make NNN leases so favorable also have the potential to be a downside.

What is a NNN lease?

A NNN lease is a type of lease arrangement in which the tenant is responsible for the property expenses and not the property owner. You could view the NNN lease structure as an outlier of gross lease structures (where the tenant only covers rent) and net lease structures (where the tenant covers rent as well as some of the operating expenses) because it suggests that property owners will have even less risk than they would in a gross or net leasing arrangement.

There is typically only a single tenant in a NNN lease, and they would most likely be leasing a free-standing commercial property. Since the single tenants usually operate banks, pharmacies, or restaurant chains on the property, these investments tend to be long-term and average at about 10 years.

Reevaluating Long-term Leases

Although longer, single-tenant leases appear to offer more predictability and consequently, “guaranteed money,” there is a false sense of security baked into the concept of a longer term. The value of the property is at its highest at the execution of the lease, and the tenant’s rent is mainly based on this initial value, so there are several problems that may occur as the investment ages.

  • Value Shifts
    The owner would benefit from a steady income during the lease term, but it would be a fixed income as you cannot increase the rent at any point during the lease. This means that if the property value were to go up in the area, the owner would not see any rent bump benefits.
  • The Flat Lease – Inflation Can Be Your Enemy
    Even though NNN leases are often considered to mean absolute net leases, it is a common misconception that the tenant truly covers ALL of the property expenses. Many NNN leases do not have an escalation clause that allows for increased costs due to inflation, taxes, or other related costs that are bound to occur over time. For a landlord, the flat lease typically associated with NNNs can be a potential pitfall over an extended period of time since it does not account for increases in payments. For example, Walgreens leases can be flat for 20 or 30 years or more.
  • Single Tenants
    Investors like to avoid large tenant turnovers through this method, but sticking with one for decades has its own disadvantages. In order to get these long-term leases, the investor reluctantly grants renewal options as most tenants will likely require it to complete a lease transaction. As the end of the lease approaches and you enter the renewal option period, the already declining value of the lease can be further negatively impacted at this point.If the tenant chooses not to renew, the owner could be left with a huge repair bill as the tenant may not have made all the necessary improvements they were in charge of covering over the past decade or two.
  • Negotiating Renewals With Large Corporate Tenants
    In general, NNN leases may be a five or ten, or perhaps a 15-year term at origination. The landlord would like to get a sense of the tenant’s likelihood of renewal well before the lease term expires but the tenant may wait until the very last minute. The lender may also require a significant lease term remaining to agree to a loan extension or casting a new loan. The lender may also get nervous and exercise their right to call the loan, creating a difficult financial position for the landlord.If your tenant is a large national corporation tenant you know they will be represented in renewal by a experienced law firm who’s goal is to negotiate lease renewal terms in the best interest of their client, your tenant. In turn, you will want to have your own experienced legal counsel to represent your best interests in the lease so that the terms are fair and equitable. Be willing to hire and pay for this competent legal representation or you may find pitfalls in your lease that benefit the tenant instead of you, the landlord.

Like their terms, NNN leases can be very long and are exhausting to read, but the most important thing to remember when handling commercial real estate is to do just that – READ THE LEASE – and hire experienced legal counsel to negotiate the terms of the lease on your behalf. Simple labels and terms that are used by brokers and landlords alike will often vary from their true definitions in the actual lease. NNN leases will not present all of the aforementioned issues immediately and parts of them will not come into effect until years later, so they require a lot of special attention. As long as you are aware of the disadvantages and ensure that your lease covers as many instances as possible, an NNN may still be right for you, but it is always best to consult with a professional before making any final says.

At 1031 DST Solution presented by Corcapa 1031 Advisors, we provide guidance and help investors find the best investments in the marketplace. Contact us today to learn more about NNN leases and a review of your real estate portfolio. – (949) 722-1031.

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