Section 1031 exchanges allow real estate investors to sell their investment properties and exchange them for similar or like-kind investments and defer the tax on the accumulated capital gains. Real estate is by far and away the most exchanged asset class allowed by the code. Triple-Net (NNN) Leased Real Estate could be a suitable replacement property when conducting an exchange. A Net lease refers to a tenant paying all or some of the properties’ operating expenses plus the rent. Before getting into the specifics of the NNN lease, one must know that there are several types of leases:
*Bond lease – The tenant is fully responsible for operating expenses, maintenance, repairs and replacement cost.
* Triple Net (NNN) lease – There are usually limitations on capital expenses. Lessee is responsible for property expenses including tax, insurance and maintenance.
* Net Net (NN) lease – Similar to NNN lease, except that landlord may be responsible for structural damage such as roof or bearing walls.
*Modified Net lease – The tenant pays utilities, maintenance, repairs and insurance. Landlord is responsible for property taxes and everything else.
Investors seeking suitable replacement property for their 1031 exchange look to NNN properties for following reasons: the structure may provide relief of management obligations, such as multi-family apartment complex owners that are looking for relief but still need the income, want to defer their tax responsibilities, and no longer want intensive landlord responsibilities. Investors may also consider NNN properties for assured income, pride of individual ownership and preservation of capital. NNN leases may also interest investors that want to provide a relatively easy estate asset for their heirs.
While NNN properties appear to be easy to own and operate, they can be a challenging type of real estate investment if the investor does not fully understand lease structure, such as lease term, which can be as long as 50 years. Even more so than typical commercial real estate, there is significant value in the lease; the lease can be more important than the building and/or the land to determining value of the real estate.
It is important that investors understand the variations in different NNN properties before investing. One should review the investment, lease document, tenant, the real estate itself, and the type of seller. After finding potential property, one needs to obtain a copy of the lease and review thoroughly before getting into other due diligence aspects, which also include inflation, local tax risk, credit worthiness and type of use.
An investor must take inflation into consideration when deciding upon an NNN lease to invest in. Frequently, rent increases are not included in the lease. This is particularly prevalent with large publicly traded retail drugstore leases. . Leases that call for rent decreases are actually prevalent in older NNN lease. The theory was that the loan would be paid off so the landlord’s spendable income would be reduced. These leases are not common today, but careful consideration should be given to the affects of inflation on these two structures.
Secondly, there are tax risks to be considered with NNN real-estate. Local laws may affect the lease values. Taxes may increase during reassessment after sale, creating additional tax burdens that may not be covered in the lease, shifting responsibility to new landlord.
Furthermore, consider the credit worthiness of the investment. Again, there is considerable value in the lease so tenant quality is a critical factor of pricing NNN leased assets. Property price should reflect the tenant’s ability to meet the terms of the lease. Capitalization rate (annual rent divided by purchase price) should adequately indicate this variable risk factor. If there is a higher risk that the tenant should become insolvent over the long term, the capitalization rate should accurately reflect the increase in risk absorbed.
It is easy to find information on publicly traded companies but it is considerably trickier for privately held entities. Many were caught off-guard by Vicorp Restaurant, Inc.’s Chapter 11 filing, which is a private corporation. However, there are investigation options for potential purchases also through fee-based tenant underwriting services and they should be considered. In an ideal situation, your broker will provide some of this research for you and at least give you an opportunity to weed out poor credit risks prior to investing significant time and energy in the due diligence process.
Even with a substantial credit rating, one needs to consider how the type of business may affect investment value. General purpose properties that are easily converted to multiple tenant needs are more desirable than a single purpose property. Manufacturing facilities are prime examples where investment or building is designed specifically for that tenant, frequently without consideration for the market as a whole.
It is not unusual with Triple Net leased properties for the purchase price to exceed replacement costs and comparable sales on a per square foot basis. Be wary of over-market rent that can’t be achieved with another tenant in the future, particularly if the tenant’s credit quality is weak.
Types of NNN Sellers
NNN sellers fall into 3 categories – Investor Owner, Owner User and Build to Suit Developer.
With an Investment Owner, the primary lease has a limited amount of time remaining. Pay careful consideration to base rent, payment/expense history, and sales volume history to determine the likelihood of the tenant remaining in the property.
Secondly, the Owner User type of seller indicates that the NNN lease is well-suited for sale/lease back. Why would the owner want to become a tenant? Simply, the seller frees up capital and makes it easier to grow his/her business. Generally, real estate returns are lower than the returns the business is generating, so selling the underlying real estate and leasing back the property enables the owner to free up cash held in the real estate to invest in the more profitable business that occupies the property. Also, sale/leaseback leases are highly flexible, but investors should be particularly aware of any stipulated methods of rent increases and the possibility that the seller over improved the property to meet the company’s needs.
Finally, the build to suit developer is probably the most straight forward form of seller. They are professionals who have set up a system for the building and disposition of assets and readily have standard information available in packages for potential purchasers. Typically, their leases are more standardized, reducing contractual surprises. However, the downside to purchasing from a developer is the lack of or limited amount of performance history for the site. It is valuable to look at developer’s past projects to see how they fared.
In conclusion, when carefully structured and underwritten, NNN investments are a terrific, viable option for Section 1031 replacement property. They can help investors reduce their management responsibilities and hold a long term lease with a strong credited tenant. Due to long term nature of this type of real estate investment, however due diligence may be even more important than with other types of real estate investment.
Some critical factors to be observed when considering a NNN lease are:
*Is the lease actually NNN?
* Will the tenant succeed in the location?
*Are there any additional local tax issues?
*Is there adequate inflation protection in the lease?