I am a Retail Broker - Here's some basics you should know before investing in retail.

[Jameson Sullivan]

Triple Net investments have gained a lot of popularity in the last 18 months and for good reason. There are lots of advantages that Triple Net investments have over other asset types, however, not every investment is created equal and without understanding the basics of net lease retail, it's very easy for an investor to get wiped out. While there are several variations of net leases with different combinations of Tenant and Landlord responsibilities, this is intended to be a high level overview of some general basics you should have an understanding of before jumping into your first net lease deal. 

1. What is a Triple Net (NNN) Lease? Not every retail lease has a triple net structure. Triple Net leases allow the Landlord to pass Operating Expenses (primarily comprised of Property Taxes, Insurance, Common Area Maintenance, Snow Removal and Property Management) directly through to the Tenants of the property on a pro-rata basis. This insulates the Landlord from rising expenses over the term of the lease.

2.  Components of Rent in a NNN Lease. There are two major components to Rent in a Triple Net Lease, the Base Rent and the Triple Net. Base Rent is money that goes to the Landlord. This money can used by the Landlord to pay their mortgage, set away reserves for structural and roof capital expenditures and most importantly, put money into their pocket. The Triple Net Component of the Lease is paid by each tenant on a monthly basis and is an estimate of what the total expenses will be on the property for the year. Most Triple Net leases allow for the Landlord to bill for Taxes, Insurance, Common Area Maintenance and Repair, Reserve Budgets, Lighting, Property Management and mostly all other generally accepted operating expenses for a retail property.

3. Base Rent Triple Net Leases are generally longer term in nature, between 5 and 20 years of initial term with options equal to the initial term. This is very important because Base Rents are generally negotiated prior to lease execution for the entire term of the lease. Sometimes they include annual increases and sometimes they are flat for extended periods of time so it is very important to understand how the base rent is structured prior to buying a deal.

4. Triple Net With some exceptions, Triple Net Expenses can change year over year as the property expenses change. Sometimes it will go down and sometimes it goes up but in either case, the Tenants are expected to pay their portion of the expenses for the property. There are cases where certain portions of the NNN Expenses are capped at increasing more than a certain amount over the previous year which is another thing to take note of when purchasing an existing asset because if the NNN's are capped then the owner runs the risk of absorbing a portion of the Operating Expenses which ultimately kills cash flow.

5. Options to Renew Options are another potential deal killer, especially if the investor has intentions of repositioning the property to achieve higher rents. Options to renew, as mentioned above, can be anywhere from 5 years past the initial term to - in extreme cases - 40 years past the initial term. Generally speaking the options are unilateral, meaning that the Tenant has the right, but not the obligation, to extend the lease WITHOUT the Landlord's acceptance. This can become dicey and should be paid attention to when buying a property. Does the Tenant have options? How many do they have and more importantly what is the rent for those options? In many cases, the rent is predetermined and could have been agreed to in 1990 so the rent that should be $5,000 per month is $2,000 per month and the Landlord can't do a thing about it.

6. Exclusive Use Clauses This is another challenging piece that is fairly unique to retail. In an  Office or Industrial project, competing business can co-exist as neighbors because they are generally providing a service for which the "playing field" is away from the property. In retail, however, the property IS the playing field. Jersey Mike's does not want a Subway in the space next to them because they are both competing for the same client during any given lunch rush so every retailer wants to find the highest quality shopping center they can and protect their space by using an Exclusive Use Clause which, in this case, would give Jersey Mike's the exclusive right to sell sandwiches in the shopping center and gives them legal remedies should the Landlord lease to another tenant that sells sandwhiches. Sounds pretty straight forward, right? Wrong. Consider this: Is a taco a sandwich? According to this article it is! (https://www.usatoday.com/story/news/nation/2024/05/16/is-a-t...)... In addition, Retailers are increasingly asking for broader Exclusive Use descriptions. McDonalds might not allow a chicken restaurant or a Starbucks, Panda Express wants to exclude ALL Asian food (Thai, Pho, etc.) so it is paramount that you understand the exclusive use clauses in each of the leases in the property that you are buying and how it will affect your ability to re-lease your spaces when they do ultimately go vacant. 

7. Concessions This is another monster that can decimate your cash flow if you're not prepared for it and don't underwrite your deal correctly going in. In most cases, new retail leases come with some amount of concessions from the Landlord which primarily consist of a Free Rent Period to allow the new Tenant to build out their space and a Tenant Improvement Allowance which is a pre-negotiated amount of money that the Landlord contributes to the Tenant to assist with the cost of the build out of the space. a Free rent period can be anywhere form 1 month to 1 year (or more) and a Tenant Improvement Allowance could be $5.00 per square foot or $50.00 per square foot (and in some cases a LOT more). Generally speaking, creditworthiness of the tenant is considered when offering a concession package and there are many nuances that go into the final agreed upon package, but being aware that these are expenses you will incur as a retail landlord and planning accordingly is important. 

8. Commissions For an investor coming out of multifamily investing and into the retail world, the cost of commissions can be staggering. Generally speaking, the landlord is expected to pay for a leasing commission for both their leasing broker and the broker representing the tenant. While commissions are negotiable, industry standard today is 6% of the gross base rents for the first 5 years of a lease term and 3% for any years after that split 50/50 between the landlord's broker and the tenant's broker. On a 10 year lease, this averages to approximately 4.4% of the total rents meaning that a space that leases for $100,000 per year in base rent could have a leasing commission due of $45,000 to $50,000. This amount is expected to be paid 1/2 upon Lease Execution and 1/2 upon Tenant opening for business so generally speaking, the entire expense would be incurred within the first 12 months of the Lease term and is not something that is paid out over time as the tenant pays rent.

While this is by no means intended to be an exhaustive list of all things Triple Net, I hope it helps someone looking to get into the space for the first time and maybe save one of you from making a terrible mistake. If you're looking to place some capital in retail assets, I am happy to schedule some time to have a more detailed discussion about your needs or net leased assets in general. 

Jameson Sullivan - Vice President - First Western Properties - Tacoma, Inc. 

[Jameson Sullivan]

@Chris Mason Ha! Double digit returns, must be a killer deal, right? In all seriousness, I will answer in the hopes that someone strolling through this post will not make a GRAVE mistake. 

Cap Rates are, indeed, the percentage of cash the investment creates annually in relation to its price. Cap Rates are also a market indicator of perceived risk in the investment. A lower cap rate indicates that the market has a lower perceived risk in the deal ( meaning that the tenant is MORE likely to fulfill their obligations under the lease) and a higher cap rate (generally) indicates a higher perceived risk (Tenant is LESS likely to fulfill the obligations under the lease or that the income is somehow less stable). A few examples of when you might see a higher cap rate is a non-credit tenant (mom and pop, one store operator, hand to mouth financials) or you might see this with a tenant whose lease term is set to expire in the near term (2 -3 years or less). In the first example, the asset may be priced at a 10 cap but the tenant has a high risk of going out of business before the end of their 10 year lease term so after year two, they file bankruptcy and the owner is left with a negative return as they are funding all expenses themselves and paying to re-tenant the building. In the second example, the higher cap rate has effectively priced in the expense of re-tenanting the building within 2 to 3 years so the 10% cap going in results in a 6% or 7% cap rate after accounting for all of the expenses to re-tenant the building only a few years after purchasing.

For an experienced investor or developer, seeking out underperforming assets as detailed above is their very business model. They hope they take the building back because large amount of equity can be created when they do ultimately refill the building with a national, credit tenant and resell or refinance the building to hold. However, for the beginner investor looking for a "set it and forget it" investment a higher face value Cap Rate is not always a higher return over 5, 10, or 15 year time horizon.

I sold a McDonald's last year for a 3.5% cap rate and received multiple offers at that price point. While a 3.5% return seems low, the buyer profile for this asset was individuals in wealth preservation mode. They were comfortable with a lower return because McDonald's is a behemoth with a large real estate department who very rarely closes a location once it's opened. The real estate in this case also happened to be phenomenal and McD's crushed it out of the location so not only did the interested parties feel that they could take a lower return in exchange for the lower perceived risk that McDonald's would ever close this location but they also knew that the underlying real estate had inherent value and they wouldn't be left holding a bag if McDonald's ever did close that location.

I would also note that there are other things to be cautious of when reviewing deals on a cap rate basis. Is this a Sale-Leaseback wherein the seller has an incentive to sign an above market rent lease in order to procure a higher sales price? Is the percentage rent from restaurant sales baked into the income that makes the cap rate look more attractive but isn't actually stable, secure income over the long term?

There are so many things to look at in this one, but the bottom line is NO, do not just buy the highest cap rate you can find and assume you found the deal of a lifetime.