To the casual observer, net lease real estate may seem like a passive, no-fuss investment. You just sit back, collect your rent and let the tenants pay the building’s operational expenses. If only it were that simple.
It’s true that net-lease properties can be relatively low maintenance compared to other asset types while simultaneously generating more stable revenue. However, there remain a number of factors that a real estate investor should keep in mind before entering this arena.
Net leases allow commercial landlords to allay some of their costs by transferring property expenses to the tenant. Depending on the style of the net lease — single, double or triple — the tenant will pay for property taxes, insurance premiums and/or maintenance costs, in addition to rent.
The benefit to the tenant is a lower base rent than what would be asked for using a traditional lease, as well as a higher level of control over their space. The benefit to the landlord is a typically longer lease term as well as a shifting of some financial risk onto the tenant.
Going into a net lease, the landlord is betting on their tenant – specifically, that user’s ability to pay rent for the life of the lease. Circumstances can always change, however, which is why seasoned investors know to be prepared should a seemingly stable revenue stream suddenly dry up.
Knowing the quality of a tenant and who’s actually on the lease is paramount; this includes dynamics that go beyond simply assessing an organization’s credit rating. For example, are they a subsidiary of a larger firm that might one day sell off or shut down that division? Are they in a volatile industry with frequent mergers and acquisitions? When a tenant organization is bought out, the new owner may look to cut costs by downsizing their footprint.
When these events happen — and they do happen — a tenant may roll up their tent and exit the property, even before the end of the lease term. It’s at this point that they may approach the landlord asking to sublease the space. Whether that’s permitted under the lease is something investors must determine early on, weighing whether the ability to shore up a property’s income is worth a possible decline in the quality of the tenant.
Fortunately, most tenants are literally and figuratively invested in the asset, which makes them less likely to leave, even after their initial term ends. But a prudent net lease investor should understand the barriers to entry in a particular market so they can assess how quickly they could replace a tenant should that be necessary. For this reason alone, it may be worthwhile to pay a premium for an asset if it’s in a high-growth area with limited supply.
The actual property itself can also determine how a landlord negotiates a net lease. If the roof begins to fail on an older building, for example, is it the duty of the sole tenant with three years remaining on their lease to pay for an upgrade when they may not be around to recoup a return on that investment? Factors such as these need to be carefully outlined before a net lease can be signed.
Even in today’s remote world, real estate remains a people business, and therefore relies on strong relationships. But institutions and the people who run them change. The loss of a primary contact at a lender or tenant organization can present additional risk to the investor, which is why it’s necessary to prepare for this early on by establishing connections with multiple contacts to the extent that’s possible.
Great deals always happen in the rearview mirror, so long as you go in with a conservative mindset built on the strong pillars of experience. That’s why investors need knowledgeable consultants to help solve — or, ideally, avoid — the myriad challenges that arise with even the most straightforward investments.
There are many external factors that together determine the success of a net lease deal, which is why no investment is a truly safe investment. Expecting the unexpected can reduce these obstacles, but that type of prognostication only comes with time. When an investor starts out by looking at all the potential downsides, the upside has a way of taking care of itself.
Ben Reinberg is Chief Executive Officer of Alliance Consolidated Group of Companies. A respected authority on commercial real estate acquisition, investment, development and transaction structuring, he has authored and published numerous articles pertaining to the trade. Ben brings value to the deal process through his ability to build trust quickly, raise equity efficiently, solve problems and bridge the gap between buyers and sellers. He founded Alliance in 1995 and the firm now specializes in net lease healthcare real estate investment.