The NNN Lease, or triple-net lease, is a common lease structure used in commercial real estate. Despite it’s popularity, the triple net lease is still commonly misunderstood (and worse: mis-explained to clients). In this post, I’m deconstructing the NNN lease, debunking some misconceptions, demonstrating it all with an example, and just demystifying the whole dang thing. You’re quite welcome.
What is a Triple Net (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. Notice the underlined word there! 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. We’ll get to what is and what is not an operating expense in a bit.
The Range of Commercial Real Estate Leases
All commercial real estate leases fall somewhere along a spectrum with absolute net leases on one side and absolute gross leases on the other end. Most leases fall somewhere in the middle and are considered to be more of a hybrid lease, but no one but us language geeks actually call them that.
It’s just as hard as I thought it would be to NOT type “absolutely gross”.
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, in a new building, the tenant may indeed be responsible for replacing things like the plumbing system or roof 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 easy hack to keeping it straight? READ THE LEASE. Labels like triple net, full service, or modified gross, which are (mis) used all the time, often conflict with the actual terms of the lease. So READ it!
Triple Net Lease Investment Risks
Thought NNNs are almost risk-free? Nope! While triple net investments offer their advantages, there are still several risks that you need to consider. The main advantages of triple net lease investments are that you get a predictable revenue stream from the long-term leases and you also get a relatively hassle-free investment due to the lower management requirements.
And with these advantages come the risks. First, because most triple net lease investments are single-tenant, credit risk becomes important. For example, not many today doubt the strength of a triple net Walgreens investment since the lease is guaranteed by the publicly-traded parent company. On the other hand, it is very possible for financially strong and publicly traded tenant to fall out of favor over the term of the lease and ultimately go bankrupt (You mean Blockbuster Video is really gone forever??). Since single tenant triple net properties are either 0% vacant or 100% vacant, you need to consider that risk while I unfold my map and find a Toys-R-Us. Maybe they’re in the phone book? I’ll just call 4-1-1.
Another risk to consider is the risk of re-leasing. Many 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, so obviously this is something you need to point out to your potential buyer/investor client.
Here’s a really basic example of a proforma for a property with an absolute gross lease:
The above proforma includes no expense reimbursements from the tenant. In other words, 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:
The second proforma has a triple net lease in place that provides additional reimbursement income and 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. This is really just to demonstrate how this works.
The NNN lease ultimately gets the responsibility, and therefore the risk, of paying the operating expenses from the landlord to the tenant. For example, if property taxes skyrocket one year, then the landlord’s bottom line cash flow will be protected under an NNN lease and the tenant will be the one on the hook for hike.
You’re all geniuses now. Happy selling!