The Beyond Multifamily series is hosted by non-residential commercial real estate investor and Best Ever Show host, Ash Patel. Ash’s goal for this series is to introduce you to the world of non-residential commercial real estate investing and teach you how to look at and underwrite different commercial asset classes.
In this episode, Ash covers the ins and outs of triple-net leases, also known as mailbox money leases. He shares how different types of triple-net leases work and the pros and cons of using each one.
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Ash Patel: Hello, Best Ever listeners. Welcome to the Best Real Estate Investing Advice Ever Show. I'm Ash Patel, and this is an episode of Beyond Multifamily, where we dive into topics other than multifamily investing.
Today, we're going to dive into triple-net leases or mailbox money leases. I'm going to do my best to try to educate you, talk about some of the pros and cons of different types of triple-net leases.
Now, wait a minute, different types of triple-net leases - what does that mean? Most people assume a triple-net lease means that the tenant is responsible for taxes, insurance, and maintenance. That's not always the case. And as the years go by, a lot of leases have actually gone pretty far away from triple-net, but they're still calling them triple-net. And I'll give you an easy example. One is a triple-net lease, however, there could be a clause in the lease where the tenant will only pay a certain amount of taxes or a certain amount per year of maintenance.
I've seen leases where we'll pay taxes up to X number of dollars per year, so if the taxes exceed that, this tenant is no longer responsible for the overage. The same thing goes with maintenance. I've seen leases where we're happy to pay for roof repairs, HVAC repairs, any exterior repairs, parking lot repairs, but we're only going to pay up to a $1,000 a year. Well, these are not triple-net leases in my book. So please, keep in mind, the devil is in the details. You have to read all of these leases line by line to find out exactly what the details are, what the landlord responsibilities are, and what the tenant responsibilities are. The only time I fully trust a broker in an offering memorandum is when I read either triple-net lease or net lease zero landlord responsibilities.
Now, let's talk about landlord responsibilities. You can have a triple-net lease, one, where you don't care if the property is located in Anchorage, Alaska, or Honolulu, Hawaii, because you truly have no landlord responsibilities; you should never get a call from your tenant. However, there's other triple-net leases where landlords are actually responsible for paying the taxes, paying the insurance, and handling all of the maintenance, but they're allowed to charge it back to the tenant. Let's think about that for a second. A gross lease is where a tenant pays one flat rate every month, every quarter, whatever their interval is, and a triple-net lease is where the tenants, again, pay for all of the taxes, insurance, maintenance as well.
So if the landlord still has to provide the maintenance, has to pay the tax bill, has to get the insurance and pay that, what's the benefit? And really, the benefit is when you go to sell the property and they cap rate that it can trade at. If you have an out-of-state buyer, they're much more likely to buy a triple-net property, because their assumption is that it's a lot easier to manage.
And a quick tip for all of you commercial property owners - keep a log of every interaction you have, either with your tenants, your property manager, or anytime you go on-site in what you did. The reason for this is I've got an office building that probably has 10 different tenants in it, and they're all on gross leases, because a lot of them are mom-and-pop tenants; it's a three-story office building. Anybody looking at it is going to think, "Man, that's difficult to manage. I don't want to deal with 10 different tenants, and renewals, and vacancies, and maintenance, and I've got 10 different people that can call me." However, what I've done with this and all of my properties is I keep a log every time any of my tenants, all of which, by the way, have my cell phone number, any of my tenants call me, I log it. If they email me, I log it. If the neighboring commercial tenant calls or emails and asks if they can use the parking lot for a big event, I log it.
The reason for that is when I go to sell this property and it's a buyer that's several states away, I can show him or her that log, and they can see, in fact, this property is very easy to manage. In fact, it might be easier to manage than other triple-net properties that I have, because I've got some rockstar tenants in place that are my boots on the ground, they're my eyes and ears, they clean the common areas, they handle all of the other tenants interactions as well.
So keep that log, very important. But again, the allure of triple-net leases is that it's seemingly very simple to manage.
Best Ever listeners, back to the triple-net leases. And I want you to keep in mind, if your idea of investing in a triple-net lease is one where you just get mailbox money every single month, never have to deal with a tenant phone call, interaction, you want to make sure you look for those absolute triple-net or net lease properties that state zero landlord responsibilities.
Now, back to everything else - I've had properties where there was a massive foundation break where half this building was essentially cracking. And in the lease, this was a building that I inherited, tenants I inherited, and in the lease it clearly stated that any floor cracks or foundation issues are the responsibility of the tenant. I was able to dodge a bullet and the fix turned out to be not as significant as I thought. Nonetheless, there's other properties where I've had tenants in their leases state that if their sales fall below a certain threshold, they can nullify this lease.
Now, when you have an anchor tenant that occupies 20, 30 thousand square feet, and essentially they can leave at any time if the economy goes into a recession, or if they have a supply chain disruption - things like that are very difficult to underwrite. Granted, it's still a triple-net lease, but the devil is in the details; you have to read every one of these paragraphs in the lease.
Now, let's talk about single net or double-net leases. That typically means the tenants will pay, on a single-net lease, they'll pay either taxes or insurance. Unlikely maintenance is the single end. On a double-net lease, they'll typically pay taxes, insurance, but not maintenance. And these are more predictable expenses, where your tenants can budget those expenses in, because they don't vary significantly year over year. Maintenance could be a big deal.
Now, speaking of which, a lot of you may be thinking, "Okay, awesome. If the A/C unit goes out, the rooftop commercial A/C unit goes out, It's $30,000 that I don't have to spend." Now, that's wrong as well, because a lot of times in triple-net leases, you are able to build back the tenants based on the life expectancy or on the contractual language per item. So if the parking lot needs to be resurfaced, maybe you could build that back over one, two or three years. If you have a roof repair, depending on if you just go by the norm or if you go by what's in the lease, it could be something that's billed back over 5 to 20 years, the expected life expectancy of whatever you're repairing.
But please, keep in mind, there's other triple-net leases where if the roof goes out, the tenant immediately pays for it on their dime, and they deal with the entire cost of the repair or replacement.
Best Ever listeners, please keep in mind, those are mostly single tenant net lease buildings. It's going to be very rare that you have a multi-tenant building and one of them is going to pay for the entire roof, even if it is the roof above their space.
Best Ever listeners, I want you to understand how roof repairs or age of the roof or age of mechanicals affects a triple-net lease. If you have a property that has a brand new roof and a brand new commercial HVAC system, tenants will be more likely to sign a triple-net lease, because they know most of their expenses are going to be taxes and insurance. The building is in great shape, the parking lot is in great shape. They're not going to be overly concerned with getting hit with repair expenses. On the flip side, if you have a roof on its last leg, a lot of patches, if the commercial HVAC unit is rusting out, tenants are going to be a little bit more skeptical, and they may sign in more conservative lease where the price per square foot is actually lower, because they're anticipating having to pay some of these big-ticket expenses at any time.
Break: [00:11:44] to [00:13:31]
Ash Patel: Historically, one of the benefits of being in commercial real estate is we have very long-term leases. And today, with inflation on the rise, interest rates going up, it's actually not as advantageous to chase these leases that have seven or eight years left. The gold standard used to be something like a Starbucks, that has a fresh 10-year lease, and they've got multiple renewals beyond that. To a lot of triple-net investors, that's a gold mine, because you're guaranteed a stream of income for the next 10 years, or however many years are remaining on that lease. And the only way Starbucks can typically get out of those leases or any national corporate-backed lease is if the parent company declares bankruptcy. So in the case of JCPenney, Toys "R" Us, Bed Bath & Beyond, if you were a landlord and one of those tenants signed that lease, you're out of luck, because they are now able to get out of their leases, or even through bankruptcy if they restructure, they're able to renegotiate leases with landlords, and they have all the leverage.
Again, Best Ever listeners, I want to make sure you understand this, is that historically we wanted those secure leases that had many years in renewals remaining. Today, because of inflation, you look at all of these apartment landlords, they're raising rent sometimes 12%, 15%, 20%, year-over-year in certain markets, where commercial leases - wer'e bound by whatever is in our signed 5 or 10 year lease. We're also bound by the renewals. Most tenants will negotiate multiple 3, 5, sometimes 10-year renewals at a preset price. I want you to understand that renewals only help the tenants, and they don't help the landlord, because let's say we're in a recession, there's a lot of vacancy in your center, and tenant A has multiple renewals that they're about to exercise one of - they can come back to you and say, "Listen, I know I had a renewal for $15 a square foot, but your center is mostly empty. I'll stay here, but I'm only going to pay $10 a square foot." And as a landlord, you don't have much leverage, because you don't have anything that says, "If the economy's booming, I get to charge you more." Or if we're in an incredibly high inflationary time, you don't get to charge more, unless it's built into your lease, where renewals or annual increases are tied to the consumer price index or some other index that allows you to have a variable rate of increases.
So for the first time in a very long time, we are actually looking for properties that are finished with renewals and options, because now we can readjust to market rates. The risk there is the tenant could leave. So if you have a Dollar General that can open up a shop anywhere, they can build them very quickly, they don't require much other than a block building, a slab and some metal siding, a metal roofing as well, you might not have a whole lot of leverage with them. But if there's a Chipotle or a Taco Bell in a very specific location that's doing well and they're out of renewals, keep in mind, they signed this lease sometimes 20 years ago, and who would've known what the prices per square foot would've been today? We've seen McDonald's that are literally paying $6, $7 a square foot because they had 30 years worth of leases renewals and options.
So if you can find one of those triple-net leases that's coming due very soon, even if it's two or three years down the road, it could be worth exploring, because just like the apartment owners, you can now readjust rents closer to market rates.
Best Ever listeners. I feel like I'm bouncing around a lot. I'm going to go back and reiterate some of the important points that I want you to have as takeaways today. One is that not all single-net, double-net or triple-net property is the same. Not all of those leases are the same, unless you see those words, "absolute triple-net" or "absolute net lease", "zero landlord responsibilities." Even if you see that, you have to dive into the details, because again, there's items that could be expensed over time. They could be amortized if it's a major roof repair, or a roof replacement, or HVAC replacement. These are things that you may have to come out of pocket for the initial expense, but you can bill back over time.
Now, let's go back and think about that for a second. If I have a tenant who's in their 10th year of 10-year lease, and I decide the roof now needs to be replaced, and I spend $200,000 on a roof replacement, what happens to that tenant? Do they have to continue to pay after their lease is over? And the answer is no. They would be responsible for their one remaining year of amortization. If they exercise a renewal option, they would continue to pay for that amortized expense. However, if they decide to leave, they are not on the hook for anything, but again, the next tenant knows that the roof was just replaced and likely not going to be hit with that big of an expense due to the roof.
I also want you to look at triple-net leases a little bit different. Historically, those mailbox leases were very appealing, because it's secured, guaranteed income. However, keep in mind, with inflation, we have rising prices, gas prices are up, commodities prices are up, groceries are up, airfare is up. The price of everything is up, except for those 10-year leases. So if you can look for some expiring leases, you're taking on an additional level of risk, because that tenant may not renew their lease. And if they don't, you're stuck with an empty building and you're having to find a new tenant for that vacant space. So you have to be confident that you'll be able to secure a tenant or you'll be able to weather any downtime that you're enduring this vacancy for.
The upside though is you can take a lease that has a very low price per square foot, and if you find a new tenant or renegotiate with the existing tenant, and you can bring that rent closer to market rates, your NOI is vastly improved. Divide that by whatever your cap rate is, and you can make a lot of money. I spoke earlier about setting up your property for a disposition or a sale, and keeping that log.
There's also things you can do with mom-and-pop tenants. You can get them closer to triple-net. And how do you do that? If you live in a climate where there's snow removal, you can say, "Okay, tenants, every year we're going to bill you back for snow removal", or if there's common house utilities for let's say exterior lighting, or if the landlord pays for heat for an entire building, you can say, "Okay, tenants, we're going to charge a variable cost for house meters, electric, heat, snow removal, landscaping..." Everybody wants a beautifully landscaped business property to work out of. And if you can make a big improvement in the landscaping, a lot of times the tenants won't be too apprehensive about paying for that.
So over time, if you can start billing back a lot of these expenses, one, it increases your NOI, it increases the value of your property tremendously. Even if you have to reduce the rent but add on some of these triple-net type expenses, it perceivably makes this property easier to manage. So that out-of-state investor, when they're doing their proforma, they can say, "Okay, look, all of these variable expenses are covered by the tenants. I still have to deal with these few here and there, but I feel a lot better about this purchase", that could be several states away.
With triple-net properties, the tenants typically pay their CAM or Common Area Maintenance charges, per month. So they know if taxes are $12,000 a year, part of their CAM charges every month is $1000. If they know that insurance is $6,000 a year, they're going to add an additional $500 onto their monthly rent as CAM or Common Area Maintenance charges, and you as the landlord are going to be the one that bills them. At the end of the year, the landlord's job is to reconcile CAM charges with the tenants. So if they underpaid you, you can get that money from them over, let's say, 30, 60, 90 days in the following year. If they've overpaid, you owe them a portion of that overpayment back.
Best Ever listeners, I hope I was able to add some value and you learned a little bit more about triple-net, double-net, single-net leases, some of the nuances that go along with those leases, and what it means to truly be a landlord for some of those leases. A great way to dive into this and look at some sample leases is get on Crexi or LoopNet, find some of these properties that have all of their due diligence materials available to download. You might have to sign an NDA, but you can read through some of these leases, and just look at the different variations from one triple-net property to another, and it'll give you a better understanding of exactly what you're looking for. But don't be afraid to explore this, dive into it. You can find triple-net properties at all different price ranges. So I don't want you to think that commercial properties are very expensive. Yes, the Starbucks are going to be $2 million, but you can find Dollar Stores that are nearing the end of their lease for just a couple $100,000.
Best Ever listeners, if you enjoyed this episode, please leave us a 5-star review, share this episode with somebody you think can benefit from it, and as always, follow, subscribe, like, and have a best ever day.
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