Triple net properties (NNN) are leased to tenants who bear the responsibility for paying rent, plus added expenses including building maintenance, insurance, and taxes. They can provide a good option for investors who are seeking mostly passive income and who wish to avoid the burdens of more active management. Popular examples of NNN properties would include single tenant retail, fast food, and service providers such as Walgreens, CVS, Dollar Stores, Taco Bell, Burger King, and Jiffy Lube among many others.
While the overall annual sales volume of single tenant NNN properties is currently higher than DST properties (roughly $50+ billion for NNN versus about $10 billion for DSTs), a growing number of our clients who have previously been NNN investors are switching to DSTs. We’ll explore the reasons for this shift in preferences in this blog post.
The Appeal of NNN Properties
First and foremost, NNN leased properties have been around a long time and are well known to real estate investors and the real estate brokerage community. They are considered to be a type of traditional real estate which allows licensed real estate brokers and agents to receive sales commissions – so they are actively marketed and promoted to investors by a large number of intermediaries as a first choice when considering passive real estate investments.
The benefits of investing in NNN properties can be compelling and typically include:
- Long term stable income per lease terms which can typically range from 5 to 20 years (plus options) in duration
- Reduced management stress and work required from the investor since the tenant is largely responsible for paying rent and expenses
- Security of income subject to the credit rating of the tenant who is often required to guarantee the performance of all lease terms
Potential Disadvantages of NNN Properties
Our firm has managed many NNN properties on behalf of our clients and while the investment benefits can be attractive, these investments can also be subject to risks that prudent investors should consider including the following:
- NNN leases generally have a limitation on the amount of annual rent increases that can be passed onto tenants. This limitation is typically based on past historical increases of the Consumer Price Index (CPI) which, until recently has been in the range of ~2%. The recent spike in reported inflation to annualized price increases above 5% has raised justifiable concerns among many of our clients over whether the income from NNN properties can keep pace with ongoing elevated inflation rates. Income properties that fail to keep pace with rising price levels can be subject to added risks that may impact overall returns.
- While a NNN tenant is obligated to perform maintenance and upkeep of the property, the investor/owner is ultimately responsible for any failure to the tenant to meet its lease obligations. As a practical matter, no matter how strong the tenant may appear to be, we advise all our NNN investors to have periodic engineering studies completed to ensure that their tenants are fully living up to their responsibilities. In our experience, it is rare that a comprehensive engineering study will not find at least several items that need to be addressed by the tenant. Even minor items such as delaying the timely replacement of a grease trap can lead to costly repairs and perhaps even contentious and expensive litigation.
- As the term of the lease declines, there are added risks to consider including negotiating favorable renewable terms plus the possibility that a tenant may not renew and leave the investor stuck with an empty building and burdened with unanticipated costs to find a new tenant. Even tenants who are doing well in one location may decide to move to a new nearby building – or leverage that possibility to negotiate less favorable renewal terms including lower rents and improvement allowances that may negatively impact overall returns.
Ironically, added renewal risks can raise the current cash yields on NNN properties with limited remaining lease term and cause unsuspecting investors who are solely looking at yield to be motivated to make poor investment decisions. NNN investors who are chasing current cash yields are wise to understand that higher current returns are often accompanied by higher risks. Investors should be wary that an above market cash yield can be a signal of a desperate seller who is trying to unload a problem property.
Comparing DSTs to NNN Properties
Like NNN properties, properties structured as Delaware Statutory Trusts (DSTs) appeal to investors who are seeking passive income and who may also be considering investments that would qualify as like-kind replacement properties when completing a 1031 exchange. Here are some of the most cited reasons provided from our clients who have shifted from NNN properties to DSTs.
- While DSTs can include NNN properties, they are also available in asset classes such as apartments and storage where owners have greater flexibility to raise rents to keep up with changing market conditions and price levels. Unlike commercial and retail properties which are subject to fixed term leases that decline year by year, apartments are perpetually leased as tenants come and go.
- Finding attractive NNN properties is especially challenging in today’s frothy market. Investors must compete to outbid other investors to secure desirable properties and time is very limited to win suitable properties if they are doing 1031 exchanges. By contrast, there is no price competition among DST investors – all who invest in a particular DST are offered their interests at the same price.
- The risk of not being able to close on an identified property is also far less with a DST than a NNN property. The DST is already owned and being managed by the DST sponsor who is reselling their interests to investors. Provided DST interests remain available, and the investor qualifies to purchase interests, they have a high likelihood of closing and no risk of losing out by being outbid by another investor.
Summary
While NNN properties currently remain more popular than DSTs, the large increase in DST investments in recent years is being fueled in part by investors who are switching from NNN investments to DSTs. Should current elevated inflation levels persist into the longer term, we would expect investor preferences for DSTs over NNN options to accelerate as investors look to reposition equity from retail and commercial assets into more inflation resilient investments such as apartments, storage, and other.
If you wish to further explore the full range of both NNN and DST investments offered by our firm, please contact us at info@FGG1031.com or call us toll free at 866 398-1031. You can also schedule a free one on one consultation with me here.
Help Save 1031 Exchanges
1 https://www.stanjohnsonco.com/trends-insights/research-library/marketsnapshot-q4-2021 and https://thediwire.com/securitized-1031-exchanges-now-on-pace-to-raise-a-record-6-billion-in-2021/
2 DST investors must be accredited i.e., have a net worth > $ 1million exclusive of equity in their personal residence or// annual income of $200K if single or $300K if married.
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