We discussed rental rate upside, tenant credit, and market knowledge in Part 1. Part 2 will delve into the importance of lease analysis and tenant financials when investing in net lease properties.
Know your lease
All net leases are not created equal. A thorough lease analysis helps to understand all clauses of the lease to ensure there are no surprises, which could have a significant negative impact on your return on investment.
An absolute triple net lease is the most attractive lease structure for an investor because it places all maintenance/tax/insurance burdens on the tenant. There are zero landlord responsibilities in a true NNN lease. Some leases are double net (NN lease) and the owner is responsible for significant capital items (roof, structure, parking lot).
A NN leased property can provide an opportunity for higher returns, but requires proper due diligence to understand the condition of landlord responsible items and how future replacement costs may affect NOI over time.
As an example, if we look at a NN leased property in which the owner is responsible for the roof, it is important to know the age of the roof and have a certified inspector or roofing specialist estimate when it will need to be replaced. Commercial roofs tend to have a useful life of 15 – 25 years depending on the quality of initial installation. If you acquire a property with a 10-year-old roof, it is wise to budget replacement costs into your analysis to provide a conservative net cash flow estimate.
Some very strong tenants operate under a NN lease structure. One prime example is Starbucks. Some investors may be willing to look past the potential for future expenses in exchange for acquiring a tenant with excellent credit and a proven history of success.
Understand Tenant Financials before Investing in Net Lease Properties
One of the most important pieces of data when analyzing a STNL asset (single tenant net lease property) is the tenant’s rent-to-sales ratio. Rent-to-sales ratio is the percentage of total gross sales that the tenant pays back to the landlord as rent. Purchasing a property with a lease in place that requires the tenant to report sales is a huge advantage. If you have the opportunity to negotiate a new lease with the tenant, make every effort to require reporting of annual sales, even if that means slight concessions in other areas.
Receiving sales information on a regular and required basis allows you as the property owner to be the first to know when a tenant is struggling or thriving. If your tenant’s sales are down, you can prepare for the possibility that a new tenant may be needed well in advance of the property actually being vacant.
Generally a rent-to-sales ratio of 8% or less equates to a very healthy and easily sustainable long-term business. If the rent-to-sales ratio creeps up to 10% or higher, there is reason for concern as the tenant won’t be able to turn much of a profit with such a significant portion of sales going towards rent.
Obviously not all tenants are required to report sales, which eliminates the ability to analyze rent-to-sales levels. This obstacle can be overcome using more hands on due diligence tactics, such as personal site visits to gauge traffic levels, feedback from store managers, or discussions with other real estate professionals familiar with the specific tenant being considered.
Also make sure to consider if the site is corporately or franchise operated. Corporate locations offer a stronger guarantee, but identifying a store with a strong franchisee will likely offer a higher return. Franchise operated stores often present an attractive opportunity with a more easily accessible tenant, so long as they have a solid operational history.
Contact HighStreet Net Lease Group, the Experts in Net Leased Properties
For expert assistance with your market analysis and property brokerage when investing in net lease properties, contact HighStreet Net Lease Group. Based in Houston, Texas, we provide highly specialized net lease investment property services across the country.