When NNN Means No, No, No
New car, caviar, four-star, daydream
Think I'll buy me a football team.
— Pink Floyd; 1973
Casinos and The Lotto excel in presenting the fantasies associated with having more money. Some people work overtime or take on two jobs. Others clip coupons or only buy items on sale. An entire industry has been built around tax reduction.
Gains from the sale of a capital asset trigger income taxes that can reach 36% for California taxpayers. (12.3% state; 3.8% for the Medicare Surtax up to 20% for federal capital gains taxes). Ignoring recapture of previously taken deprecation, 36% is a big enough bite to catalyze the search for solutions.
IRC Section 1031
IRC 1031 provides for tax “deferral” on the sale of property held for investment when exchanged for “like kind” replacement property. Qualification requires compliance with strict, time-sensitive rules including the 45-days to “identify” and 180-days to “close” on replacement property. The deferral strategy can stay in place until the death of either spouse, generating a “step-up” in cost basis that can facilitate the elimination of income tax upon sale.
We are advocates of the strategy, but sand traps abound.
NNN (sometimes referred to as triple-net) is real estate jargon for a property that is owned under a lease that renders the tenant responsible for expenses including taxes, insurance, and maintenance. Prevalent with single tenant properties such as restaurants and smaller retailers, these properties attract exchange buyers because:
- The protection against rising operational expenses.
- The general lack of management responsibilities.
- The potential strength of the tenant.
- Easy access provided by the price point (typically $2.0 - $5.0 million).
Yet, like new cars, caviar, and football teams, not all NNN deals are created equal. Three components deserve attention including the tenant, the lease terms, and the location.
NNN real estate appeals to investors seeking to limit their responsibility to check cashing. Achieving that level of cruise control requires confidence that the tenant responsible for paying the rent and the operating expenses can deliver on their end of the agreement.
Tenants come in three flavors: credit, franchisees, and individuals. Credit tenants, offering both financial strength and a reputation to protect, represent the best option. We have a client who exchanged into a Walmart concept grocery store. Two years into a 10-year lease Walmart gave up on the idea and evacuated the building. They never missed a lease payment over the ensuing eight years. Look no further than this week’s bankruptcy of Rite Aid to realize that being a publicly traded company does not inherently guarantee strength; so, perform your due diligence.
Many quick service restaurants are owned by groups that control multiple units. The larger the number of stores owned, generally the better. Balance sheets should be provided and scrutinized. A franchisee that only owns a few units might not represent the long-term financial security sought.
Individuals that own a single store must present strong financial statements that include a personal guarantee on the lease.
Essential services, such as food or healthcare services offer greater resilience than industries threatened by technology such as gas stations or banks. Many fast-food restaurants are owned by financially strong, publicly traded companies. Drug stores and auto parts stores feature many publicly traded companies.
Lower quality tenants attract buyers by offering higher cash flow yields. Consider the long-term nature of real estate and the risks of releasing a property before being seduced into a poor-quality tenant. Paying both leasing commissions and tenant improvements, along with the downtime of having no tenant in place should be incentive enough to just avoid the risks associated with a lower quality tenant.
Terms of the Lease
Even a strong tenant in a strong location can present risk. Some NNN leases include an Assignment clause that allows the tenant to have another party accept the responsibilities under the lease. A publicly traded Habit Burger, for instance, might want the right to assign the lease to a franchisee. That could change the owner’s security in the lease without compensation. Do not skimp on expenses, have an attorney analyze the lease terms. It might be unrealistic to assume that Walgreens or Tractor Supply will change their standard lease terms to meet a buyer’s needs but it’s important to get a clear understanding of the associated risks.
The current rents should ideally be at or below market. Above market rents can artificially drive up the cost of the property but increase the renewal risk. Rents should be a reasonable percentage of sales. Chik-fil-A is privately held but their rents typically represent less than 5% of revenues, an excellent ratio.
“Bumps”, or the annual pre-determined increase in rents, can vary. A typical lease allows for a 2% per year increase in rents. Some are crafted to increase 10% after five years. Both the level and frequency of the bumps impact the present value of cash flow expected from the investment.
NNN should be pure. Any clause that requires the landlord to pay for the replacement of a roof or outside walls constitutes a modified NNN lease and presents financial risk to the owner.
Renewal language can be critical because much of the risk on NNN properties exists at the end of the base lease term. We have seen Starbucks ignore the renewal options and threaten to leave without a cut in rent.
The greatest protection against end of lease risk, however, is the selection of a strong location.
Price, in a free market, depends on the intersection of supply and demand. Great properties feature strong demand drivers that can include a growing population, rising income, lack of competition, or economically insensitive neighbors such as a hospital or college campus.
Basic due diligence on any property acquisition should assure clear title, a clean soils report, minimal building restrictions, and an understanding of flooding or erosion risks.
The property should have adequate parking, easy access (a hard corner is superior to being in the middle of the block) and ample access to transportation routes. Of particular importance in California, the property should be easily insurable. The property should have a good appearance and exist in a low crime area. Potential demand can be measured through traffic counts.
Hints on the future supply of competing properties include building permits, the density of existing development, and the community’s general attitude toward growth and entitlements. It’s tough to build in California, creating an intrinsic barrier against future competition that might not exist in Arizona or Texas.
Although cost constraints limit the depth of due diligence that a buyer can accomplish, national tenants such as Walgreens or Starbucks do considerable homework before finalizing the decision to open at a location. Their mere presence, though not a guarantee, constitutes an underlying vote of confidence.
NNN leases behave like bonds because of the quasi-fixed level of cash flow. The initial cap rates on these properties (the yield to an all-cash buyer) move in tandem with interest rates. With the recent artificial drop in rates, cap rates have been similarly low. When interest rates rise, as we experienced in the past 18 months, cap rates should follow. Beware NNN buyer, you have some interest rate risk with your investment. In fact, returns from NNN lease properties, by nature, tend come from the steady cash flow with moderate appreciation potential. Apartments, by contrast, tend to provide higher long-term returns.
Pink Floyd summed it best when they wrote, “Money, It’s a gas, Grab that cash with both hands and make a stash.” We concur. IRC 1031 can be a significant tool for building and retaining wealth. However, one must be circumspect throughout the transaction to ensure those alluring benefits come to fruition. We strongly encourage a national broker with a strong network of sellers, a transactional attorney well versed with exchanges, and a financial adviser acting as a fiduciary to integrate income taxes and economics.