Living through the COVID-19 pandemic complicated commercial real estate investment in a myriad of ways, shifting economics of every asset class in the industry. While some investors pulled back, preferring to sit out the storm on the sidelines, others have rushed in with mountains of dry powder to scoop up battered hospitality, retail and office properties in anticipation of strong consumer demand rebound.
Other asset classes that were the darlings of investors through the pandemic are now facing compressed cap rates and sky-high valuations, as hot money continues to flow into multifamily and industrial properties. Sponsors need a keen eye for growth markets or a crystal ball to discern a potential long-term opportunity from an expensive disaster.
But there is one asset class that stood apart as a beacon of stability throughout the pandemic: single-tenant triple-net-leased assets (NNN). NNN assets are perennially one of the most popular real estate product types in both good and bad economic times, due to ease of management and predictability of cash flows. Industry experts, such as SRS Real Estate Partners, have reported that activity in the net-lease space has remained strong during the pandemic, especially for sectors such as necessity-based uses, publicly traded companies with strong financial positions, and quick-serve restaurants with drive-throughs.
THE TRIPLE-NET ADVANTAGE
As we hope to round the corner on the worst of the pandemic, NNN assets retain their luster as a stalwart of sponsor investment. Single-tenant triple-net-leased assets are traditionally stable and have consistently proven themselves to be recession-resistant, generating reliable income streams in all economic climates. Through the Great Recession and during previous real estate cycles, this asset class continued to perform well, demonstrating tenacious shock absorption in volatile market conditions. And in 2020, NNN flourished, with quick-service restaurants opening new drive-throughs to accommodate health regulations. Transactions in the net-leased asset class set a record of $79 billion in volume, a 39 percent rise since 2019, according to JLL.
One reason for this notable stability is that NNN assets are usually leased to high-credit national tenants that have time-tested strategies for weathering economic ups and downs. Leases signed with international brands have the benefit of strong corporate backing, usually offering guarantees not common to smaller tenants. Large brands also wield the power of the purse strings, sitting on large deposits and credit lines of available crisis capital, which insulates NNN landlords from financial disruptions to local outlets.
NNN tenants usually sign long-term contracts to ensure stability, with leases locked in for 10 years to 25 years. Avison Young reports that the current national average lease term for net-lease properties is 11.6 years, a number that has risen during the pandemic. Decade-long time horizons make income streams transparent to potential investors, who don’t have to judge how a particular location is going to fare over the years. In return, tenants can forecast their rental expenses over the lifespan of a franchise. NNN leases usually feature step-up lease rates at regular intervals, making cash flows highly predictable.
Another reason why NNN assets are so popular is because of low management and maintenance requirements from the buyer. In single-tenant triple-net leases, the tenant is responsible for most, if not all, maintenance procedures and capital expenses that would typically fall on the investor’s shoulders in other types of lease arrangements. Property taxes, insurance and common area maintenance are transferred onto the tenant, insulating landlords from tax policies, natural disasters, and material defects. While each lease is structured differently, the low-maintenance, low-expenditure nature of these investments makes them especially appealing to investors who may not have the time, ability or desire to manage a property hands-on. This structure allows sponsors to sit back and “clip coupons” without paying a property manager.
Given their stability over time, NNN assets appear to be better able to withstand black swan events, such as COVID-19, and emerge relatively unscathed. Research from Green Street shows that while overall commercial real estate pricing has decreased 10 percent during the pandemic, pricing has held up for properties with high-credit tenants and significant lease terms that are common to net-lease deals. Although cap rates have been compressing in some markets, the average cap rate for net-lease assets has remained largely steady at 6.51 percent, despite the market slowdown, according to Avison Young.
NNN properties can offer specific tax and liquidity advantages. Single-tenant net-lease assets fall under the category of like-kind exchanges under IRS Code Section 1031. This designation allows investors to postpone paying taxes on the capital gains for these properties, provided they reinvest sales proceeds in a similar property that qualifies as a like-kind exchange within a given amount of time. Because taxes can be deferred and 1031 exchange properties are constantly in demand, NNN assets can provide considerable tax and liquidity advantages to investors, contributing to the steadily increasing popularity of these assets in the commercial real estate investment community.
One final advantage of triple-net-lease properties is their diversity. Diversification is a hallmark of smart investing, so spreading capital over a variety of asset types can help investors hedge against downturns in any one sector, industry and business. NNN leases are common in many industries, including quick-serve restaurants, drugstores, convenience stores, automotive shops, financial institutions, and even logistics facilities. Because of this breadth, investors can substantially diversify their portfolios with NNN assets while retaining the stability of the category.
THE TRIPLE-NET FUTURE
There is an increasing shortage of NNN inventory, as owners are hesitant to let go of these assets in uncertain times. The lack of supply and strong demand have been catalysts for increased NNN construction. Deal flow is shifting from acquisition to construction capital for such assets, which are increasingly pre-leased before breaking ground. Additionally, shortage of pre-existing inventory on the market is making growing franchisors more bullish in lease negotiations and guarantees.
Since many lenders stepped back from their usual pre-pandemic volumes, many investors in this space are choosing to engage financial intermediaries that have long-standing relationships with a variety of lenders. Such intermediaries are positioned to negotiate on behalf of borrowers to secure the best terms for NNN deals. The sector has seen these properties skyrocket as investors flock to stability amid recessionary and inflationary fears.
THE TRIPLE-NET UPSHOT
Although COVID-19 has shifted the investment landscape and investor appetite preferences to lower risk, growing demand for single-tenant triple-net-leased properties will likely continue over the next 12 to 24 months. Investors who can find the deals and funds they need will benefit from these assets’ consistent stability, low-expense nature, industry diversification, and tax and liquidity advantages. This combination of factors makes NNN assets a winning sector for a variety of investors for years to come.
Andrey Abramov is a director at Tauro Capital Advisors.