When it comes to commercial real estate investing, one of the most important aspects to understand is lease structures. As a concept, leasing may seem straightforward — your tenant occupies your asset and pays rental income. However, there are many kinds of leases out there, and some divide the expenses between the tenant and the landlord. These structures are called net leases.
The most common types of net leases are single net, double net, and triple net leases. Each one has its own distinct divisions of expenses, creating unique characteristics, advantages, and disadvantages. As an investor, you’ll want to understand the specific features of each to determine which structure works best for your investment needs.
Below, Realized 1031 shares a comprehensive guide to help you compare each type of net lease, including their pros and cons, and how market conditions impact them.
A net lease, also called a single-tenant net lease (STNL), is a type of lease agreement where the tenant agrees to pay a net operating expense aside from the base rent. These net expenses can be property taxes, insurance premiums, or maintenance costs.
In contrast, the gross lease is the structure where the tenant only pays the base rent. The landlord or property owner will pay all the net operating costs. Gross leases are more common in residential properties or office arrangements. However, net leases are popular in commercial properties because they allow landlords to share the burden of property operations with tenants.
Aside from sharing the operating costs, investors also favor net leases because they can provide some level of protection in certain market conditions. Others prefer the reduced involvement in certain aspects of operations.
The first entry in our discussion is the lease agreement with the simplest structure: the single net lease, also known as an N lease. The only additional expense the tenant shoulders, aside from the base rent, is property tax in most cases. Rarely are N leases dedicated to insurance premiums or maintenance costs.
The N lease is the first step away from a gross lease, where the property owner pays for all net operating costs. As the lease shifts the property tax burden to the tenant, you can reduce your financial exposure, especially now that property taxes are rising.
Here’s a breakdown.
The next structure, which assigns a bit more responsibility to the tenant, is the double net lease. This arrangement is also called the NN lease, and it’s often recognized as a true middle ground for tenants and landlords. In an NN lease, the tenant pays the base rent, property taxes, and insurance premiums. Thanks to this model, there’s a better balance in financial responsibility compared to gross or N leases. However, it still isn’t as passive on the investor’s end as a triple net lease.
Double net leases are often the ideal choice in cases where the tenants need more flexibility over insurance coverage. By default, landlords pay for property insurance in gross or single net leases. However, this coverage may not be enough for certain needs. For example, a tenant operating a high-risk business, such as a laboratory or a manufacturing plant, may require more comprehensive coverage than a standard policy provides. A double net lease lets the tenant tailor their coverage to their unique operational needs.
Here’s a breakdown of the double net lease.
The triple net lease, also known as the triple net lease, places the most financial responsibility on tenants. In this structure, the landlord relinquishes the duty of paying property taxes, insurance premiums, and maintenance costs. This leaves the tenant fully in control of the net operating expenses, and the landlord enjoys passive income.
A triple net lease is often preferred by investors who no longer want an active role in the management of their property. Examples are those who are entering retirement and want to spend more time enjoying their freedom instead of overseeing their commercial properties.
Triple net leases appeal to tenants who want full control over the real estate asset. These tenants are typically large national chains or single-location businesses with substantial operations. They often need to customize the property, so assuming maintenance costs help them keep the building up to industry standards or branding needs.
Here’s the breakdown.
To summarize the differences of each net lease structure, here’s a simplified chart.
Different market environments create certain conditions that affect each type of STNL. Here are some of these environments and how they influence the cash flow and risk levels of net lease variations.
Economic conditions are never set in stone, and the dynamic environment can result in unpredictability across all lease types. Strong economic conditions result in generally favorable effects, with tenants more comfortable assuming additional operating expenses. Meanwhile, economic downturns result in more wary or financially conservative tenants who prefer N leases since property taxes aren’t as affected.
In terms of interest rate fluctuation, lower numbers usually result in more investors putting their capital in NNN properties. The predictable and passive income stream becomes especially attractive, and the lower interest rates help with debt management. Meanwhile, rising interest rates make N and NN leases more popular because they can offer more competitive rental agreements.
Local property tax hikes or surging insurance premiums can heavily influence lease desirability. Tenants may push back against triple net leases if these costs become volatile or burdensome. In such cases, landlords may negotiate double net leases, sharing in certain risks to keep long-term tenants happy and leases sustainable.
Inflationary environments make NNN leases more popular to investors than other net leases, particularly because of rent escalation. The caveat is that tenants are less likely to enter this lease structure due to the volatile costs of goods and services.
The supply and demand for commercial properties for rent also affect net lease appeal. In environments with high demand and low vacancy rates, investors tend to prefer NNN leases since tenants are more likely to stay for the long term. Meanwhile, in markets with heightened supply and lowered demand, tenants prefer N or NN leases since they have more bargaining power and want fewer financial responsibilities.
Given the pros and cons of each net lease and how they perform under certain market conditions, it becomes apparent that each variation fits certain types of investors, especially with regard to their individual risk tolerance, income goals, and overall investment strategy.
In summary, there is no one-size-fits-all net lease structure. You must carefully consider your desired level of control, risk exposure, and long-term stability.
Net lease properties can be acquired through various methods, with direct property ownership as the most straightforward option. A 1031 exchange is a kind of tax-advantaged transaction you can use to enter a net lease property. If you already own an asset that’s held for investment or business use, then you can swap that for a net lease property and defer capital gains taxes.
The traditional 1031 exchange results in direct ownership. However, there are variations to this transaction that can help you access commercial real estate through indirect ownership. One method is the aforementioned DST, which is eligible for 1031 exchanges. You acquire beneficial interests in the DST from the sale of your relinquished property, and you earn monthly income proportional to these interests.
One additional benefit of DSTs is that they allow you to access income from NNN properties, which are usually out of reach for small-time investors, given the high upfront costs. DSTs pool money from several investors, allowing them to create a portfolio of institutional-grade assets that may include an NNN property.
Single, double, and triple net leases each have distinct features, advantages, and trade-offs that investors must understand before committing to a net lease investment. From the modest financial relief of N leases to the hands-off involvement offered by NNN leases, each structure presents benefits that make it appealing to certain types of investors. Careful evaluation of these characteristics, particularly their impact on your risk exposure and long-term goals, is crucial to increasing the chances of success.
Sources:
https://www.investopedia.com/terms/n/net-lease.asp
https://www.newsweek.com/america-property-tax-headache-2065595