Lease structures are essential in real estate investments. These contracts serve as the foundation for property agreements and can determine who pays for what, how each party manages costs, and how tenants or landlords handle long-term financial obligations. One lease structure that has become popular in recent years is the triple net lease agreement or NNN lease. You’ll typically find such arrangements in commercial properties, such as retail stores and office buildings.
A triple net lease shifts key expenses and financial responsibilities from the landlord or owner to the tenant. Many investors who want a less hands-on approach to their investment find this structure appealing. Some tenants may also find NNN leases more attractive since the rent base may be lower and more manageable.
What are these specific financial responsibilities? How do NNN leases differ from other types of leases? And how can investors use triple net lease properties for transactions like 1031 exchanges? Below, Realized 1031 has shared a guide to answer these questions and help you determine if this structure is the best fit for your financial goals. Keep reading to learn more!
What Is a Triple Net Lease?
In a traditional lease arrangement, the tenant pays rent and utilities — nothing else. The landlord would be responsible for the property’s upkeep, maintenance, insurance, and other expenses. However, this arrangement has been proven to have various disadvantages, such as the higher expense for landlords, which later translates to higher rent for the tenant.
On the other hand, a triple net lease structure assigns three key financial responsibilities to the tenant. Instead of just paying rent, the occupant will have to pay property taxes, building maintenance, and insurance. These three areas are where the NNN (net net net) comes from — “N” because these are net operating costs.
Here’s a breakdown of each net operating cost in a triple net lease.
Property Taxes
Local governments charge property taxes, and the default entity with the tax liability is the property owner. In an NNN lease, the liability transfers to the tenant, who is then recognized as the taxpayer. These taxes can fluctuate from year to year and from jurisdiction to jurisdiction, so tenants must be prepared for potential increases.
Insurance
There are many types of insurance required by financial institutions in the U.S., particularly banks and lenders. These include fire, property, and liability insurance and can easily add up. Investors can free themselves from these costs through an NNN lease. Tenants, on the other hand, can be more selective of the insurance they get. This flexibility is important given how some industries require more specific types of coverage.
Maintenance Costs
Another major expense in rental property operations is maintenance costs. In a triple net lease, the tenant will take care of the associated costs. These include routine upkeep, repairs, and in some cases, major capital improvements.
You typically encounter these lease structures in commercial real estate properties, especially ones that are standalone or larger commercial complexes. Thanks to the NNN lease, landlords can expect stable and predictable income. On the other hand, the tenant has more control over the costs of managing the property’s operations. Here are a few types of commercial properties that follow triple net lease structures.
- Retail Buildings: These include stores, shopping malls, and strip malls.
- Office Buildings: Examples are companies renting floors or standalone office buildings.
- Industrial Facilities: Warehouses, distribution centers, and production buildings are some examples.
An NNN lease offers various advantages to both tenants and landlords. From the flexibility to the hands-off management, either party can leverage these benefits to help with cost management and other areas. Of course, NNN leases do have their own disadvantages and risks. For example, the tenant takes the brunt of the expenses, even some of the unseen ones. As such, it’s important for either party to have a deep understanding of what this structure entails before committing to one.
How Does a Triple Net Lease Work?
Given how a triple net lease gives over significant responsibility to the tenant, this structure is a bit different from other types of leases. Landlords transfer the financial obligation for insurance, taxes, and maintenance costs. As an effect, the property owner pays little out of pocket for their asset’s daily operation. The tenant, on the other hand, can typically enjoy a lower rent. However, they do need to be more efficient with their budget because they’re covering a major chunk of operation expenses.
Here’s the typical structure of an NNN lease.
1. Base Rent
The tenant will still need to pay rent to the landlord or property owner. The monthly payments are typically lower than average, given the additional costs the occupant is shouldering.
2. Additional Costs
In the lease agreement or contract, the writing outlines the additional payments the tenant has to take on. These values may fluctuate annually, especially maintenance costs. As such, the tenant has to be more mindful of the expense and ensure that the lease agreement clearly specifies how these additional costs will be calculated and adjusted.
3. Long-term Stability
One common characteristic found in most NNN leases is that these are long-term commitments. The contract will typically require tenants to stay in the property for 10 – 15 years. Such an arrangement provides stability and predictability for both tenants and landlords. For investors, long-term contracts provide a steady income source over a longer period.
Let’s provide an example calculation.
A tenant of a rental building pays a base rent of $10,000 a month but would also be responsible for paying the following:
- Property taxes: $1,500 per month
- Insurance: $400 per month
- Maintenance costs: $700 per month
In this scenario, the tenant will shoulder $12,600 monthly on rent and operational expenses. However, the landlord receives only $10,000. The tenant will pay the other costs to the respective companies or local revenue department.
Realistically, there’s plenty of room for negotiations when it comes to NNN lease contracts. Investors must keep in mind that tenants can still ask for lower base rent rates if they bring a few other things to the table. For example, tenants can negotiate who will be responsible for making capital improvements to the property. Plus, they may try to ask for a rent credit or reimbursement for costs associated with improvements. As the property owner, you must keep these possibilities in mind to make more informed decisions.
Who Pays for Unforeseen Expenses?
This question is a common concern among tenants and landlords. However, who covers what depends on the type of unforeseen expenses the property encounters. Let’s say that new local legislation increased property taxes. Per the structure of NNN leases, the tenant will be the one responsible for the unexpected expense.
It’s rare for the landlord to shoulder any unforeseen costs unless stated in the contract. One instance would be if the unforeseen event is directly related to the landlord’s negligence or breach of the lease agreement. A landlord may have failed to disclose the faulty plumbing system, for example, which led to costly repairs. As such, tenants need to be thorough when it comes to evaluating the condition of the lease. On the other hand, landlords or property owners must be upfront about the issues of the property to avoid any issues in the future.
Key Differences Between Single Net, Double Net, and Triple Net Leases
Triple net leases are not the only available lease structures in commercial real estate. There are two that precede NNN leases: single net leases and double net leases. Together, these three fall under what’s called the single-tenant net lease structure (or STNL). As the name implies, there’s only one tenant for each rental property in each lease arrangement. The only difference is how either party divides the net operating costs of the property.
Let’s break down the characteristics of each of the three to compare them.
Single Net Lease
A single net lease, also called an N lease, requires tenants to only pay property taxes apart from the base rent. The landlord or property owner will take care of the other two, building insurance and maintenance costs. While this arrangement offers more cost savings for tenants, landlords will need to shoulder a bit more on their end. As such, the tenant’s base rent may be higher to compensate for the expenses.
For landlords, there’s lower risk involved in the management since you’re still handling the bulk of property operations. You’d be more in control of the types of insurance to get for the property as well as the frequency of maintenance work. Of course, landlords need to maintain a balance between operating costs and rental income. Otherwise, they might find the N lease financially unsustainable in the long run.
Tenant Responsibilities
- Base Rent
- Property Taxes
Landlord Responsibilities
- Insurance
- Maintenance Cost
Single net leases are not set in stone. In most cases, tenants will handle property taxes. However, either party can still negotiate the terms to change which net operating cost the tenant will handle. For example, a renter who plans to do some heavy modifications on the property for brand image purposes may ask to handle the maintenance costs. That way, they have more control over the way they present the property to customers.
Double Net Lease
A double net lease or NN lease requires the tenant to shoulder two net operating costs. The most common are property taxes and building insurance. On the other hand, the landlord remains in charge of maintenance costs and repairs. Compared to single net leases, NN leases have a more even split of financial responsibility. This option is the ideal balance for either party, serving as a middle ground between NNN and N leases.
Tenant Responsibilities
- Building Insurance
- Property Taxes
- Base Rent
Landlord Responsibilities
- Maintenance and Repair Costs
As the tenant takes additional financial responsibility, landlords can enjoy reduced operational costs. However, maintenance expenses can still be unpredictable. Some industries are also more prone to constant repairs and other types of upkeep. As such, investors must be aware of these possible increases, especially in industries that require lots of cosmetic or aesthetic changes to the property.
Triple Net Lease
A triple net lease, as discussed earlier, takes on three net operating costs — the highest among the three. This arrangement requires the most involvement from the tenant while offering landlords the greatest level of financial responsibility.
Tenant Responsibilities
- Building Insurance
- Property Taxes
- Base Rent
- Maintenance and Repair Costs
Landlord Responsibilities
- None or minimal based on the specifications of the contract
Still, in a triple net lease, there are a few expenses that property owners may need to be responsible for. Here are some examples.
- Structural Repairs: The landlord may be responsible for major structural repairs that are beyond the scope of ordinary maintenance. For example, if the building’s foundation or roof requires extensive repairs, the landlord may be liable for the costs.
- Environmental Issues: There are cases when the property becomes contaminated with hazardous materials and other environmental problems through no fault of the tenant. In this case, landlords may be responsible for the remediation expenses. Such a problem can go beyond ordinary maintenance costs as well.
- Legal Compliance: Landlords are also responsible for ensuring that the property complies with local, state, and federal requirements. Modifying buildings to stay compliant with zoning laws, building codes, and environmental laws will entail expenses. In such cases, the landlord will be the one to shoulder the costs.
Triple Net Lease vs. Gross Lease
Apart from the STNLs we outlined above, there’s another option that investors can leverage: a gross lease. This arrangement is often compared to triple net leases because of the major differences in cost allocation. While triple net leases assign most of the operational expenses to the tenant, a gross lease makes the landlord responsible for most, if not all, of the operational costs. As such, this structure offers more simplicity for tenants while giving landlords complete control over the expenses.
How Gross Leases Work
With a gross lease, the tenant only pays a fixed monthly fee. The landlord takes care of all other expenses, such as property taxes, insurance, maintenance costs, and sometimes even utilities. This lease type can be considered the traditional structure, and it’s something often used in residential settings.
Tenant Responsibilities
- Base Rent
Landlord Responsibilities
- Building Insurance
- Property Taxes
- Maintenance and Repair Costs
- Utilities
For commercial properties, such a structure provides landlords with full control over the operations of the facility. This setup may make it easier to predict costs and ensure that the rental income can balance the expenses while still providing some profit. On the flip side, triple net leases remove most of the control to landlords. If you’re an investor who prefers more hands-off management, then the latter arrangement may be the most suitable choice.
One disadvantage of gross leases is that they may expose investors or property owners to more risk. One example is the possible rise of property taxes or maintenance services. Since the landlord will be in charge of these expenses, they will need to shell out more money as the expenses rise. As such, you will need to negotiate rates with tenants to reach a value that can cover these unforeseen expenses.
Choosing the Ideal Lease Arrangement for Your Investment Goals
Selecting the right lease structure is critical if you want to ensure higher returns. Gross leases and NNN leases lie on either end of the spectrum, making it challenging for investors to choose one that suits their needs. You must take into account your investment strategy, risk tolerance, and desired level of involvement to make more informed decisions.
You may want to choose a gross lease if you want the following benefits:
- Full control of operations and associated expenses
- A justifiable reason for higher rent — to cover all operational costs
- More stable and predictable income source
- Focus on a market of tenants who prefer less involvement in the maintenance and other operations of a rental property
- Potential for rent increase to compensate for higher net operating costs
- Reduced risk of tenant default
What of triple net leases? What are the distinct advantages they offer that make it the ideal option for some investors?
The Benefits of Triple Net Leases
As NNN leases shift most net operating costs to tenants, landlords and investors can enjoy the following benefits:
Hands-off Involvement
All investors have to do for the majority of the contract is wait for the rent payments. There’s no need to manage day-to-day operations, adjust for increasing property taxes, or supervise routine maintenance jobs. These tasks fall to the tenant, sparing the investor from the effort and unpredictability of these operational tasks. As such, NNN leases become an ideal choice for those who want less involvement in their investments. The fewer management duties allow you to focus on other assets or ventures, especially ones that demand your frequent attention.
Triple NNN leases are also popular among those about to retire. These properties provide a steady source of income without requiring constant attention. As the investors reduce their workload after retirement, they’d still have investments that provide revenue to fund their lifestyles.
Stable Income Sources
Speaking of consistent revenue streams, NNN leases are known for providing predictable rental payments. We’ve mentioned how these arrangements typically last for at least a decade. This longevity provides investors with reliable cash flow and makes it easier to plan for future investments. Property owners can also enjoy potentially lower risks of vacancy and financial disruption thanks to the nature of the lease agreement.
Protection From Fluctuating Expenses
Unexpected or unforeseen costs can eat away at your revenue significantly. Such risks are common in setups like gross leases. However, you have more insulation against the fluctuating expenses in NNN leases since someone else is paying for them. Tenants handle the operational costs, so as property taxes, maintenance service rates, and insurance premiums rise, they will bear the brunt of the expenses. This reduced exposure to cost volatility helps investors mitigate risk and preserve their income streams. Along with this benefit is a more predictable income stream.
Attractiveness to Institutional Tenants
Institutional tenants are ones that we can consider large and creditworthy. These entities are usually corporations, franchises, and even government agencies that have enough resources to take on the net operating costs of the property. As such, institutional tenants are more than likely to be reliable in terms of timely rent payments and property upkeep.
Another benefit of institutional tenants is that they are more likely to abide by the demands of long-term contracts, potentially reducing vacancy risks and turnover.
NNN lease structures are attractive to these types of tenants because the agreements provide predictable and stable cost structures. Tenants are only paying for rent, and this certainty plays a major role in long-term planning and budgeting. Plus, there’s the fact that tenants have almost full control of property operations. This flexibility gives institutional tenants additional freedom to use methods that make their own operations more efficient.
Diverse and Potentially Healthier Portfolio
Given how NNN leases typically provide a low-maintenance and stable income source, they help investors build a diverse portfolio. Adding such properties to their holdings provides some balance. So, even if the investors try more high-risk investments, NNN properties can provide some cushion if the other ventures experience volatility.
The Risks and Drawbacks of NNN Leases
As appealing as they seem, triple net leases have risks, pitfalls, and challenges that every investor must take into account. Understanding these issues can help you determine if this lease structure is appropriate for your investment goals.
Lower Rent
Given how the tenant shoulders all net operational expenses in an NNN lease, investors should expect lower rental rates — much lower compared to that of gross leases. For investors who are only looking for short-term investments, NNN leases may not be the best option. You won’t get the ROI you need before you let go of the investment. Plus, there’s the fact that most NNN leases last for at least a decade.
Long-term investors have a higher chance of recouping their invested capital and gaining some profit. In due time, the rental payments may eventually pay off the initial investment, even if the monthly rate is low.
Dependence on the Tenant’s Financial Stability
The success of an NNN arrangement is heavily dependent on the financial health and reliability of the tenant. Since they are responsible for paying the operational expenses, any sort of financial instability could snowball into significant issues. For example, if the tenant is unable to pay maintenance costs, you may end up needing to handle this expense even if it isn’t part of the deal. Otherwise, the property will go into disarray, lowering its value and appeal.
Landlords must be more discerning when it comes to choosing tenants to avoid such a scenario. Find ones that have proven financial strength to ensure that the occupants can fulfill their obligations for the entirety of the contract. The same advice applies to investors who are buying a property with a tenant and an existing NNN lease.
Responsibility for Major Structural Repairs
Maintenance and repair costs in NNN leases only refer to expected wear and tear over time. This doesn’t include major structural repairs in most cases. These structures include the roof, foundation, or HVAC systems. Often, landlords or property owners are responsible for issues with these structures and systems. These problems can be large, eating away at the profitability of the property.
There’s only so much you can do to prepare for major structural repair, especially if the issue comes sooner than the expected lifespan of the structure. As such, you’ll need to account for these unforeseen expenses when calculating your long-term returns. That way, you can set more realistic expectations and allot resources for possible future expenses.
Extended Vacancy
In an ideal scenario, your tenant stays for the duration of the contract. However, it’s not unusual for some tenants to vacate the property prematurely. Tenants could face major losses in the future that leave them unable to pay the net operating costs or default on the lease. After they leave, you could face difficulty finding new tenants. Not a lot of companies can handle the expense associated with NNN leases, adding to the challenge. During the prolonged vacancy, you will of course be in charge of the operating costs.
Extended vacancies can severely impact cash flow and profitability. This issue is particularly hard-hitting in areas with low demand for NNN leases. It could even take you years to find a willing tenant. As we mentioned previously, finding a reliable and financially stable tenant becomes critical if you want to avoid such a scenario.
Limited Rent Increases
Triple net leases do have clauses that detail how much rent can increase annually to match inflation. While these terms offer predictability, it also means that investors can miss out on higher rent increases when the market is favorable to them. In other words, the NNN lease locks you into a long-term agreement that stifles your ability to take advantage of a growing market.
Little to No Control Over Property Upkeep
Letting the tenant handle the maintenance costs may sound appealing on paper. However, neglectful tenants can delay or perform subpar maintenance to cut costs. The lack of oversight can result in more damage, deteriorating your property and reducing its value. It’s important to choose tenants that you trust will properly maintain the building.
Triple Net Leases and 1031 Exchanges
NNN leases and 1031 exchanges are two different processes in commercial real estate investing, but using them together can offer considerable financial benefits for investors. Either strategy offers tax benefits as well as long-term returns, making them attractive to strategic investors. Still, before you commit to 1031 exchanges and NNN leases, you must first understand how each one is connected.
What Is a 1031 Exchange?
Let’s first discuss 1031 exchanges, also known as like-kind exchanges. During a normal sale of a real estate asset, an investor typically earns capital gains. Capital gains are taxable, and the value can reach hundreds of thousands of dollars for large properties. A 1031 exchange helps investors avoid the large tax liability by “swapping” the property for a similar one. The swap isn’t considered a sale, so there’s no taxable event.
There is more to a 1031 exchange than this including advantages and risks but this is a brief summary.
Why Pair Triple Net Leases With 1031 Exchanges?
One major requirement in a 1031 exchange is the like-kind property. Thankfully, this rule is relatively flexible. As long as the acquired property is real estate and will be used for investment purposes, the IRS will recognize it as a like-kind property. This freedom also means lots of choices for investors. While they can choose a commercial property under a gross lease or any other type of lease agreement, those under NNN leases offer a few advantages. These include the hands-off involvement, tax deferral, and high potential for a stable income stream.
The IRS doesn’t have any rules regarding what lease agreements an acquired property should have to qualify for 1031 exchange. However, investors do need to take into account the strict regulations regarding 1031 exchanges to maintain the tax-deferred status. Apart from the like-kind requirement, these rules include the following:
- 180-day timeframe, including the 45-day identification period
- Need to work with a qualified intermediary
- Equal or greater value
- Investment or business property only — no residential property exchanges
- Arm’s length transactions
Triple Net Leases vs. Delaware Statutory Trusts
Acquiring triple net properties is not the only route investors can take for a 1031 exchange. One other option is to invest in a Delaware Statutory Trust (DST). This investment vehicle allows investors to use the proceeds from the relinquished property to purchase undivided fractional interests in the trust.
In a DST, the investor doesn’t really own the acquired property. Instead, they own shares of the trust that owns the property. The DST’s sponsor then distributes the earnings of the property among the shareholders. In most cases, you’re not the sole investor in the DST. There will be others who contributed their own capital to the trust.
Given the structure of DSTs, these investment vehicles offer long-term, hands-off involvement over the operations of the property, much like an NNN lease. The sponsor and its chosen property manager instead take care of the operations, including net expenses. However, this arrangement also means a lower monthly payment.
The biggest difference between the two is that investors remain the direct owners of a property in an NNN lease. For DSTs, investors only own shares of the trust and not the real estate asset. You’ll need to keep this in mind when choosing between either, especially if you want to retain some level of involvement in the acquired property.
Triple Net Leases vs Opportunity Zones
Qualified Opportunity Zones (QOZs) are another type of investment vehicle that has similar tax incentives and investment duration as NNN leases. QOZs are designated census areas all over the U.S. and its territories, specifically ones experiencing economic distress. By investing proceeds from a real estate sale into a qualified opportunity fund (QOF), investors can enjoy various benefits such as the following:
- Deferred capital gains taxes or possible elimination thanks to a step-up in basis after a 10-year holding period.
- No taxes on appreciation for the acquired asset.
- Helping disadvantaged communities grow, bringing investors one step closer to philanthropic and sustainability goals.
NNN leases and QOFs have similar structures and benefits, such as long holding periods and tax benefits. However, investing in an Opportunity Zone comes with higher risks. For triple net leases, investors still have the option to find properties in thriving markets. However, QOZs are limited to economically distressed areas and can lack liquidity. Even so, the high risk comes with a higher potential for reward if the area begins to thrive thanks to the investments. There’s also the possibility of eliminating capital gains taxes from the initial sale.
Ultimately, you must decide whether you value the stable income of an NNN property or the long-term tax advantages and potential for higher returns of a QOZ property.
Considerations Before Entering an NNN Lease
Triple net leases offer many features that make them attractive to investors and landlords. However, before you enter this lease agreement, make sure that you’ve considered the following factors. That way, you’ll know what to look for in the fine print and anticipate the long-term implications of the investment.
- Tenant Quality: The kind of tenant you’ll work with determines the success of the investment. Find ones that have proven financial stability by conducting a thorough assessment or background check. Strong, creditworthy tenants are your best bet.
- Lease Length and Renewal Terms: The long-term nature of NNN leases limits their flexibility. As such, it’s important that you check the renewal terms and determine if there’s room for negotiation. That way, you’ll have ample opportunities in the future to adjust rent based on market rates.
- Structural Responsibilities: As we mentioned, NNN leases don’t free investors from major structural expenses. So, before you enter a triple net lease, make sure that you conduct a thorough inspection of the property to find any potential structural issues. This practice can help you avoid unexpected costs and potential legal disputes in the future.
Final Thoughts on Triple Net Leases
Triple net or NNN leases are arrangements where tenants shoulder three major net operating costs: property taxes, insurance, and maintenance costs. This structure offers various advantages for investors and landlords, such as a hands-off approach, a steady income stream, and protection from fluctuating net operation expenses. While NNN leases aren’t without risk, these arrangements can still provide a high potential for stable investment returns. It’s one of the ideal lease agreements for investors who prefer less involvement in daily operations while maintaining complete ownership of the property.
If you want to learn more about NNN leases, 1031 exchanges, and related topics, Realized 1031 can help. Contact us today and schedule a consultation with our team.
The tax and estate planning information offered by the advisor is general in nature. It is provided
for informational purposes only and should not be construed as legal or tax advice. Always
consult an attorney or tax professional regarding your specific legal or tax situation.
Sources:
https://www.investopedia.com/terms/t/triple-net-lease-nnn.asp
https://www.law.cornell.edu/wex/triple_net_lease
https://www.investopedia.com/terms/s/single-net-lease.asp
https://brainly.com/question/44947541
https://www.investopedia.com/financial-edge/0110/10-things-to-know-about-1031-exchanges.aspx
https://www.irs.gov/credits-deductions/opportunity-zones-frequently-asked-questions
