Your Cheat Sheet to Single Tenant Net Lease Essentials

Single Tenant Net Lease investments – alternatively called STNL, Triple Net, or NNN – are a popular form of real estate investment. They offer the promise of high stability and low management. Much of the time Single Tenant Net Lease properties consist of the usual suspects such as a Walgreens/CVS, dollar stores, banks, auto parts stores, and restaurants. However STNL properties can also include some businesses that you may not normally expect such as industrial and manufacturing properties and medical buildings. I have even seen a single cash ATM being marketed as an NNN investment property. These properties are typically sold with long term leases backed by national and regional chain retailers and businesses.  There are four major risk factors associated with the longevity and viability of STNL investments.  Understanding these risk factors is vital. This article delves into each of these.

 

The typical Single Tenant Net Lease property is one that a developer builds a prototypical building for a specified retailer or business. Often that developer is known as a ‘preferred developer’ for the chain and builds them nationally or regionally. That developer has a set of criteria that their tenant-client is looking for in terms of location, build-out, demographics, etc. The developer will enter into a long term lease (typically 10-15 years) with the business in hopes of creating a valuation spread between what it takes to buy the land and build the structure and what the developer can resell the completed and leased property to an investor for.

 

Once the building is completed and the business opens and is stabilized these properties are then usually sold on the open market. The value to the investor is influenced largely by several factors: the length of the lease (the longer the better), the creditworthiness of the tenant, the type of lease (less responsibilities to the landlord the better), type of business, and location. There are a number of other factors but these are the basics. The four major risks include:

• Credit risk of the underlying tenant
• Success of the tenant at the specified property
• Renewal and roll-over risk
• Industry obsolescence risk

 

Credit Risk of Underlying Tenant

There are plenty of names of retailers and businesses that were common twenty years ago that aren’t around today.  A retail chain can decline due to a variety of reasons: changes in consumer tastes or technology, inability of management to adapt to change or competition, or inability to weather economic storms. Obviously there is a substantial valuation premium for long established businesses that have built up a strong balance sheet, and have proven profitability and profitability trend lines. The difference between a seasoned publicly traded chain and a younger start up can be substantial, easily a 3-4% spread.  Generally you also want to buy a NNN property that is leased to a publicly traded chain rather than a private company due to the added level of transparency inherent in a public company, which is constantly under the watchful eyes of stock market analysts and auditors, though there are certainly exceptions with some fairly large and profitable private companies.

 

Success of the tenant at the specified property

The underlying tenant has to be successful in the NNN property regardless of how profitable or strong the chain is nationally. If the tenant is losing money or just made a bad locational choice they are either going to close their doors (‘go dark’) or certainly not renew their lease once the initial lease term expires. Even though the tenant may keep paying rent after they go dark until their lease expires, it’s just a matter of time before the inevitable happens. Change is not good for most NNN investors as they typically have bought the asset under the believe that the income stream is stable and continuous. Change can mean opportunity, but it usually also includes a cost.

 

Renewal and Roll-over Risk

The first two risk factors discussed above can result in renewal or lease roll-over risk. Often a lease renewal for a Single Tenant Net Lease investment property will provide the tenant an opportunity to try to renegotiate the rent or extract some other type of concession from the investor landlord. Some retailers are particularly renowned for taking advantage of their situation. Many times the lease renewal option held by the tenant will have the rental rate adjusted by ‘fair market value’ which is an open invitation for some serious negotiations and a game of hard ball. The tenant will often consider relocating and opening up their coffee shop across the street where the landlord is cheaper. This can often provide the tenant the opportunity to ‘right size’ their space (bigger or smaller).

Of course sometimes it is the landlord that is sitting in the driver’s seat. There have been many situations where the former tenant had been enjoying $2 per square foot when comparable rents have moved up to $10. Even chapter 11 companies try to hold on to such below market rental situations given the arbitrage situation created. Kmart is a great example of this.

 

Industry Obsolescence

One of the more timely risk factors is the ever-accelerating industry obsolescence risks. I think there are many NNN categories that are in a heightened state of risk due to technology. Banks no longer need 5,000 square foot branches with 4 drive-throughs. There has been a steady erosion in the branch banking industry over the years that will likely grow more. Are 15,000 square foot drug stores at risk with Amazon now delving into that industry? I say yes. Are gas station chains at risk when cars are making a huge changeover to all-electric in the next 5-10 years? I suspect they are.  As an investor you don’t want to be holding on to a portfolio of drug stores and gas stations when the music stops.

 

NNN properties can be great for many investors, but the investor needs to understand that the property is either 100% leased or 100% vacant. Understanding the risks above should be understood and factored into the decision process. Part of the answer comes down to other factors: is the building readily adaptable to other uses, is the location strong enough to be enduring.  Endurance and longevity trumps higher short term yields.

 

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