prime advantage of commercial real estate ownership is the
inflation hedge it creates. By periodically raising rents, real estate owners
can keep pace with inflation and preserve the purchasing power of their rent
dollars. However, when leases fail to provide timely and adequate adjustments
in rent, lessors’ collected rent delivers progressively less purchasing power
as the years go by, thereby defeating the investment goals.
This may be occurring in today’s market more often than real
estate owners realize. It is especially true for many senior investors who are
attracted to non-management-intensive tenancy-in-common replacement properties where the tenant is a single-credit tenant signed
to a triple-net lease. Most TIC sponsors promote 1031 tax-deferred exchanges as
a means of deferring the tax on an investor’s unrecognized capital gains and
promote credit tenants signed to triple-net leases as near-ideal tenants that
require little management attention throughout the lease term.
In those situations in which there are multiple occupancy
tenants, TIC sponsors frequently create a special purpose entity and enter into
a long-term master lease with the SPE. Under this arrangement the master tenant
remains obligated for the flat rent due to the property owners but usually gets
to keep all rent increases paid by the sub-tenants.
The common element of both structures is that the NNN lease
typically is written for a term of 20 years or more and provides either no rent
increases or very meager rent increases over a long term. Multiple option periods
frequently are appended, often extending the potential term of the lease to 40
or 50 years.
Before investors jump feet first into TIC transactions with
triple-net leases, they should consider the multitude of factors involved in
these complicated structures. Not all triple-net leases are created equal, and
investors — particularly senior investors nearing retirement — are wise to
utilize the services of experienced commercial real estate professionals to
investigate the pros and cons of these leases.
NNN Leases vs. Ground Leases
Triple-net leases bear a close resemblance to the leased-fee
interests of ground leases in that both typically extend for long terms,
usually 20 years or more. In addition, both triple-net leases and leased-fee
interests of ground leases offer little management involvement and generally
furnish an income stream that behaves like a finite annuity.
For this reason experienced leased-fee owners are keen on
setting periodic increases in ground rent not only to preserve an investment’s
present value in the event of a sale, but also to provide an annuity that keeps
pace with inflation and thereby preserves the purchasing power parity of the
lessor’s rental dollar. This also should be a primary concern for buyers of
triple-net lease properties, especially when the tenant holds the right to exercise
one or more options, potentially burdening the property for future periods at
In today’s market, triple-net leases are the darlings of TIC
sponsorships. Leases written by credit tenants with strong balance statements,
such as Starbucks, Walgreens, Barnes & Noble, FedEx, Best Buy, and
Applebee’s, among others, are highly prized. These types of triple-net tenants
often specify initial terms of 10 years to 20 years. Rent frequently remains stable
for 10 years, then increases by 6 percent to 10 percent and remains level for
an additional 10 years. In some cases, rent remains level for 25 years. Option
periods usually provide meager increases, resulting in a very serious
impairment in the purchasing power parity of the lessor’s rent dollar as well
as reducing the property’s resale value.
For example, consider the present value of a lease that
provides $1.00 in monthly payments for 10 years and then $1.10 in monthly
payments for an additional 10 years. The lease operates in an inflationary
environment of 3.5 percent per year, applied monthly. The purchasing power, or
constant value, of the collected rent declines steadily until it reaches 70.7
cents of its original dollar value at the end of the 10th year. By the end of
the 20th year, the constant value is only 54.6 cents of its original value.
If the lease is subject to two five-year renewal options
providing a 5.0 percent increase per option period, the constant value of the
rent will have declined to 43 cents by the end of the lease. Had the owner been
able to apply a rent increase every 12 months equal to a 3.5 percent annual inflation
rate, he would have been able to preserve almost all (95.8 percent) of the
purchasing power. As it is, the owner loses 45.4 percent of purchasing power at
the end of 20 years and 57 percent by the end of the 30th year.
Inflation is an important factor in the rate of loss in
purchasing power. The Inflation Increases by Decade table shows the average
annual inflation rate as reported by the Bureau of Labor Statistics (www.bls.gov)
for the preceding decades. The period between 1971 and 1980 especially is
noteworthy as a time of rampant inflation. In contrast, inflation during the
last five years (ending December 2006) has averaged only 2.68 percent per year
largely due to Consumer Price Index manipulation such as hedonic regression.
Many economists echo the sentiments of shoppers whose day-to-day experiences
tell them that inflation has been, and is likely to remain, much higher than
that reported by the BLS.
The average annual compounded inflation rate for the period
1960 to 2006 is 4.25 percent. If this inflation value is applied to the same
lease structure, the rental dollar loses not 29.3 percent, but 34.3 percent of
its purchasing power in only 10 years and 52.4 percent rather than 45.4 percent
by the end of year 20. These are sobering numbers, especially for senior
investors who are on the cusp of retirement and seek inflation-protected income
and reduced management involvement.
When successive option periods convey to the triple-net
tenant the right to perpetuate this arrangement for years to come, the serious
penalties that lessors accrue are steep. A property burdened by this kind of
lease, or variations of it, becomes difficult to re-sell to informed buyers. If
circumstances compel a sale, the owner is likely to suffer a substantial loss
of hard-to-replace equity. It may mean that the owner is better off accepting
some management responsibilities rather than becoming a fractionalized owner
and taking on a credit tenant whose lease is designed to reduce the tenant’s
future rent at the cost of suppressing the constant purchasing power of the investor’s