417: Investing in Triple Net (NNN) Commercial Properties – Part 1

SHOW NOTES FOR EPISODE 417: INVESTING IN TRIPLE NET (NNN) COMMERCIAL PROPERTIES – PART 1

There are many types of real estate investing, from fix and flips to rental properties to self storage to mobile home parks, to name a few. Triple Net (NNN) leasing, although having a higher price tag, has a great return without the hassles associated with other types of lease based investing like office or residential leasing.  In this episode, commercial real estate broker and investor Joel Owens shares the value of this truly passive real estate strategy and some of the long-term benefits.

What You Will Learn

• Why commercial triple net investing is the most desirable type of commercial investing
• What double net, ground lease, multi-tenant lease properties are
• The best markets to to have a triple net property
• What the different types of “flat rate retail” are and where CVS and Dollar Stores fit in that definition
• How to get into commercial leasing for as little as $400,000
• What the requirements for a net lease landlord
• The five levels of risk of potential tenants

About Our Guest

Joel Owens

Joel Owens, owner at NNN Invest, is a principal commercial real estate broker and investor with a special emphasis on commercial retail Single Tenant and Multi-tenant properties nationwide. He has 16 years of experience and evaluates thousands of properties a week across the country. He enjoys retail because of it’s more passive aspect of ownership and returns versus other types of real estate.

More About Joel

• Growing up, he started a number of businesses: car audio business at 18 years old
• Worked at Domino’s Pizza, became manager
• Owned a restaurant franchise – required too many hours
• A friend just sold his business and went into real estate
• That sounded good, so Joel got his license
• Started in residential for a few months but didn’t like the nights and weekends again
• A friend referred him to a guy (a developer) selling a laundromat
  • He reviewed the guys purchase and sale contract and helped him a lot
  • The guy was impressed and asked Joel to work for him assembling land pieces for a 25 acre, mixed use, commercial development, $150 million after build value, 600,000 of retail
  • He spent 3 years doing that
  • Around 2007-2008, the great recession hit
  • There wasn’t much development going on because buyers could purchase existing buildings less than they could build them
• He moved into selling large apartment buildings (still does it part-time today)
• His main focus is now on commercial retail properties over the last 10 years (90% of his business)

Commercial Retail Defined

• Commercial Retail defined
  • Single Tenant – One tenant, one building
    • Absolute Triple Net (NNN) – You own the land and building
      • Tenant pays for building upkeep, property taxes, landlord insurance, anything involved with the building – they care care of it
      • You, as landlord, just collect the checks and you have the full tax benefits
    • Double Net (NN) Lease – You own the land and the building
      • Landlord may have responsibility for some or all of these: the roof, structure, parking lot, utility lines that run underneath the parking lot (it depends what is written into the lease)
      • Cap rates can be higher but the capital expenditures can be high
    • Ground Lease – You own the land but not the building
      • Tenant pays you rent
      • Tenant pays for construction and maintenance of their own building
      • You have a “primary lease term” – for example, 10-15 years where they guarantee they will pay the landlord on the lease.  After that, the options and renewal kicks in
        • If they don’t renew the option on the ground lease at the end of the primary lease term, the landlord gets to keep the building for free
    • Multi-Tenant Net Lease Properties (MTNL)
      • Retail centers
        • Power Center
          • REITs generally own these
          • Couple million square feet
          • Super center with a Target, Costco, Loews – big box businesses
        • Neighborhood Street Retail
          • What most of his clients buy
          • The hottest are right now
          • Internet-resistant tenants
          • Usually sitting outside of a subdivision in strong suburban core area, high median income and population levels
          • Suzy homeowner can go there, put her kids in Karate classes while she goes to the nail salon next door and afterwards, pick up the kids from their Karate class and walk down to the Pizza Parlor at the end for dinner
          • Large malls used to fulfill these needs prior to Amazon

Different Markets

• Three different types of areas
  • Urban Core Areas
    • Strong Suburban
      • Joel prefers his clients choose this market unless they live near a property in the other locations
      • Higher price points
    • Weak Suburban
    • Rural Location
  • If you are retired and want to travel and don’t want to worry about the property, NNN in Strong Suburban Urban Core areas are best

Different Types of Flat Rate Retail

• Walgreen’s and CVS – during the primary term, they have flat rent but in the option periods they will have rental increases
  • $2.5-10 million to buy
  • A lot are typically $3-4 million
  • Preferred
  • Typically on a red light corner
  • Two high traffic roads intersecting
  • Large back anchors
  • 10-15,000 sq ft all brick building
  • Sitting on 1.5-2 acres of prime real estate
• Dollar General – during the primary term, they have flat rent but in the option periods they will have rental increases
  • Can buy for $1.5-2 million to buy
  • Construction – Sheet metal sides and back
  • Mid-block locations – not as optimal
  • If you lose the tenant it will be hard to find a placement

Types of Assets

• Stabilized Assets
  • Tenants already in-place
  • Good for retirees
  • Example: Buying a Walgreen’s
    • Buying for $4 million
    • 30% down: $1.2 million
    • Loan of $2.8 million
      • Interest rate of loan 4.0%
      • 25-30 year amortization
      • Fixed for 7-10 years
      • Borrowers are looking at buyer’s net worth to match loan balance ($2.8 million)
      • 10% liquidity ($280,000) – they don’t count stocks in this number
    • 6.0 cap rate

Lease Terms

• It used to be that brand new buildings would have 20-25 year primary lease term for NNN tenants
• But recent changes in account changes, because of different debt load assessments, so now companies prefer to sign 10-15 year primary lease terms
• When developers build these types of properties ($5 million and less), they typically have a “cap rate to cost,” which means a break-even for the developer, which means they sold and didn’t make a profit. That’s typically a 9 cap
  • When the developer sales, they have to pay long term capital gains, legal fees, brokerage commissions
  • Typically, that takes away 100 basis points of return (100 basis points is equal to 1%)
  • Do, if the sold at a 9 cap, that means their break-even is an 8 cap
  • That means that they will typically sell the property, fully developed, with a tenant in place, at a 5 to 6 cap, making 200 basis points of profit  in their spread
• When you look to buying this properties, you start out at a 15-year primary term lease
• As the years wind down, anything with 7 years or less remaining on the primary term lease, is hard to get financed because:
  • the cap rate is a little higher
  • There’s less security from the tenant on the length of the primary term of the initial lease because the lenders don’t count the options.
  • Lenders don’t count the option period because the tenant may not renew the option period and then you’ll have a “dark building” where you’ll have to get it re-tenanted again
• There are some higher cap rate deals, for example…
  • Where a Walgreen’s, instead of being a 6 cap with 14 years left on the primary term lease, maybe it only has 5 years left on the lease, is in a good location, and the cap rate instead is like a 7.5
  • But, when you’re ready to buy, you’re not going to get in with 30% down.  You’re going to have to put 60-70% down to get the loan
  • On single tenant properties, the way the lenders look at the value is…
    • they will get an appraisal done and ask the appraiser to do a value of the building with a tenant and income in place
    • They’ll also get a “dark value.” A dark value means, at the end of the primary lease term, what is the property worth without a tenant and income in place-  with just a vacant building and the land that it sits on?
    • The lender want’s the property’s mortgage balance to be paid down to be less than the dark value
    • That way, if you can’t re-tenant the building and the lender had to take the property back, they would be made whole on their loan
    • That’s why the calculation with how many years left on the primary lease term equates to whether you can get a 25 to 30 year amortization schedule or a 10 or 15 year amortization
      • The less years left on the primary lease term, the less years on the amortization schedule because they want accelerated pay-down on the mortgage balance

New Tenant Ramp-Up Time

• How long does it normally take to find a new replacement tenant?
  • It depends on what type of property
    • Mom and pop tenant (not part of a franchise brand)
      • Like Joe’s Tacos
      • Just looking to relocate
      • These usually move the fastest and can make decisions the quickest
      • From LOI to lease execution stage to getting all the necessary permits and build-outs to opening – 3-4 months
    • Regional tenants –  6 months
    • National tenants – (Walgreen’s, Starbucks) 9-12 months

Finding the Right Property

• You want to look at rent-per-square-foot
  • The value of the dirt is what drives your long-term success
  • If you have a great location, with high traffic counts, great visibility and access, that’s where the value will be for the long term
  • Example:  If you call up a typical broker on the seller side, they’ll just try to sell you whatever’s out there
    • One of his clients was looking at a Starbucks in a weak suburban area
      • The broker was saying
        • It’s a great national tenant
        • It’s only $1.9 million
        • 10 year lease
        • It’s an amazing property to buy
      • But when you look at it
        • They had an early termination clause on the 10 year lease
        • And Starbucks went out in a weak suburban area in an economic downturn
        • Rural to weak suburban areas are first areas to decline and the last to recover
        • Whereas, urban core to strong suburban areas that stay more stabilized in an economic downturn and are the first to bounce back
    • Joel had another client that was looking for a Starbucks
      • He found a property for his client that was only $400,000
      • Whereas the income average for the other Starbucks was $66,000, the income for this area was $125,000
      • An “A class” location versus a “C- location”
      • They still have the Starbucks today
      • It’s not just about the tenant.  It’s about the location as well
• What kind of property you can buy depends on your price point
  • That’s why Joel always looks at the client’s financials first
  • If a client’s price point is $10 million and below, there’s only certain tenants that would fit that price point
  • If you’re $2 million and below…
    • You won’t be looking at
      • Pharmacies
      • Sit down restaurants (Red Lobster, Olive Garden, Bahama Breeze, etc.)
    • You will be looking at:
      • Auto Zone
      • Advanced Auto Parts
      • QSRs – fast food places, quick sit-down
        • Bojangles
        • Taco Bell
        • Subway
      • With pizza places you have to be cautious
        • Pizza Hut went to only deliveries
        • They have eliminated sit down eating space
        • They may have a drive through
        • And just a counter for pick-up

Five Levels of Risk

• HIGHEST LEVEL OF SECURITY
• For example: Yum! Brands
  • Owns Kentucky Friend Chicken and Taco Bell
  • The most security on a lease for the landlord would be:
    • Their guarantee (which is backed by over 20,000 locations)
    • The guarantor is the parent corporation
• SECOND HIGHEST LEVEL OF SECURITY
• Subsidiary of the parent corporation
  • 20 other states and 6,000 stores is backing it
• THIRD LEVEL OF SECURITY
• Large Franchisee in the Yum! Brand organization, for example
  • Owns 100 Taco Bells
  • Been in the industry 10-20 years
  • Well established
  • They are backing all their stores
• FOURTH LEVEL OF SECURITY
• Small Franchisee
  • Owns 1-3 locations
  • Never to the system
  • Not that well established yet
  • Net worth isn’t as strong as a large franchisee operator
• FIFTH LEVEL OF SECURITY
  • Not a Yum! Brand
  • No franchisee agreement
  • No royalty advertising backing them
  • Mom and Pop
  • Joe’s Taco type of business
  • Highest risk

THIS CONCLUDES PART-ONE OF OUR PODCAST SERIES ENTITLED “INVESTING IN TRIPLE NET (NNN) COMMERCIAL PROPERTIES.”  STAY TUNED FOR THE EXCITING CONCLUSION ON MONDAY, JUNE 1.

DISCLAIMER:  Many of the above strategies take knowledge and have a higher degree of risk.  You need to do your research and/or work with someone who is experienced to reduce your risk.

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