By Barry Hardwick, CCIM
NNN investing is often marketed as “mailbox money.” The phrase is appealing, but it can oversimplify the investment. The attraction is predictable income with limited to no day-to-day management. The risk is that the investment still depends on tenant credit, lease structure, real estate fundamentals, financing, and exit strategy.
Many investors consider NNN Investing to be like Bond Investing in that there is typically a set lease term and set rental payments over the term of the lease. One of the biggest differences between a bond and a quality NNN investment is the potential for income growth and property appreciation. Unlike a fixed-rate bond, many NNN leases include scheduled rent increases during the lease term. Those increases can improve the investor’s yield over time. In addition, if the property is in a growing market with strong demand, the underlying real estate may appreciate, creating potential value beyond the rental income stream at the end of the investment.
While NNN investments are sometimes compared to bonds because of their long-term contractual income, they are still real estate investments. Tenant default, non-renewal, above-market rent, property condition, cap rate changes, and weak location fundamentals can and will affect value.
Let’s look at some of the advantages, disadvantages, and who should and should not consider NNN Investments.
Predictable income stream and more visible NOI: Most NNN investments have 10-, 15- or 20- plus year lease terms, often with scheduled rent bumps. This creates a stable and predictable income stream for the term of the lease; and in addition, the tenant pays or reimburses the taxes, insurance, and maintenance cost which shields the owner from the Inflation risk associated with these expenses and the negative impact they have on NOI. With the tenant paying property expenses it gives the owner a more visible picture of the true NOI over the term of the investment which makes the investment easier to underwrite: especially for investors looking for retirement income, 1031 exchange replacement property, or a more passive real estate holding. Whereas with multi-tenant investments with the owner responsible for property related expenses, predicting NOI becomes more of a challenge and subject to market shifts.
NNN Investments have less intensive management compared with multi-tenant properties (whether retail, office, industrial or apartment ownership), where the landlord is usually involved in daily operations, repairs, vendor calls, CAM reconciliations, and property management. No more late night or weekend phone calls from the tenant or chasing vendors who don’t show up when promised.
Potentially stronger tenant credit: Many NNN properties are leased by national or regional companies, franchise concepts, medical providers, automotive, bank, drugstore, dollar store, C- stores, QSR tenants with strong credit. While tenant credit does not eliminate risk, it can reduce perceived default risk when compared with a smaller local tenants with limited financial strength.
Useful for 1031 exchange buyers: NNN assets can be attractive to sellers coming out of more management-intensive properties who want to preserve capital, defer taxes through a 1031 exchange, and simplify ownership.
Single-tenant dependency: The biggest risk is that many NNN investments depend on one tenant. If the tenant stops paying, closes, files bankruptcy, or rejects the lease, the owner may go from “mailbox money” to no money overnight. The best way to mitigate this risk is to fully understand the credit of the tenant before purchasing the property. You want to fully vet, not only the tenant operating name, but the actual entity signing the lease. An additional due diligence item is to know the fundamentals of the market where the real estate is located. If worse comes to worse, can you find a replacement tenant and at a rental rate similar to the rent the previous tenant was paying.
Credit risk can change over time. A tenant that looks strong at purchase may weaken during the lease term. Retail formats change, franchisees get overleveraged, restaurants underperform, and even national brands close stores.
Real estate fundamentals still matter. A long lease does not turn a bad location into a good property. If the tenant leaves, the owner is left with the dirt, building, access, visibility, traffic pattern, zoning, parking, and market demand. A weak site with a strong lease can become a weak investment when the lease expires or if the tenant defaults
Re-tenanting risk can be expensive. Some NNN buildings are highly specialized: old drugstores, QSR buildings, bank branches, auto service buildings, daycares, medical clinics, or single-purpose retail boxes. If the tenant vacates, the next user may require significant retrofit costs, rent concessions, downtime, or a lower rent.
Limited upside compared with active real estate. NNN investing is usually more income-focused than value-add focused. The tradeoff for stability is that the investor may have limited ability to raise rents, reposition the property, add tenants, or materially increase value during the lease term. Rent bumps may not keep up with inflation. Many NNN leases have fixed 1%–2% annual increases, 5% every five years, or flat rent for a period of time. In an inflationary environment, those bumps may lag market rent, construction costs, insurance increases, and interest rates. Interest-rate and cap-rate risk. NNN values are very sensitive to cap rates because the income stream is often stable and bond-like. If interest rates rise or investor demand cools, cap rates can move up and values can fall, even if the tenant is still paying rent. This is especially true when financing NNN investments with five to seven year loan terms.
Not all NNN leases are truly passive. The phrase “NNN” gets used loosely. Some leases exclude roof, structure, parking lot, HVAC replacement, environmental issues, insurance deductibles, or capital repairs. Know the lease and what expenses each party is responsible for repairing and or replacing.
Investors seeking stable income more than aggressive growth. NNN Investments can be a good fit for investors who want predictable cash flow, lower management responsibility, and a long-term hold rather than hands-on value creation. NNN Investments can be a strong fit for 1031 exchange buyers coming out of active management properties such as apartments, shopping centers, or management-heavy real estate and wanting to simplify ownership while keeping capital in real estate. Likewise, NNN Investments can be attractive for Retirement-minded or estate-planning investors who want income, simplicity, and a property that may be easier for heirs or advisors to understand. Regardless of reason for the investment, the Investor must understand the credit, the lease and the location quality of the investment. The best NNN buyers are not just buying a cap rate. They are underwriting the tenant, lease language, rent level, replacement rent, building condition, and exit value.
Investors who need liquidity. Direct ownership of a single NNN property is not like owning a publicly traded REIT or stock. Selling takes time, and value depends on market conditions at the time of sale.
Investors chasing only the highest cap rate. A higher cap rate may indicate higher perceived risk, such as shorter lease term, flat rent, franchisee or local credit, a specialized building, weaker location fundamentals, or below-average residual real estate value.
In conclusion, NNN investments can be excellent income-producing real estate, but they are not magic. The investor is not simply buying rent checks; the investor is buying a tenant, a lease, a building, and a piece of real estate that must still stand on its own when the lease ends. For more information about NNN investing, or to discuss how a net lease property may fit into your real estate investment strategy, contact Centennial Retail Services.
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