Net Lease Rental Agreements: Investment Potential and Risk Factors
By: Alec D. Gooley
One of the most common lease agreements in the commercial real estate industry is a net lease. Net leases are rental contracts between landlords and tenants that require the tenants to contribute payments toward operating expenses in addition to an annual base rental rate. Although many office and industrial leasing contracts are net lease agreements, net leases are also popular in retail properties such as drug stores or fast food chains. Investors are attracted to these properties because they often represent safe investments that boast steady returns over a long period of time. When investing, it is important to consider the risk factors that can influence the overall return of a net lease investment such as landlord responsibilities, tenant retention, and capitalization rates.
Investors place a considerable amount of weight on the extent of landlord responsibilities outlined in a lease when negotiating with a tenant. The lease type impacts the annual income produced from any investment property. The three primary net lease types are listed below:
- Double Net (NN) – Tenant is responsible for base rent plus property taxes and insurance
- Triple Net (NNN) – Tenant is responsible for base rent plus property taxes, insurance, common area maintenance, utilities, and operating expenses
- Absolute NNN – Tenant is responsible for base rent plus all other operational and real estate expenses
The Absolute NNN lease provides the landlord with the least amount of risk, and is therefore the most attractive lease type for investors.
Retail Tenant Retention
Retail tenants with certified credit ratings above BBB- are in the highest demand for both private and institutional net lease investors. The credit of the tenant leasing an investment property is directly related to the amount of risk associated with that investment. Higher-credit tenants, such as international fast food chains, typically attract more demand from investors, which result in higher purchase prices. Ideally, a good credit tenant will remain in a property over a longer period of time and exercise options to extend their lease after the duration of the original lease term expires.
Good credit retail tenants seek out prime real estate locations in order to maximize annual sales revenues. Having an excellent location and visibility will help ensure tenant retention over the long-term investment period. Locations with decreasing economic stability or low traffic counts may dissuade the tenant from extending their original lease term at the end of the original term’s life. If the tenant continues to produce high sales revenues at a specific location, the chance of lease renewal substantially increases.
Investors prefer net lease deals that provide adequate returns along with somewhat minimal risk. The capitalization rate is a reliable indicator of investment security. The capitalization rate is calculated by dividing the annual net operating income of a property into the market value of a property.
As the market value of a property increases due to demand, capitalization rates tend to decrease. Tenants with high credit ratings, popular name brands, long-term lease agreements, and prime locations reflect the lowest capitalization rates and the highest demand. Tenants with low risk of abandoning the property and a high probability of renewal are considered safer investments. A high-credit tenant with 25 years remaining on their original lease term carries much less risk than a tenant with only two years remaining on their original lease term. If tenant renewal is uncertain, the demand for that property will decrease due to the risk of vacancy. This results in a lower market value of the property and a higher capitalization rate. The graphic illustrates this principle:
Net-leased retail properties have the potential to provide a safe investment with attractive returns. Depending on the lease terms and escalation clauses, a net lease investment property could provide stable cash flow over the course of 50 to 75 years. Net lease investments are generally considered low risk, although the risks that do exist must be examined carefully. The demand for net-leased properties remains high, and capitalization rates remain generally low. High-credit tenants with over 20 years remaining on their original lease terms currently serve as the safest investments. Tenants with lower credit or less than five years remaining on their original lease terms have increased risk and higher capitalization rates. The net leased retail sector remains a strong market and is expected to continue growing in years to come.