An Introduction To NNN Investing
Retail Categories
The Investment
Types of Sellers
The Buying Process
Market Analysis
Highest and Best Use Explained
Location and Site Analysis
Financial Feasibility
Industry Trends
Due Diligence
Financing
Low Risks of Default
Sample Lease Agreement
Sample Letter of Intent
Sample Commercial Inspection Report
The Investment
Before we get ahead of ourselves, thinking we are investing in real estate with a NNN lease and its inherent advantages, lets step back and rethink about what we are really buying.
It would be easy to get lost in the euphoria and overlook the most important detail by assuming you’re buying a guaranteed triple net lease with all the expenses covered by the tenant. So, what could possibly go wrong with guaranteed income for the next 10-15 years?
The point to remember is you are buying real estate first and at some point the lease will expire. What value will the property have at that point? Will the location still be desirable for its intended use? Will demographics or some other factor have changed its value to the point it cannot be released or sold for a profit?
“Remember the adage, Location, Location, Location.”
Location
Long-term risk is directly related to the quality of the location because the lease will expire at some point. When it does you want a location that will warrant current or greater rents. Like “beef”, you have prime, choice and select locations.
A “prime” location will be at or close to a four-way traffic signaled intersection with a high “average daily traffic” count. The site should be prominent with good visibility and access on and off the main road. The demographics within 1 mile, 3 mile, and 5 miles of the site should be heavily populated and growing. Income figures should be strong with enough disposable income to support the area retailers.
The location should have a large number of national retail brands within close proximity of the site. McDonalds, Wal-Mart, Walgreens, AutoZone and CVS are good examples of strong national brands.
Free Standing or In-Line
A freestanding building is preferred to one of many in-line stores. The freestanding location can be located on the main road with individual signage, drive-thru access, designated parking and easy access.
The freestanding building will generally have 3,000 to 12,000 square feet and can be easily adapted to a variety of retail uses. Careful consideration should be addressed to the type of building some tenants use because all buildings are not easily adapted for different uses. This could be a critical issue if the tenant does not exercise the options.
Lease Considerations
As mentioned before, the tenant lease can be a single net (N), double net (NN) or triple net (NNN). The NN or NNN lease is the standard for national retail tenants and satisfies the investor goal of owning a passive investment with limited day-to-day responsibility. All leases are not the same and good legal advice will be needed to explain the potential problems that may arise.
Local or Distant Location
One of the biggest advantages of NNN leases is the lack of property management. With all expenses and maintenance of ownership the responsibility of the tenant, the physical location is less important. This means your investment can be targeted to high growth areas of the country where more investment opportunities exist. This goes against the tendency to own property close to home where you can routinely check on your property. Research indicates that most individual real estate investors favor locations within 50 miles of home. To acquire the best locations this is a tendency to overcome.
Off Market Properties
Mostly mostly large national companies with numerous locations dominate the NN and NNN retail market place. Over time, most of these companies have developed relationships with “preferred developers” who acquire land that fits the location requirements of the national company.
These developers are given lease commitments, which are used to secure construction financing and build to the company’s specifications. The preferred developers often sell the NNN properties in off market transactions.
Over time, the preferred developers have established relationships with investors who have expressed interest in acquiring these low risk NNN properties. This custom means that some investment opportunities never make it into the traditional broker network.
Remember, these NNN investments are considered low risk with a large demand. The “baby boom “ generation is entering retirement and these investments are ideal for this purpose.
Leverage
Using borrowed funds for a real estate investment has several advantages. Leveraging lender capital with personal equity allows:
Preservation of capital for other uses
Allows the purchase of larger investments
Increases yield if leverage is “positive”
(Positive leverage occurs if investment return is higher than cost of borrowed funds but more risk if cash flow is unstable)
Calculating Return on Investment
The retail triple net lease market uses “cap rate” as the primary starting point for valuation. It is a simple calculation that uses the ratio between “net operating income” and “cost of the asset” (as if it were a cash transaction).
Net Income/ Cost = Cap Rate
Example:
$113,750/ $1,750,000 = 6.5%
Net income (rent) – $ 113,750
Cost (purchase price) – $1,750,000
Cap rate – 6.5%
This represents a 6.5% return on a $1,750,000 investment.
This might be a good opportunity to discuss the negotiating philosophy when buying a NNN retail property. This is a niche market, part of the larger commercial real estate market. Because of its low risk, demand is high and submitting low-ball offers may be counter productive.
Consider the above example and an offer 5% below the asking price. It seems reasonable but for the gain is a .003 increase in the return from 6.5% to 6.8% which might cause you to miss out on a trophy location. Of course, this is a personal decision but something to consider when bidding in such a competitive environment.
Cash on Cash Return
Another industry standard of calculating investment return is cash on cash. This return is calculated by dividing the annual net cash flow by the net cash invested
Net Cash Flow/ Cash Invested = Cash on Cash Return
Example: A net leased Walgreens tenant pays
$135,000/yr. rent. You purchased the property at a 6.5% cap rate for $2,076,923 and financed the purchase with a 30% down payment of $623,076.The cash on cash return would be (135,000/ 623,076) 22%.
Other considerations include the tax deduction from depreciation and appreciation.