Why would a multi-tenant industrial or retail property NOT achieve the listed NOI?

Question

Soon purchasing my first commercial property, I am looking at multi-tenant NNN industrial or retail. It seems like other than capex that the landlord is responsible for (typically roof and HVAC) there aren't many reasons why I wouldn't achieve the broker's forcasted NOI.

There are 3% rent increases built into the leases and I can bill the tenants for increased CAM expenses, taxes and insurance.

Am I missing something here? Is there any risk of not achieving the listed NOI other than a tenant moving out? If a tenant leaves I know I will be hit with leasing fees, TI's and vacancy.

Henry Clark · Answer

1.  Never trust anyone's NOI or Cap rate figures.  I never use 100% occupancy, even if it currently exists.

2.  Never trust lease contracts.

3.  Never trust insurance coverage.

4.  Never trust zoning and permitting assumptions.

5.  Assess capex.

6.  Any EPA issues?  Lead pipe, abestos, etc.

7.  Any subcontractor issues?

I'm sure their math works.  It would primarily be the due diligence items that would cause a snag.

John McKee · Answer

Here are some examples of misinterpretations I've encountered:

HVAC. Tenant response is that we don't own it.   Landlord Response: but your the one who wore it out!

Paving:  Tenant says this is a landlord responsibility.  Landlord Response:  It's your customers that are causing the wear and tear.  Resealing is an operating expense on you.

Glass:  Tenant thinks this is a part of the structure.  Landlord Response:  No it's not foundational and neither are the floors your tenants walk on.

County says you need to plant new grass in the water retention area on the property with new grass.  Tenant says this is not part of my business.  Landlord Response:  Not my problem, lease says you pay everything.

Roof leak:  Tenant says your responsible.   Landlord says I will do a full replacement, but not minor repairs.  Repairs are on you.

The point is you have to spell out EVERYTHING in your lease.  Unfortunately leases that were inherited do not do this very well.

Alex Sarnoff · Answer

Sounds like capex as opposed to operating expenses which are usually left out of NOI for all asset classes.

Example for multifamily- My 4plex had a tenant in one unit paying $24000 annually of which I achieved $14,000 annually NOI after taxes, insurance, yard work, common area utilities. After the tenant was there for 3 years they moved out. It was trashed, I had to repaint, redo carpet, cabinets, holes in the walls etc. It cost me $10,000 to renovate and 2 months of lost income so effectively $14,000. I just lost ONE FULL YEAR OF NOI on the 3 years leased to that tenant.

When I sell that property, it will be listed as $14,000 annual NOI for the unit. The next investor takes the risk.

I'd rather go with a NNN lease property even if the lease isn't iron clad.

Sohail Bas · Answer

Your biggest risks are tenant defaults and rent collection issues. Take for example covid times, lots of defaults or people asking for rent abatement.

Also make sure you have a good inspection done. Hidden damages or poor construction can cause issues down the road.

And last but not least any environmental issues can be a big hassle. Check to see if any previous dry cleaners have operated there among many other things.

Gabriel Graumann · Answer

@Alex Sarnoff I like what Evan and Henry have already shared. Going from MFH to NNN retail or industrial, you are trading one set of issues for another, though presumably easier issues. MFH carries all of the emotional issues and local governance that tends to favor tenants over landlords because you're dealing with "people's homes", not an investment property. From a management position, Evan is correct in that most issues are dealt with on a business hours timeframe vs. 24-7 for anything residential in nature. If you intend to self-manage, you will appreciate this difference long-term.

For the rest of your question, as Henry already stated, don't trust someone else's numbers. Perform your own investigation and build your own rent roll/spreadsheets to confirm everything. Draw your information straight from the leases on a tenant-by-tenant basis. Work hand-in-hand with your broker and leasing agent to confirm what market rates are doing compared to what is being paid currently. It's easy to say you'll raise rents to market rate but pulling that off can be difficult in softer markets with supply/demand dynamics without causing temporary vacancies, which leads to new TI's and other lease incentives to refill the space.

I'm sure you have an investment strategy for the replacement property, and that should include which markets you are looking to reinvest in. That is perhaps the most important question if you're considering multi-tenant NNN retail like a strip mall instead of single-tenant net lease deals. Based on your purchase price I would assume the latter. In theory, you should only be considering the strongest of markets, buildings in the best locations, with high demand and high barrier to entry for new retail developments. Where do the people (and business by default) want and need to be? Buy there, even if lower cap rates. A strong location with solid tenant mix, with strong market dynamics will trump a higher cap rate opportunity in a secondary market over the long-run 100% of the time. One vacancy in a lower tier market, could take 1+ years to fill, compared to a prime retail location that has a tenant waiting list just hoping a vacancy appears at a center. More demand equals less TI, rent abatement, or other LL concessions to provide when a vacancy does occur, so select accordingly. Your overall return on a 10-20 hold period will show the merits of this approach.

Evan Polaski · Answer

@Alex Sarnoff, I will add to others, that there is a lot that should be covered in the hypothetical and legal world of NNN (even if they are absolute) but in the real world doesn't work.

Whether is be national tenants with NNN carveouts and caps or local tenants who simply can't afford any unforeseen increases to their NNNs, you will always run into something.

And speaking about retail, you also have other real world issues that can impact things: co-tenancy requirements, use restrictions, etc, that may not be an issue with the current tenant lineup, but can certainly impact your ability to fill vacancies or maintain occupancy as tenants roll.

And to address what seem to be your follow-on questions for people: there is no exhaustive list.  If you are serious about either retail and/or industrial, I would be sitting down with brokers, looking up owners, making friends with people that work in the space and trying to pull out their war stories.  And not just the investment sales brokers, but the leasing brokers.

The biggest downside to me of retail or industrial is that any vacancy is likely going to sit a long time, and cost a lot of money to fill (6% commissions to leasing agents on the full gross rent over the entire term and TI buildouts/allowance that can run into the tens of thousands and up).  The upside is typically better returns (assuming not totally mismanaged) and management is business hours not 24 hours, typically.

Alex Sarnoff · Answer

Do you happen to have an exhaustive list?

John McKee · Answer

NNN leases are not absolute NNN leases.  Yes absolute is a term in the industry.  A lot of properties are advertised as NNN, but you have to read the lease to understand what is actually covered.  So for example:  NNN usually refers to taxes, insurance, and maintenance.  How do you define maintenance in the lease?  Does maintenance factor in replacement costs of the HVAC, Roof, Glass windows, structural piping, Parking lot repaving, sprinkler systems, etc.  How much of the structural part of the space is covered by the tenant?

Why would a multi-tenant industrial or retail property NOT achieve the listed NOI?

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