There are three “nets” associated with a property lease within the world of commercial real estate in the United States.
- Property taxes that are associated with the land and structures being rented.
- Property insurance that maintains the land and replaces structures should an unforeseen event occur.
- Property maintenance costs which are required to maintain or improve the value of the land and structures being utilized.
This type of lease, using parlance from the U.S., is referred to as a triple net lease. It may sometimes be called a Triple N lease or just referred to as an NNN agreement.
The primary benefit of a triple net lease is that it reduces the financial hassles for the owner of the property. They are still listed as the property owner, with the rights that are associated with that status, but are not responsible for the maintenance, taxes, and insurance that is required to maintain ownership. The tenant of the property must pay all these expenses or face that jurisdictions eviction process.
The disadvantage of a triple net lease is that it reduces overall rental profits. The three nets are classified as expenses that are passed through to the tenants. After the expenses are cleared, whatever remains from the lease payments is passed to the property owner as a profit. Because the expenses are still associated with the property owner, however, there can be tax liability concerns because the paid expenses may still be classified as rental income.
Here are some additional triple net lease pros and cons that are worth considering.
List of the Pros of a Triple Net Lease
1. There are different formats that can be utilized.
A triple net lease can be formatted as a bondable lease. This makes it an “absolute NNN” or a “true Triple-N” lease. It is the most extreme variation of this concept and it requires the tenant to assume every imaginable responsibility that is associated with the real estate in question. Those responsibilities would include an obligation to rebuild after a casualty event, no matter what insurance proceeds may be available.
Another standard variation of the triple net lease is called a “ground” lease. This type of lease involves the land of the property owner being used to construct a building, created a leasehold interest. In such an agreement, the structures built on the land become the property of the landowner at the conclusion of the lease, while the triple net responsibilities generally remain the same.
2. It provides a stable income.
A triple net lease is usually structured with either a flat rent or a fixed increase. For a property owner, that means there is a fixed income that can be counted on each year during the lift of the lease. A standard agreement includes up to a 3% fixed increase to account for inflation, providing growth to the property owner. With lengthy terms, most property owners don’t need to worry about vacancies for decades.
3. There are no owner responsibilities during the lease period.
Under a true NNN agreement, the owner of the property has no responsibilities to it whatsoever. Others transfer capital expenditures to the owner. That makes it a different form of real estate management because there really is no management involved once there is a tenant for the property. Any improvements made to it even become the owner’s property once the lease expires.
4. Both parties have the right to audit.
Most triple net leases have a “base year” written into the expense of the lease. That means the annual cost to maintain the property is listed as a specific amount. Then the actual costs of maintaining the property are passed through to the tenant, potentially increasing the cost of this. Both parties have the right to audit the charges that are required, including calculations and allocation percentages.
5. The property can be sold with the lease.
Property owners are still permitted to sell, even when there is a triple net lease in place for a tenant on that property. That allows a property owner to be able to get the investment return they need from their real estate. At the same time, the lease transfers with the sale of the property, which means the tenant doesn’t need to worry about an eviction. For the new owner, they must abide by the terms of the lease, but they still benefit from the pass-through nature of the NNN structure.
6. The income figures are separate from the actual rent.
Within the structure of a triple net lease, the cost of the rental payments is kept separately from the other costs that become the tenant’s responsibility. In this lease structure, the tenant agrees to pay the property taxes, maintenance costs, utilities, and insurance in addition to the monthly lease amount and separate from it. That makes it easier for the property owner to maintain their own accounting books, even though the financials of such an agreement can be quite complex.
List of the Cons of a Triple Net Lease
1. A triple net lease can have a limited upside.
Even with built-in structures that created fixed increases, the returns that can be provided with this type of lease are not guaranteed to keep up with the pace of inflation. Although there are guaranteed income levels associated with this type of agreement, there are investment risks involved as well. This type of lease is similar to the purchase of a treasury or municipal bond that offers a fixed return rate.
2. There is a risk of experiencing a complete vacancy.
Most triple net leases are designed to provide an agreement that offers a minimum of 10 years’ occupation. Some leases may offer an initial term as long as 25 years. For a property owner, that means income security over a long-term investment period, but it does have drawbacks. Once the lease expires, a tenant is placed into an all-or-nothing proposition. They may choose to vacate the property, creating a 100% vacancy.
3. It can create high capital expenditures after a lease period.
After a property has been occupied by a tenant for 10-25 years, the building may no longer be suitable to a new tenant when they leave. It becomes the property owner’s responsibility to prepare the property so it creates an attractive re-leasing process. Depending upon how the property was used by a previous tenant, the costs of preparation could be several million dollars on some commercial properties. In a worst-case scenario, the financial gains achieved during a tenancy could be wiped out while trying to re-lease the property.
4. It may be difficult to find a tenant.
Because all the pass-through costs of maintaining the property go directly to the tenant, finding a suitor that will sign the triple net lease may be difficult. It is a fairly one-sided lease that places all the risk at the feet of the tenant without much risk going to the property owner. For that reason, a majority of NNN leases occur in locations that are classified as being Class A locations. These locations have high traffic levels, meet needed zoning requirements, and have needed features and functionality.
5. There can be large pricing gaps during the negotiation process.
When working out the terms of a triple net lease, tenants are given an initial estimate of what the cost will be from a square footage perspective. The cost may be $1.75 NNN per square foot, for example. The actual rent is based on variable factors, such as property valuation, which means taxation responsibilities and other costs may increase dramatically. The actual cost on the lease can be much higher than the estimated cost initially quoted to a potential tenant.
6. The costs of maintaining a triple net lease may negate its advantages.
It requires complex accounting to maintain a profitable triple net lease. Property owners must be able to properly assess the costs which apply to their tenants, which is often done in a proportionate way. To further complicate the issue, some NNN leases provide incentives to certain tenants if they can attract higher traffic levels, create more sales, or recruit new tenants to the building. For that reason, many tenants and owners that use a triple net lease work with real estate brokers to ensure their best interests are always maintained.
These triple net lease pros and cons might cause some to wonder why any tenant would bother to enter into such a one-side agreement. The fact is that for some retailers, location is the most important component of their business identity. With a prime business location that is properly zoned, they can maximize their profits. That allows the tenant to earn a comfortable income, the property owner gets to benefit too, and everyone comes out ahead in the agreement.
For best results, a prospective tenant should work with a skilled negotiator and property owners should work with trusted real estate advisors and property management teams for the best possible lease and working relationship.