The Complete Guide to NNN Leases
- Things to look for before buying NNN properties
- How to read NNN property leases
- Improve your chances to secure a hard money loan
- Negotiate a new NNN lease with confidence
NNN Properties - an Introduction
NNN properties are a type of commercial real estate in which the tenant is required to pay the landlord’s cost in addition to the monthly rent. NNN properties gained popularity because they require less management (“zero-landlord responsibility”), provide good returns, and have long term leases in place. Unlike other investment properties, the value of NNN assets is mainly composed of mostly 2 factors:
- Location of the property
- Quality of the tenant and the content of its lease
The returns on NNN properties are higher as well – around 6.5% industry wide, compared to 5.6% in multifamily nationwide, and require significantly less management. Investor and institutional money cashed on this trend, accelerating investment in NNN properties that continues to this day.
This new opportunity also presents challenges to new investors:
- Decisions have a long term effect as a result of multi-year leases with limited ability to amend them
- Rental agreements of NNN properties are highly technical and are often misunderstood by investors and brokers alike
Knowing what you’re getting into before you purchase is important – to prevents unpleasant surprises down the road and strengthen your leverage in future negotiation (and and perhaps to negotiate a discount at closing). Over the course of reviewing new deals – we often see buyers who enter the NNN market without knowing what they are actually buying. This confusion and misunderstanding often leads to broken escrows – which we believe are entirely avoidable if investors have access to the content of the lease and professional advice to guide them through it.
NNN leases are long – sometimes 50 pages long with several amendments. We are going to review important aspects of the NNN lease that are prevalent in corporate leases. While we will focus on whats important, it is always recommended you speak with a lawyer to review the terms of the lease before any purchase.
NNN Leases - The basics
We will cover the most important parts of the lease you need to review before purchasing a triple net property. The following parts of the lease will require special attention – the kinds that could radically change the value of your property over time. Parts of the lease will not come into effect right away but only after a few years, like term extensions, to note one example.
The Corporate Guarantee
Definition – A corporation agrees to be held responsible for all lease obligations in the event the tenant/operator defaults. NNN leases are often marketed as a safe investment solely because the lease is backed by a credit-worthy corporation.
Why it’s important – In two words – guaranteed income. You will receive rent checks for the term of the lease unless that corporation files for bankruptcy. This is why the guarantee clause in the lease is the single most important part of a NNN lease. A corporate guarantee is better than an individual guarantee, or a guarantee from a single-member LLC.
What to look for – make sure that the entity that guarantees the lease matches the credit entity. You can find the name of the corporations using any finance tool, like Yahoo Finance. ‘Credit tenants’ are rated by financial agencies like Standards and Poor’s, and the better the rating, the higher the value of the property. For example – a lease guaranteed by T-Mobile USA Inc. is a corporate guarantee – since the entity is listed in the NYSE. A lease guaranteed by T-Mobile West LLC, however, is not a corporate guarantee since it is backed by a subsidiary of T-Mobile, not the actual credit-entity.
- Confirm a corporate guarantee of the rent/lease – either on the lease itself or a separate guarantee of lease via a lease amendment.
- Evaluate the corporation’s credit rating by looking up its default/closure rate for stores, you can find a list here. Better rating means a safer investment (and more expensive).
- look for early guarantee opt-out or assignment without landlord’s consent.
Lease Term and Options to Extend
Definition – how long the tenant commits to stay on the property and pay rent. Options to extend can make the initial term longer, usually at the tenant’s option near the expiration of the initial term. NNN leases often have multiple options to extend that could last well over 30 years.
Why it’s important – since the options to extend usually belong to the tenant, it provides them with some negotiation leverage when a term is near its end. Also, if you are interested in removing the tenant (for development, use the space yourself, or find a better tenant) you’d want to prepare ahead of time.
What to look for – pay special attention to early termination clauses, and the manner in which the tenant has to exercise the option to extend. In most cases, the tenant has to exercise the option in writing and within a certain timeframe. The wording of the option matters, for example, consider the following: “tenant can exercise the option to extend no later than six month prior to the expiration of the first term.” This means the tenant has the entire term minus the last six months to exercise the option. Limit the time to extend to discourage drawn out negotiations.
- Find the options to extend and note the final date of the final option to extend to establish a complete timeline.
- Verify the manner in which the tenant must exercise the option to extend.
- Look for any early termination options.
- Pay special attention to ‘market price rent‘ clauses upon new extensions terms – if an option to extend calls for the parties to agree to a new market rate at the same time, you can expect a negotiation before every extension.
Rent, Escalation, and NNN Charges
Definition – NNN charges are separate from monthly rent, and include reimbursement for property taxes, common area charges (CAM) and property insurance. Escalation clauses tell you when and how you can raise the monthly rent.
Why it’s important – Triple net protects you from rising costs such as property tax reassessment, or a sudden insurance premium bump. But the triple net portion of the lease is notoriously long and can contain various pitfalls that limits the tenant’s responsibility to reimburse you for expenses.
To name one example – some commercial leases have reimbursement caps for property taxes. In states like California, the property taxes are re-assessed upon a sale, which may result in a much higher property tax bill for the tenant. Many NNN leases have protection against such hikes and keep the property tax reimbursement at the previous level, which leaves you responsible for rest of the bill.
What to look for – when examining the rent and NNN sections, focus on the long term. How much rent is the tenant paying ten years from now? Are you protected from increasing costs or are the NNN reimbursement limited in some way? We won’t go into all the details that need to exist in a proper NNN lease clause, but consider the following questions when going over the tenant’s lease:
- Reports – how often and in what manner does the tenant pays the CAM – quarterly, monthly, or yearly? When does the tenant has the right to audit your expense reports?
- You want to know if you are required to pay the insurance (and choose it yourself) and then send a bill to the tenant, or alternatively the tenant pays for the bill directly. Who gets to choose the insurance carrier?
- If you face fines or late fees for property taxes, who pays for them?
- Under what conditions tenants can contest NNN charges?
- Are the tenants responsible to pay for management fees for the property?
CAM – (common area maintenance) – utilities, trash collection, gardening, and repairs of common area items
- Check to see who picks the vendors (gardener, cleaner, etc…)
- Pylon and signs – maintenance can be costly – make sure repairs are not excluded from NNN
- Can you increase yearly/monthly CAM payments?
- Check to see if management fee is included
- Common area insurance should also include umbrella coverage for 3rd person injuries
- Disability parking – common lawsuit against landlords and tenants under ADA guidelines – look for protection under the insurance policy
- 3rd party certificates – make sure the tenant includes you as a 3rd party beneficiary on the certificate of insurance
- Look for property tax reassessment protection, especially if the property is located in states where a sale triggers one – brokers miss this one all the time and it can costs you thousands a year
- Right to contest property tax bill – can the tenant do it on your behalf?
- Property taxes will be the biggest expense for you and the tenant
- Some NNN leases also cover capital improvements/expenditures to property such as a new roof, new pavements, etc.
- Absolute net lease will include capital improvements – and can be negotiated on new structures and industrial properties
Assignment and Subleasing
- Assignment – transferring rights and obligations described in the lease to another tenant. After the assignment, both parties are still responsible for the obligations on the lease but the new tenant has possession. This is common when the business is sold to a new operator.
- Sublease – when a tenant finds another tenant to occupy a portion of the premise.
Why it’s important – the value of a NNN property comes from the identity of a tenant. A local pizza shop with 1 location is not as marketable as a nationwide franchise as a tenant. You want to make sure the assignment clause gives you leverage to screen bad, or non-credit tenants. Assignment clauses come up when the tenant puts up the business for sale, or goes out of business. If the guarantor can assign the lease to another entity who is not credit worthy, it will impact the value of your property dramatically since it essentially the same as an opt-out clause.
What to look for – written consent to any assignment of rights is mandatory – most NNN leases should have this already. Note that if you are negotiating a new NNN commercial lease, the wording of the assignment clause matters. Different states have different standards, but most jurisdictions favor assignment of contracts. In other words, it won’t be easy to outright disallow all assignments – so consult a local lawyer in order to find out what wording serves your interest the best.
- Before agreeing to any assignments, confirm the new tenant is credit worthy – losing a corporate guarantee is a death-knell to your property’s value. Demand financial statements, bank accounts, and credit history.
- Ensure landlord must give consent to every single assignment of rights or sale of business.
- When assigning a contract to a new operator/tenant – make sure both parties are responsible for the list post-assignment.franchise
General Terms - Miscellaneous
Option to Purchase/Right of First Refusal
The tenant/operator has the right to purchase the property before any other entity in the event you want to sell it. Perhaps one of the strongest rights awarded to a tenant – it gives tenants tremendous leverage when you want to sell the property and usually will appear towards the end of the contract. If you are purchasing a property with an existing right of first refusal – you will need to get a waiver from the tenant before opening escrow.
Attorney fees provision provides the winner of litigation between landlord and tenant with reasonable attorney’s fees. For example – if the landlord sues the tenant for non-payment of rent and wins the lawsuit – the tenant will have to pay the missing rent AND the landlord’s attorney fees.
The landlord has a right to ask for an additional fee from the tenant if rent or NNN charges were paid late. For example, if the rent is due on the 1st of the month and the tenant pays the rent late, on the 15th of the month, the landlord can choose to apply a late fee in additional to the rent. The language of the late fee clause is important – generally speaking ‘fines’ are not favored in contracts, so it is important word the contract in a way that explains why the late fee applies in specifics, and not make the late fee too excessive.
Personal property that is attached to the real estate which is used by the tenant during the course of business. Some fixtures are ‘trade fixtures’ – property the tenant can remove once the lease ends. Equipment fixed to the property like vents, walk-in freezers, and grease-trappers are valuable when you will try to find a new tenant.
Reporting requirement is a big plus for the landlord – it will require the tenant to deliver yearly reports of income/sales. It will show you how well the tenant is doing, and negotiate accordingly. If the tenant’s sales are up year-over-year, they are less likely to leave.
A clause that specify what the allowed commercial uses of the user/tenant. This part of the contract comes into play when considering exclusive use in multi-tenant. Tenants will want an expansive use language and landlords will want more restriction and limited.
Brokers and Commission
If any brokers were involved in drafting the NNN lease – it will probably have wording related to the commission that the brokers are owed. Many of the ‘standard NNN leases’ are drafted by broker’s organizations and made in large part to protect the brokers’ interest. If you purchase a NNN property – take special note of the commission portion of the contract – sometimes you will be required to pay commission for extensions, options, and additional terms. This means that if the tenant chooses to extend the term of the lease through a lease extension or exercising an option – you will be on the hook for 6% of the total rent new term. Unlike many of the other clauses of the lease – this one can definitely be negotiated during the purchase process.
The tenant is required to carry sufficient insurance on business activity to protect both the landlord and the tenant from liability. Under best practices want the tenant to name you as a 3rd party beneficiary on their insurance as well – for full protection.
This requires the tenant to sign a document confirming elements of the current lease in case you want to sell the property – like monthly rent or an acknowledgement that the tenant is current on all rent payments. Even if you are never planning to sell the property, a lender may ask for an estoppel certificate before approving you for a loan. If you don’t have an enforcement mechanism like estoppel certificate, tenants might get ideas to leverage a request and ask for a lease amendment in order to comply.
Total Square Footage
A commercial NNN lease should indicate how much square footage the tenant is leasing. Match the square footage in the lease to the number in the marketing materials, and the figure on the city/tax records. This step is important to avoid mistakes – tenants can request discounts/adjustments if the square footage is calculated wrong. Often overlooked, this is perhaps one of the biggest pitfalls we run into when advising clients on NNN leases – and one of the first things lawyers choose to litigate when a dispute arises.
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