Real estate investors looking for passive income opportunities, with minimal management requirements, often look to net-leased, single tenant properties.
These are the retail stores that we frequent on a daily basis, such as Walgreens or Dollar General or Walmart. These real estate investments are often low risk and financing is typically readily available.
Below I’ll explore the key points to be aware of when investing in net lease single tenant properties to maximize the return on the investment and leverage availability.
Most leases for single tenant retail properties are triple net, often shown as “NNN”.
Generally speaking, NNN means that the tenant is responsible for maintenance of the property and its expenses, such as insurance and taxes. This translates into minimal management required for the landlord, a sought after trait for investors seeking passive income.
The Tenant: Credit vs. Non-Credit
The financial strength of the tenant is an important characteristic because it will affect the price, which affects your return and financing availability.
“Credit” tenants are those companies that have investment-grade ratings by one or more of the three major commercial credit agencies, Standard & Poor’s, Moody’s or Fitch. Most of these companies are large, public companies. They are financially strong and pose on low default risk.
“Non-credit” tenants range from local mom-and-pop shops to regional companies and franchises, such as restaurants. These companies lack the financial stability of a large public company and therefore have a greater risk in the event of an economic downturn.
Risk correlates with reward, meaning credit-tenant leased properties are often higher-priced and provide a lower return on investment (“ROI”) versus non-credit tenant leased properties.
Understanding Your Lease Agreements
The most important component of the lease is its term. The longer the term often means a more attractive investment, which typically reaps a higher likelihood of obtaining financing.
For credit tenants, leases often start with a very long initial term, such as 20 years, while non-credit tenant properties typically start with a much shorter initial term, such as five years. In either case, leases usually have renewal options that the tenant may exercise.
As an investor, you should pay close attention to the remaining term of the lease, as that will usually track the term of any financing.
For example, if there are seven years remaining on a 20 year initial term, the investor should expect a loan with no more than a 7-year term. If there are only one to three years remaining on the initial term, financing will be difficult to obtain as lenders often structure loans with 5, 7 and 10 year terms.
Investors considering acquiring a property with less than 5 years remaining on the lease term may want to think about providing incentives to the tenant to exercise a renewal option in connection with the purchase. This will improve financing availability.
Also be mindful of early termination clauses, as they usually affect price given the added risk. These will affect a lender’s view of the risk of the deal.
While triple net leases often defer most expenses to the tenant, there are a few that the landlord may still incur. For example, your legal and accounting expenses are not going to be covered by your tenant. Also, for older properties, leases may exclude structural repairs.
Location, Location, Location
Properties located in more affluent areas or fronting on major streets or intersections are often more expensive than properties in lower income areas.
However, prime location doesn’t necessarily mean that the business will succeed.
You should take time to identify traffic patterns, neighborhood demographics and neighboring commercial properties, especially competing companies, to determine the potential for long-term success.
For example, a Toys R Us may not succeed in an aging neighborhood, but a Walgreens may do very well.
You should always consider the financial performance of the business that is leasing the property. The success of the business will no doubt affect whether the tenant will renew the lease.
In particular, where the tenant is closing stores, such as part of a merger or a restructuring, investors should pay close attention to the financial performance as a means of predicting whether a store would be closed. This can present an arbitrage investment opportunity.
Condition, Size and Shape of the Property
Clearly, a property’s physical condition is an important consideration of any real estate investment.
You should always make a thorough inspection of the property prior to investing. Also consider the physical characteristics of the building, such as its size and shape.
This is especially important if the lease contains an early termination clause or the term of the lease will expire in the near term because you may have to find a new tenant.
Buildings with a unique size or shape limit the potential tenants. Conversely, big box store like BJ’s or Home Depot can be typically converted to accommodate new tenants. Lenders generally don’t like unique shapes and sizes.
Prior, Existing and Future Use
Make sure you evaluate prior and existing use.
Certain uses will naturally involve environmental concerns, such as oil change facilities or dry cleaners. You should also consider limitations on use, whether that relate to signage, parking, or other factors. These can affect attractiveness to potential tenants and lenders. Thinking about future tenants prior to investing and evaluating these risks will pay dividends in the future.
The availability for financing for net-leased single tenant properties will depend on the various factors discussed above.
Federally insured institutions such as banks and credit unions are usually the best option because they offer the lowest rates.
CMBS is also available for single credit tenant properties, which means you must be rated by Moody’s. Also, the loan amounts need to be larger, typically starting in the $5 Million range.
Private lenders are typically more expensive, but can be a viable solution when time is limited or to provide a bridge to permanent financing.
For example, in the case of an expiring lease, a private bridge loan may be a good solution to allow the investor to acquire the asset and then negotiate a long term lease, thus making the asset attractive to a bank or credit union for a permanent solution.
The amount of leverage a bank or credit union is willing to lend is invariably tied to the creditworthiness of the tenant. The better the tenant, the higher the leverage.
Non-recourse financing is usually available where financing is 65% or less of the total value/cost, though can be obtained for up to 80% LTV in certain circumstances and with certain lenders.
Not every bank or credit union like the single-tenant retail asset class. Therefore, knowing which lenders like these types of deals is critical to efficiently securing financing.
Similarly, where sponsors are out of area, it can be especially difficult because banks and credit unions like their clients to be close to home.
Again, though, certain lenders focus less on these issues and they are often the ideal financing solution. An online platform like Raisal.com is a convenient way of navigating these issues to instantly connect with the ideal lenders for your particular situation.