“Better safe than sorry” is an adage that often gets overlooked in the world of real estate investing. When evaluating a potential property, calculating the expected return is relatively easy, but understanding the associated risks is really difficult. What’s a real estate investor with a lower tolerance for risk to do?
Single Tenant Net Lease (STNL) properties are a popular option, particularly for investors doing a 1031 exchange who no longer want the day-to-day burden of being a landlord. STNL properties can be great investments, but they aren’t without risk.
In this post, I’ll highlight the risks investors should consider when weighing an investment in an STNL property.
STNL properties are usually free-standing, specialized buildings leased to household name brands under long term triple net (NNN) leases. Single tenant net lease investments are also referred to as “NNN properties" or “Net Lease” properties. The NNN refers to the nature of the triple net lease, which requires the tenant to pay (in addition to the rent) property taxes, insurance, and maintenance on the property.
STNL investments are appealing because they require limited ongoing landlord responsibilities, and provide the owner with a long-term predictable stream of rental payments.
Sounds great, right? It can be—as long as everything goes as planned, which brings me to one of the first risks of NNN investing.
Risk #1: Vacancy
STNL properties are either 100 percent occupied, or 100 percent vacant. With only one tenant, if a company goes out of business or leaves, the rent goes to zero and you (the owner) are responsible for the taxes, insurance, and maintenance.
What does an investor do with a vacant, former Burger King or Chic-fil-A? Lease it to another fast food restaurant, of course! Oftentimes, this is easier said than done. There’s a reason that XYZ chain is no longer occupying the property, and it likely has something to do with the location. This highlights risk number two.
Risk #2: Location Matters
Don’t get enamored with a high profile tenant, or the “above average returns” a property promises to generates. At the end of the day, STNL properties are real estate investments.
A vacant building that was previously home to Tractor Supply or Dollar General is incredibly difficult to re-lease at the same rent if it’s located in Truth or Consequences, New Mexico, or Tyrone, Pennsylvania—two towns I know and love.
Even if a property is located in a large metropolitan area, you still need to pay attention to the location. How much is the next buyer willing to pay eight years from now for an Applebee’s in a marginal neighborhood that only has two years left on the lease?
Let’s go to the other extreme by assuming an STNL has a really good location but the tenant for whatever reason doesn’t make it, or decides not to renew the lease. Even if other tenants are standing in line to lease the property, a former Wendy’s or branch bank is not what I’d call generic real estate. This highlights the next risk.
Risk #3: Specialized Buildings
Typically, STNL properties are designed and built to meet the requirements of a specific tenant. Re-leasing an STNL property to a different type of tenant can take a long time and cost the landlord a significant amount of money.
The more specialized a building is, the greater the amount the next tenant will expect the landlord to contribute in upfront tenant improvements. Even if a building is in an A+ location, marketing and lease negotiations can easily mean no rent for six to 12 months. This can be particularly challenging for an absentee investor who lives far away from the property and/or does not have the capital necessary to attract the best tenants.
For these reasons, investors considering an NNN property should be vigilant in understanding a tenant’s ability pay the rent. Often, STNL buyers, particularly those in 1031 exchange 45-day identification periods, don’t pay much attention to the lessee on the hook for paying rent. This is the next major risk of which NNN investors should be aware.
Risk #4: False Sense of Security From a Corporate Brand
Just because a household brand name is on the sign out front doesn’t mean that the corporation behind it is obligated to pay the rent.
It might come as a surprise, but it’s fairly rare that well-known corporations actually sign a lease. Just because the tenant is Wendy’s, Best Buy, or Exxon, doesn’t mean those publicly-traded companies are paying the rent. Even if the property is a “company store,” the lessee is typically a subsidiary, and the parent company may or may not be guaranteeing the rent payments. This brings me to the next risk.
Risk #5: Failing to Understand the Tenant’s Ability to Pay Rent
Make sure you do your due diligence on the tenant to ensure they have the financial wherewithal to make all the agreed upon rent payments.
The truth is the majority of STNL properties are leased by franchisees, not the corporation traded on the New York Stock Exchange. This is not necessarily a bad thing; franchisees can be very creditworthy. Often, a local franchisee will have 10+ stores in an area, and it’s not uncommon for regional franchisees to operate 50 or more stores across multiple states.
Even if the tenant appears to have strong credit, it’s simple for them to set up a limited liability company (LLC) with a similar name for the sole purpose of signing the NNN lease on a property. Remember, if the tenant is an an LLC or corporation that has no assets, it shields even the largest company from having to honor the lease.
The main point here is that investors need to roll up their sleeves and make sure that if a tenant vacates before the end of the lease (for whatever reason), there is an entity on the hook with deep enough pockets to continue paying the rent through the term of the lease.
In his post The Risks and Benefits of Triple-Net (NNN) Properties, Ray Alcorn, a commercial real estate expert, provides some good advice: "In leasing [a tenant] your property, you are essentially providing capital to the business, and their continued success has a direct bearing on the long-term health of your investment. Past history and future prospects are both relevant."
Now, let’s get to the final risk that’s so easy for yield-hungry investors and 1031 exchangers to overlook.
Risk #6: Interest Rate Risk
The value of STNL properties is very sensitive to changes in interest rates.
It’s appealing to think about receiving a six, seven, or even eight percent return from an STNL property each year. Who doesn’t like “mailbox money” that shows up right on time each month? Many investors think about STNL properties more as fixed income, bond-like investments instead of real estate. This is understandable, with tenants like Walgreens, Bank of America, or other large franchisees guaranteeing the rent payments.
But, there’s a catch. On the plus side, STNL are similar to bonds, as they represent a series of fixed payments over a specified timeframe. On the downside, just like bonds, when interest rates go up, the value of STNL properties goes down. You’ll hear people argue this point, but it’s a fundamental principal of finance. The fixed rent structure of STNL properties makes them more susceptible to interest rate risk than most other types of real estate.
Another response I’ve heard more times than I can count is, “Interest rates have been at historical lows for more than a decade and will be for a long time.” I’m not going to argue the point, but I will say this: there’s never a guarantee that rates will stay low—and this uncertainty is the risk.
With all the risks I outlined above, it’s important for me to emphasize that I do not advocate that investors avoid STNL properties. Heck no! STNL/NNN properties can be great long-term investments, but they do carry “hidden risks,” which is why they are important to know, and why investors need to do their homework before they invest.
When evaluating real estate investments, understanding the potential risks can often be difficult. On the flipside, calculating expected returns is relatively easy. With an STNL investment, the greatest challenge most investors face is resisting the urge to believe that STNL investments are risk-free. Unfortunately, the only way to determine what the real risks are in a real estate investment, or in life for that matter, is with the passage of time. But one of the best ways to mitigate your risk is to make sure you understand all the risk involved before making the investment.
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