Which Lease Terms are Most Important for Net Lease Investments?
The lease is one of the most important considerations of a single tenant net lease investment (perhaps second only to the property itself). As the expression goes, “the devil is in the details” and for single tenant net lease properties, much of the detail is found within the tenant lease.
An experienced real estate attorney can be a great asset when reviewing a lease. The following is not an all encompassing list of lease terms to be concerned with nor does the following provide any legal advice. The intention here is to help you become more aware of several potential lease issues that are common to single tenant net leases.
Expenses Tenant is Responsible For:
For the lease to be an Absolute Triple Net (NNN) Lease the tenant is responsible for paying ALL property related expenses. This includes the operating expenses such as property taxes, insurance, utilities and other maintenance and repair items as well as the capital expenses such as roof, parking lot, building structure and foundation. Brokers often advertise a property as NNN, but follow it up with “minimal landlord expenses” such as roof, HVAC, structure and parking lot. This is not a Triple Net NNN Lease (it’s a Double Net or NN Lease).
Double Net Leases are not necessarily bad, but they aren’t the completely “hassle-free” properties that NNN Leased properties should be. The landlord needs to be aware of the potential expenses they might incur and plan accordingly.
You’ll also want to dig deeper into the lease to see who initially pays for the expense. In many cases, the landlord pays the initial expense, such as property taxes or insurance, and the tenant later reimburses the landlord.
If the lease is set up for tenant reimbursements then you’ll want to pay close attention to the lease to make sure there aren’t any reimbursement caps (such as property taxes) that limit how much of the expense the tenant will actually reimburse.
Extension Option(s): does the tenant have any lease extension options? If so, how many and for how long? How much advance notice do they need to provide? What will be the rental rate during each renewal option? Etc.
Early Termination Option: does the tenant have the option to terminate the lease early? Sometimes this is obvious and sometimes it may be buried deeper in the lease such as in the case where they have the option to terminate if there are changes made to the law which materially affect their business.
Co-Tenancy Clause: a co-tenancy clause occurs when a tenants lease is tied to another nearby tenant. This clause may allow the tenant the right to terminate their lease early if the nearby tenant vacates or it may instead give the tenant the right to reduce their rental payment.
Right of First Refusal: a Right of First Refusal allows the holder (usually the tenant) the right to purchase the property before the owner is entitled to enter into a sale with a third party. Important to understand when you purchase and for when you plan your exit strategy.
Other Lease Terms:
Legal Entity: who is the legal entity that is party to the lease? The DBA (“doing business as”) may be a recognizable national brand, but the actual tenant is the legal entity that is party to the lease. Who or what stands behind that entity? Do they have sufficient assets to ensure compliance with the lease? Etc.
Rent Escalations: what are the rent escalations and when do they kick in? Are they pre-defined or are they tied into the consumer price index (CPI)? Etc.
Percentage Rent: percentage rent is a form of rent paid in place of or in addition to the normal base rent which is tied into the tenants gross sales. Once a tenant exceeds the gross sales threshold, the tenant will pay the landlord a certain percentage of their sales as rent.
Guaranty: is there a guaranty? Who is it with? What assets does the Guarantor possess? When does it expire? Etc.
Right to Assign: does the tenant have the right to assign their lease to another tenant? If so, are they still responsible for the performance of the lease or is that obligation removed?
Tenants Use: what is the defined use in the lease and is the tenant operating their business in conformance with that use?
Security Deposit: is there a security deposit? If so, when does it need to be returned and if it is after your purchase date you need to make sure you collect it from the current owner at closing as you’ll be responsible to for repayment once you become the landlord.
For additional due diligence information for Single Tenant Net Leases please visit our Due Diligence for NNN Investments page.