Publications

- July 1, 2017: Vol. 4, Number 7

Real Estate’s Triple Play: Single-tenant, triple-net leased assets are a relatively safe way for investors to access real estate without taking on management and operating costs

by Sheila Hopkins

Despite its many benefits, real estate is well known for a few specific characteristics that give private investors pause. Its illiquidity, management fees and high cost to diversify are a few of the most-often cited hurdles. Single-tenant, triple-net leased (NNN) assets, however, can mitigate many of these objections. These investments are stable, income-producing, low-maintenance, bond-like investments that also retain the growth and tax advantages of real estate.

Triple-net leased assets are particularly attractive to investors new to the real estate world because they act so much like fixed-
income investments. They provide annual rent growth, good current yield and long-term predictability of cash flows (sometimes as long as 20 years) that feels a lot like a bond. But investors also get the real estate advantages of property appreciation and tax benefits, plus the security of owning a hard asset as opposed to commercial paper. NNN real estate investing is a marriage of structure and function that would make Frank Lloyd Wright weep for joy.

“Triple-net lease is a comfortable jumping off point to other types of real estate,” says Chris Czarnecki, CEO at Broadstone Real Estate. “It’s often the first step toward more investing in real estate because it is an interesting in-between investment opportunity.”

Net lease assets, however, are not a distinct real estate asset class. Instead, NNN refers to a lease structure that can be used for a variety of sectors and asset sizes. Portfolios of these assets can hold small buildings leased to retail tenants — which is often the image conjured up by investors when thinking about NNN assets — but they also hold assets ranging from small office buildings housing a single tenant to huge corporate headquarters, and from a local self-storage facility to an Amazon distribution center (and everything in between). Furthermore, within these sectors, it breaks down even further. For example, retail might consist of consumer brands, such as Dollar Store and TJ Maxx, but it might also mean food and entertainment brands, such as McDonalds and Starbucks, or specialized businesses such as gas stations.

Whether it’s a retail, office or industrial building, however, the fundamental feature of a NNN asset is that the building is leased to a tenant (typically a single tenant), who is responsible for real estate taxes, maintenance, insurance and utilities. By moving these expenses to the tenant, the investor is insulated from rising operating costs. In addition, the lease is normally between 10 years and 20 years, with preset annual rent increases. These long-term leases provide a surety of income not often found in other forms of real estate investment.

From a manager’s perspective, NNN assets are not so much an investment as a business opportunity. The manager takes on the risk of purchasing the asset, but then is able to lease it to a long-term tenant who takes over the operating costs.

“We are in the business of providing capital to corporate America by providing long-term housing for their businesses,” explains Glenn Rufrano, CEO at VEREIT. “We front the capital to purchase or develop the asset, and then lease it to a single tenant to house their business long term, typically 10 to 20 years.”

In addition, private equity managers have taken notice of NNN managers and have begun using them as part of the financing for deals where the private equity firm buys a company, but has already set up plans to recoup part of the purchase price by spinning the real estate off to a NNN REIT. These deals can be complicated with lots of moving parts, but in the end, the private equity firm gets returns based on a business conducting and managing its core activities, and a property firm gets returns based on owning and managing property.

From an investor’s perspective, NNN assets are a relatively safe way to access real estate without taking on the typical management and operating costs.

“You are effectively buying a proxy for fixed income,” says Kevin Shields, chairman and CEO at Griffin Capital Co. “If you are buying a long-termed, single-tenant, net leased asset, the value proposition associated with that asset turns on the structure and duration and, of course, the credit of the tenant. The credit quality of the lease payment stream is the same as the tenant’s senior unsecured bond rating.”

With investors looking for a higher return than they can get from the bond markets without taking on more risk, the triple-net lease investment market has experienced significant growth and competition over the past few years. Sales volumes have more than doubled since 2011, while cap rates have fallen by about 130 basis points in that time. Today, the market looks like it has stabilized, with growth and cap rates in first quarter 2017 mirroring those of 2016.

According to Net Lease Trends: Market Snapshot Q1 2017 put out by the Stan Johnson Co., first quarter 2017 was nearly a duplicate of first quarter 2016, with approximately $11.4 billion of net leased commercial real estate sales closed in first quarter 2017 and $11.9 billion closed in first quarter 2016. By the end of 2016, $55.5 billion of net leased assets had closed, which is just about the same amount industry experts expect 2017 to end with.

Average cap rates for the total market have also remained relatively stable for the past two years at 6.25 percent. First quarter 2017 saw the average cap rate for the total market come in at 6.24 percent. Individual asset classes, however, had a more than 50 basis point span between highest and lowest. Currently, net leased office assets are averaging a 6.68 cap rate, while industrial assets are seeing a 6.64 rate. Net leased retail assets have the lowest cap rate of the three asset classes, seeing an average of 6.01 percent.

Despite the cap rate compression in the past five years, spreads to Treasury are still attractive, continuing to make NNN assets an attractive investment opportunity. In addition, investors are finding that they provide a higher return with greater safety than bonds.

“Investors buying fixed income can buy corporate bonds and get a consistent, reliable return,” explains Rufrano. “However, our portfolio holds NNN leases for properties housing those same corporations. So, we’re giving investors a higher return than they can get through bonds, but we also own the real estate housing the businesses, so we are giving them greater security than they’d get with just their bonds. In addition, real estate provides a pretty good hedge against inflation long term, which is something bonds can’t do.”

Investors can add NNN assets to their portfolios via direct investment or via funds, which are typically set up as private or public REITs. Choosing the most appropriate method depends on how much time and expertise the investor has to manage the property, as well as their knowledge of real estate and the amount of capital available to put toward these assets. And, as with most investments, the amount of capital available to put toward the investment is a crucial deciding factor.

“There is a broad range of asset sizes, so you can easily buy a $500,000 or $1 million net lease asset, or you can just as easily spend $150 million,” says Czarnecki. “If someone is looking to make an allocation of $100,000 or $200,000 to real estate, they are definitely going to be looking at a fund format because it is outside the grasp of them being able to acquire an asset individually.”

NNN assets are often used in 1031 exchanges for their tax benefits, but owning a single asset with a single tenant incurs vacancy risk that many investors would have a hard time covering. Even the most creditworthy tenant can run into trouble and need to vacate. It is hard for a private investor to own enough real estate to truly diversify that risk. For that reason, most investors prefer to add real estate via the fund route.

“From a risk mitigation perspective, net-leased real estate should generally not be owned ‘one off,’” says Shields. “Real estate owned in a diversified portfolio substantially lowers volatility and provides insulation against discreet tenant defaults.”

To provide safety and continuation of income, the best NNN funds diversify across geographies, tenant credit quality, asset classes, lease durations and industries. The dotcom crash of the early 2000s still has a place in the institutional memory of NNN investors, who populated their assets with high-flying tech firms only to have them disappear almost overnight. A diversified portfolio is the key to preventing this type of shock to an investor’s investment income.

“It’s really about scale and diversification to deliver what our investors clamor for — a long-term, consistent, stable return with low portfolio beta,” says Shields. “The bigger and more diverse our portfolio becomes from a lease duration and tenant-quality perspective, the better I sleep at night. I know that with a large, diversified portfolio, I can weather whatever comes up in individual properties pretty easily without it having a demonstrable impact on the overall portfolio.”

Using REITs or funds to access this investment opportunity provides benefits that private investors typically seek. Diversification is an obvious benefit. As is professional management. What investors might not consider, however, is that REITs and other fund managers find it easier to finance these assets than an individual investor can.

“These assets carry binary risk,” says Czarnecki. “Each asset is either 100 percent occupied or it’s 100 percent vacant. This makes financing more difficult. Banks underwrite more conservatively for net lease assets because of the binary credit risk.”

Funds are also able to achieve economies of scale that reduce costs and increase returns.

“It’s inherently easy to think of these as very passive investments,” continues Czarnecki. “But property management done well is not a passive activity. Our portfolio contains 450 assets, and we have 120 tenant projects going at the moment. You can sign a 20-year lease, but businesses are living, breathing organisms. Things change, and all the things that can happen in a multi-tenant property also happen in a single-tenant property. During a 20-year lease term, there will be multiple times when you have to act as a property manager.”

Despite all of its benefits, some investors wonder if this is the right economic environment for entering the real estate market. Everyone expects interest rates to rise and, historically, rising interest rates have hurt REITs and NNN investments because they often serve as proxies for fixed income. The difference is that NNN leases can be tied to CPI (though they usually have fixed-rate increases), so they act as a hedge against rising rates, and real assets can retain their value in both up and down markets.

“As long as the rising interest rates are a result of growth in the economy, we can participate in that growth through increased rents. A strong economy means strong, healthy tenants,” says Rufrano. “In addition, the REIT will continue to acquire assets. As long as the spread between our cost of capital and our asset acquisition cost is maintained, we can keep growing income and be competitive.”

Assuming that interest rates will rise because the economy is growing, real estate should benefit, and investors would be served well to stay with the asset class.

“If interest rates are increasing as a function of economic buoyancy, the market will experience both employment and GDP growth,” Shields explains. “Employment growth absorbs supply overhang, which, when coupled with rising replacement costs, drives real rental rate growth. In the intermediate and long term, interest rate increases tend to bode well for the real estate industry. In fact, we are seeing professional investors beginning to rotate out of public equities and fixed income into real assets as they seek an inflation hedge.”

While it is true that NNN investment is considered a safe investment as far as real estate investments go, it is also true that investors need to look carefully at the different available funds before investing. As with any investment, some are better than others.

One of the easiest things for investors to look at is the fee structure.

“Frankly, there have been some very high fee products on the market that have not been very shareholder friendly, and that has been grossly unfair to the private investor class,” says Czarnecki. “Investors deserve professional management, and a fair fee structure is very important.”

Because the primary reason to invest in this space through funds is to access their ability to diversify, investors should check out just how diversified the fund actually is.

Investors should also check the rent collection history of the fund manager. The higher the occupancy rate, the better returns an investor can expect.

“Nothing destroys value like a vacant building,” says Czarnecki. “If you don’t have a tenant paying rent then your building is probably worth less than what you paid for it.”

In these days of economic, political, social and lots of other kinds of upheaval, investors struggle to find investments that give them a reasonable return with a reasonable amount of risk. While triple-net leased real estate is not for everyone, its stability and growth potential certainty make it a contender for a “sleep well at night” award. And with the number of funds available growing each year — NNN REITs now account for about 7 percent of the REIT market — investors who want to take advantage of this opportunity are finding it easier than ever to take that first step into real estate.

Sheila Hopkins is a freelance writer based in Myrtle Beach, S.C.

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