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TRIPLE NET LEASE: THE PROS & CONS
EDUCATION
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There are many flavors of lease agreements in commercial real estate. For investors who operate commercial space for rent, the lease is a basic building block. A lease is a legally enforceable contract that specifies how much the tenant will pay to occupy a set amount of space, and for how long. The lease also determines how the tenant can use that space, and it might spell out conditions such as whether competing business are allowed to lease space in the same property.
Compared to residential leases, commercial leases can be quite complicated. A residential tenant leasing an apartment or rental house typically makes one monthly payment that covers all occupancy costs. In commercial real estate, the spaces are larger, the expenses greater and the variables more varied. Who pays the property taxes, insurance and maintenance on a piece of commercial real estate that’s leased to a user?
Those details are subject to negotiation between landlord and tenant. A triple net lease is a tool commonly used to settle the question of which party pays which expenses. Because the arrangement offers benefits to both landlords and tenants, the triple net lease is widely accepted and frequently used in the commercial real estate industry. Read on for more about the advantages and disadvantages of triple net leases.
“Triple net lease” (also called a triple N or NNN lease) is a bit of real estate jargon that refers to a standard type of agreement between landlords and tenants. The name refers to the landlord not paying -- netting out, in other words -- three major occupancy costs: building maintenance, property insurance and real estate taxes. In a triple net lease, these costs become the legal and contractual responsibility of the tenant; the landlord passes the cost onto the tenant.
Tenants with triple-net leases pay their proportionate, or pro rata, share of operating costs. To give an overly simplified example, a tenant who occupies 5,000 square feet in a 50,000-square-foot building would pay 10% of the maintenance costs, insurance premiums and property taxes. Triple net leases are common across property types – they’re standard at office, retail and industrial buildings.
A triple net lease isn’t the only type of lease arrangement. Landlords and tenants sometimes negotiate gross leases, in which the landlord directly pays for maintenance, insurance and property taxes, and then adjusts the tenant’s rent upward to reflect the higher level of expenses borne by the landlord. In another twist, single net leases call for the tenant to pay property taxes, while double net leases oblige the occupant to pay property taxes and insurance.
Another type of lease agreement is the percentage lease. Commonly used for retail space, the percentage lease calls for the tenant to share a portion of sales with the landlord.
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The base rent usually is lower with a triple net lease than with gross or percentage leases. When the landlord can market a competitive rental rate, securing tenants becomes easier. Therefore, the landlord is likely to enjoy higher occupancy, and less likely to endure vacancies when competing against properties that structure their rents as triple-net leases.
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With a triple net lease, the landlord passes on costs associated with the property to tenants. Local authorities raise property taxes? That’s the tenant’s problem to deal with. If insurance carriers boost premiums in response to a spate of bad weather or other factors, that’s the tenant’s issue. Same with regular upkeep expenses – if the cost of maintenance rises, the tenant bears the increase. In an inflationary environment such as that of 2021 and 2022, triple net leases let landlords transfer some of the risk of rising prices to tenants.
Because landlords offload risk to tenants, investors view properties filled with tenants on triple net leases as conservative, low-risk assets. An investor will hold onto a triple net property for five years or longer, building equity as tenants’ rent payments cover any debt service. Then, if the market peaks, local population surges or other cyclical factor prove favorable, the owner can exit the asset and roll the proceeds over into another investment. (A 1031 exchange allows an investor to defer capital gains taxes by rolling the proceeds into a similar property.)
Tenants typically sign triple net leases for a period of years – often five years or longer. If you’ve assembled a diverse mix of tenants – companies with strong credit histories and stable track records – you as a landlord can enjoy steady rental revenues over a period of years. Even if one tenant moves out at the end of the lease, or if a tenant suffers a business failure and stops paying rent, the landlord has built enough of a buffer into the tenant mix that the overall rental stream remains reliable.
By passing variable expenses onto tenants, the investor gains some protection from unexpected increases in the costs of operating commercial real estate. The COVID recession underscored the beauty of long-term triple net leases for landlords: Even as government lockdowns temporarily closed many offices and retail locations, tenants kept paying their monthly rent.
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Tenants typically sign triple net leases for long periods of time – five and 10 years are standard lease terms, but the deals can stretch to 15 and 20 years. This sort of long-term commitment by tenants gives peace of mind to landlords. If the rent roll is filled with tenants that have long track records and thriving business models, chances are they’ll be in the space for years to come.
One of the beauties of triple net leases is that landlords can transfer nearly all of the costs and uncertainty onto tenants. A well-maintained property filled with thriving tenants makes life easy for the investor who owns the building. The landlord makes sure everything continues to run smoothly at the property, but in these dream scenarios, there’s not much for the owner to do beyond collecting rent checks and building equity as the property value appreciates.
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If ownership is such a great deal, aren’t tenants getting the short end of the bargain? Not necessarily. Triple net leases often represent a win-win scenario for both owner and occupant. Tenants accept this arrangement because most don’t want to be in the commercial real estate business; they believe it makes more financial sense to devote their capital to operating their businesses and growing their customer bases, rather than tying up capital in real estate ownership.
Even major corporations with sophisticated financial departments deploy a real estate strategy that focuses on renting rather than owning. What’s more, triple net leases offer tenants some protections against soaring rents (more on that in a minute).
Tenants can build their occupancy costs and operating expenses into their overall business costs, thereby achieving tax benefits.
Customer-facing businesses typically don’t like to move locations. It’s annoying to employees, confusing to customers and disruptive to the business’s ongoing operations. That’s why triple net lease tenants tend to stay in one location for long periods of time. Longevity in one location can become a marketing tool. And from a practical standpoint, individual companies don’t have the buying power or scale to capture a prime location.
A law firm that needs 5,000 square feet of office space near the courthouse probably isn’t going to buy or build a downtown office tower; it’s just more practical to lease space in a building owned by an investor. The same goes for a retailer that wants space near a major intersection – the prime corners are already developed, so getting a store in a high-traffic spot means signing a lease.
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If there were no risk in commercial real estate, investors would reap no rewards. Vacancy risk is perhaps the gravest threat faced by landlords offering space on triple net leases. Vacancy can occur when a tenant moves out at the expiration of a lease and the landlord struggles to fill the vacated space, perhaps because overall market demand is weak, perhaps because of some shortcoming in the property itself. Vacancy risk also can occur when a tenant’s business model falls victim to broad disruptions in the tenant’s industry.
During the Great Recession, for instance, many office tenants in the financial, real estate and mortgage sectors fell on hard times and no longer could pay the rent, no matter how long they had prospered previously. And the retail sector has been beset by vacancies in recent years. Video stores have been vanquished by Netflix. Bookstores went mostly extinct amid Amazon’s rise. Music stores have all but disappeared. There’s a long list of once-expanding retailers that have been forced into major downsizings – Borders, Circuit City, JCPenney, Kmart, Macy’s, Office Depot, Sears, Sports Authority, Virgin Music, to name a few.
Some simply move out when the lease is up. Others hit hard times so suddenly that they file for bankruptcy protection, and court-approved plans for reorganization typically involve the struggling tenant moving out and turning the space back to the landlord. The tenant’s empty bank account doesn’t allow for rent payments.
A vacancy isn’t always horrible news, however. If the old tenant’s rental rate hadn’t kept pace with market rents, the landlord has an opportunity to bring in a new tenant at a higher monthly rent. And some corners of the retail sector have proven Amazon-proof. Supermarkets are doing well, as are fitness centers and discount retailers such as Ross, TJMaxx and Marshall’s.
Triple net leases offer landlords peace of mind, stability and long-term income streams. However, one tradeoff is that if lease rates spike, there’s not much the landlord can do to cash in on the more favorable market conditions. Rental rates in your market have jumped 10% in the past year? Sorry -- you’ve signed a contract that locks the tenant into a pre-determined rental rate, perhaps with some modest annual increases. In this case, the tenant is the winner – the long-term rental rates will fall below what the market would bear.
During the pandemic, this phenomenon was particularly pronounced in the industrial sector. A shift to e-commerce meant Amazon and other online retailers competed fiercely for space, and rents on distribution space climbed accordingly. The ripple effect was felt even in older warehouses that might not have appealed to e-commerce giants.
Landlords can offset some of the pain through inflation clauses written into leases. As a building owner in a booming market, you can’t do much to cash in on soaring rents in the short term. In the long term, however, a sustained rise in rents will make your property more valuable.
During the course of a triple net lease, the landlord is off the hook for maintenance and improvements. The free ride ends, though, when a tenant moves out. Say you own a rental property, the lease expires, and your long-term occupant opts to relocate to a different location. Chances are your old tenant didn’t fully remodel the space before they moved out. So you’re probably left with a space with worn or outdated décor, and a floor plan and layout that might not fit the needs of the next tenant.
To make the space marketable, the landlord needs to thoroughly renovate the space. If the new tenant is significantly different from the old one, or if there’s deferred maintenance, the building owner is on the hook for the cost of remodeling. Depending on the size of the space and the scope of the work, the tab could be tens of thousands or hundreds of thousands of dollars. In many instances, the new occupant will insist on a construction budget in the form of tenant improvement dollars.
Yes, by all means. Triple net leases are a commonly negotiated contract type, and they’re a widely accepted form of occupancy in the commercial real estate sector. While there are some downsides to triple net leases for both sides, on balance this arrangement is favorable to both tenants and landlords.
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