The success of a triple net (NNN) lease investment largely depends on the tenant, as their stability ensures consistent cash flow to the landlord. What happens, then, if the tenant files for bankruptcy? How will they be able to pay the three net operating expenses? Would the contract dissolve as well?
Tenant bankruptcy has serious implications for the landlord, and Realized 1031 explores the specifics of this rare event below. Let’s take a closer look.
A tenant filing for bankruptcy means they no longer have the capability to pay their outstanding debts. They can file either Chapter 7 or Chapter 11 to help repay lenders. The former implies the tenant needs to liquidate their assets to pay their debt; meanwhile, Chapter 11 is the reorganization of debt.
For landlords, the key issue is whether the tenant will assume, reject, or renegotiate the lease during bankruptcy proceedings.
Tenant’s assuming or renegotiating the lease will likely leave your rental income intact. The main problem comes if the tenant chooses to break or reject the lease. If they leave, the property will be vacant and your cash flow will be disrupted. Landlords can file a claim in bankruptcy court for unpaid rent, but recovery is often limited and can take months or even years.
Another effect of the rejection is that the net operating expenses will once again become the landlord's responsibility. Not only did you lose rental income, but managing the property falls back to you completely. This financial burden can be significant, especially if the tenant hasn’t been able to pay previous expenses due to financial difficulties.
Tenant bankruptcy is rare, especially in NNN leases. If you choose a tenant with a high credit rating and robust financials before entering the lease, then the chances of this event happening are low. In the rare case that bankruptcy does happen, here’s what you can do to minimize the damage.
The most effective way to avoid this scenario is to choose a tenant with a strong credit rating and financial history. It’s also helpful to diversify your portfolio, so even when a tenant's bankruptcy occurs, you have other assets that help cushion the negative cash flow. Negotiating lease terms is also a good practice. You can request personal or corporate guarantees or co-tenancy clauses, which provide you with legal and financial recourse should tenants break the lease.
While tenant bankruptcy is rare, this event could result in the loss of stable income and additional financial responsibility on your end. Steps like choosing tenants with robust finances, diversifying assets, and negotiating strong lease protections are some steps you can try. When a bankruptcy occurs and the tenant breaks the lease, working with an attorney is helpful for filing claims for unpaid rent. Whatever the case, professional guidance and in-depth understanding of the bankruptcy process help you protect your investment.
Sources:
https://www.wardandsmith.com/articles/bankruptcy-destroyed-my-perfect-landlord-tenant-relationship
https://www.investopedia.com/terms/b/bankruptcy.asp
https://www.investopedia.com/terms/t/triple-net-lease-nnn.asp