Many investors are drawn to net lease real estate assets due to their allure of predictable income and minimal management requirements. When thinking of net lease properties, one might envision Walgreens, FedEx distribution centers, Amazon fulfillment centers, Chipotle restaurants, Albertson grocery stores, or other large, single-tenant commercial buildings. These properties are often referred to as NNN (Triple Net) properties, where the tenant is responsible for insurance, maintenance, and property taxes, theoretically offering a “hands-off” investment opportunity. In these arrangements, tenants, often high-credit or investment-grade entities, are legally obligated to pay rent regardless of occupancy. While net lease assets can diversify a portfolio of DSTs (Delaware Statutory Trusts) or TICs (Tenancy-in-Common), several critical considerations are often overlooked.
1. Disposition Strategy: Investors should ask, “How will the property generate profit beyond covering fees?” Net lease properties are favored for their predictability, but they typically offer limited returns beyond cash flow. Unlike residential properties, the value of net lease properties often declines as the lease term diminishes, complicating profitable sales. Potential appreciation largely depends on the tenant renewing the lease or the sponsor securing a new tenant with equal or better credit. Historically, net lease properties do not appreciate at the same rate as multifamily or self-storage properties. Recent trends show cap rates for single-tenant properties expanding, indicating a drop in price relative to rental income. This may be a good opportunity for buyers but not great for current owners. With Sponsors charging upfront fees ranging from 9% to 20% and disposition fees of 3% to 5%, overcoming these costs can be challenging, especially for debt-free properties.
2. Mortgage Considerations: Properties without mortgages avoid risks of bank foreclosure if the tenant leaves. However, properties with mortgages are susceptible to prepayment penalties, defeasance, balloon loans, cash-flow sweeps, and foreclosure risks. Additionally, the bank may control who the re-occupies the building, complicating the re-tenanting process further. A debt-free property significantly mitigates risk but might struggle to appreciate enough to cover fees without leverage.
3. Tenant Risk: What happens if the tenant leaves or stops paying rent? Sponsors often assume tenants will renew leases without considering the challenges of re-tenanting a vacant property. Finding new tenants for large, high-quality properties can be timely and costly. From a practical point of view, sometimes companies decide just not to pay. A sponsor needs to be prepared for these situations. In a DST, once the capital raise is complete, no additional funds can be contributed, necessitating substantial reserves. Sponsors might either allocate investor funds to a reserve at the start or build reserves from property cash flow. In contrast, a TIC can request additional funds from the investors as needed, therefore requiring less of a reserve fund. Either way, the sponsor must have a broker network and legal team positioned to support if needed.
4. Adequate Reserves: Re-tenanting can be timely and expensive. If sponsors use investor principal to maintain reserves, this money can be taxable as “boot.” Alternatively, building reserves from net operating income might reduce cash flow to unattractive levels. If a tenant indicates that they plan to vacate, cash flow may stop for years. In contrast, TIC sponsors can request additional capital from investors when needed, therefore not requiring a large reserve fund. This limits the risk of a tax as a consequence for the investor if the sponsor capitalizes the reserves, and it keeps more of the investors’ money in their pocket. DSTs are not allowed to invest in reserves. Therefore, keeping more money in the investor’s pocket empowers the investor to seek additional returns elsewhere or keep the cash as a personal safety net for unforeseen life events.
By understanding these key aspects, investors can better navigate the complexities of net lease real estate investments and make more informed decisions.
Disclosure
1031 Exchange Risk
Internal Revenue Code Section 1031 (“Section 1031”) contains complex tax concepts and certain tax consequences may vary depending on the individual circumstances of each investor. RM Securities and its affiliates make no representation or warranty of any kind with respect to the tax consequences of your investment or that the IRS will not challenge any such treatment. You should consult with and rely on your own tax advisor about the tax aspects with respect to your particular circumstances.Please note that RealtyMogul does not provide tax advice.
This article is for informational purposes only, and is not a recommendation or offer to buy or sell securities. Information herein may include forward looking statements and is for informational purposes only. Forward-looking statements, hypothetical information, or calculations, financial estimates and targeted returns are inherently uncertain. Past performance is never indicative of future performance. None of the opinions expressed are the opinions of RealtyMogul. Advice from a securities professional is strongly advised, and we recommend that you consult with a financial advisor, attorney, accountant, and any other professional that can help you to understand and assess the risks and tax consequences associated with any real estate investment. All real estate investments are speculative and involve substantial risk and there can be no assurance that any investor will not suffer significant losses. A loss of part or all of the principal value of a real estate investment may occur. All prospective investors should not invest unless such prospective investor can readily bear the consequences of such loss.
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