Triple-Net Effects

Investing in NNN tenancy-in-common properties requires careful planning.

A 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 below-market rents.

Triple-Net Consequences
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 income.

Robert J. Donohue, CCIM

Robert J. Donohue, CCIM, is a real estate instructor at the University of California, Irvine, and owner of the Donohue Co. in Newport Beach, Calif. Contact him at (949) 833-3656 or rjdonohue@gmail.com.