NNN v. other commercial - which really has the best returns?

Question

Hi Everyone -

Thanks for all your valuable discussion and willingness to share advice.  Tapping into the wisdom and thinking of folks who have greater perspective/different perspective and experience is so very valuable.

Here's my question:

Courtesy of an upcoming property sale and 1031 exchange, I have a sizable chunk of equity to invest. Figuring out what strategy to use and weighing either putting it all in an absolute NNN property or splitting into two properties that are commercial office and multi-family as a way to diversify.  Planning to buy and hold for quite a while if I get it right - what with 1031 possibly being gone and also just the work to find and make transactions, want to put the money somewhere it can stay for a long while.

I know absolute NNN gets lower cap rates that the other types, and I'm not afraid of some hands on management (have managed SFR for more than 10 years) but what I am trying to figure out is if the somewhat better cash flow (cash on cash) from the commercial/multifamily actually balances out to about the same returns as the absolute NNN once you account for the maintenance, leasing agent fees, etc. that one will incur over a 10-20 year time frame OR if the total returns are better for the commercial/multifamily provided one is willing to put in the time to manage them.

In other words, NNN gets much lower cash flow, the others higher - so NNN seems like you make less money but is that really true over the long term?  The others require more work, and possibly more investment along the way.  What is the experience of those on these forums - after, say 20 years, are they all about even or will one of those investing strategies leave me with greater *wealth* (i.e. not just cash flow, but also appreciation).  Realize that can vary by location so assume same location.

Thanks very much - look forward to the replies.

Christian Decker · Answer

This is a wonderful question! Personally I love NNN buildings (not absolute NNN) I own 3 NNN buildings (2 retail, 1 office) and a gross office building. Your question has multiple layers but I'm going to focus my response on 2 of those, first is multi-family vs commercial, and second is NNN, Absolute NNN and gross rent structures.

1) Commercial vs Multi-Family. Personally I love Commercial (Retail, Office or Industrial) over Multi-Family for a lifestyle advantage. With commercial you typically have less tenants than a multi-family building of comparable value. This means less headaches (for me). Second reason I prefer commercial is that you are dealing with businesses instead of residences. There is more professionalism in commercial and very rarely are there problems that come up after working hours. This allows me to have a better separation of work and home life. Finally, Commercial traditionally has longer lease terms (5-10 years in my market) instead of the 1-2 of multi-family. This provides security and even though there is risk in the longer down time to release, I just budget that in.

2) NNN, Absolute NNN and Gross Rent Structures. You say in your post that NNN gets lower cash flow, I am assuming this is an Absolute NNN building. Personally I do not like the returns on Absolute NNN's. I prefer NNN buildings for many reasons. First, a majority of our buildings have property management built into the NNN cost, so that does not come out of my pocket. Second, The tenant covers all the expenses of the building, so if insurance or property taxes spike, the tenant covers that instead of us. With a Gross lease, you have to bite that expense and the property manager expense. So, I feel like I personally get the best return on NNN buildings even though they require a bit more accounting. Personally, the decreased return of an Absolute NNN building does not add the value of not having to manage it because I know by having a manager or self managing I can get a better return on the same building.

Naturally, these are my opinions. I'm happy to discuss these further if you would like! I like buying gross buildings that are poorly managed, cutting costs and then releasing as NNN. Good Luck!

Joel Owens · Answer

On Absolute single tenant NNN there is no management fee. On NN sometimes there is an admin fee the tenant pays. Either way it is nothing like owning a retail center at all.

I look at about 1,000 of these properties a week and it's all I do. My clients that own NNN single tenant absolute literally might put in a few hours a year time. It's mainly sending tax notices to the tenants and updating financials to the lenders once a year. This is for BBB-investment grade tenants. If you had mom and pop tenants or small franchisee on absolute NNN then maybe you put in more time and hand holding on a few items.

Single tenant NN it depends on what is written into the lease it could be just roof with a warranty and little to nothing to do OR it could be roof, structure, parking lot, utility lines, association fees as part of a larger project etc.

When you start doing all that for a lower return and cap rate it gets away from the intent and spirit of owning NNN so my clients do not really by those. The cap rate might be 20 basis points higher on the asking price and better to buy something without all that and negotiate 20 basis points higher from asking with better lease structure.

When you get into neighborhood street retail with say 3 to 5 tenants if they are all national credit rated then typically base plus cam rent and management fee built in. Management not heavy with national tenants you might talk to property manager once a month and review a report. When mix of center moves more to regional, small franchisee, mom and pop tenant mixes and 5 tenants and up the work for yield increases a lot. Still not what multifamily usually requires but more involved and dependent on a good manager.

I know people that own the larger retail shopping centers grocery anchored. I don't really care for those that much as I am not that big on management. Syndicators love to syndicate those deals just like multifamily because they take huge sponsor fees going in so if the deal tanks and doesn't perform like they said they still made bank.

I like buying dark STNL deals because with one lease the value is fully realized right away and in a short time span of under 1 year whereas these big projects have long lead time projections of 7 to 10 years to double the money invested. During that time as you get some tenants into a center certain other businesses can go out so really getting nowhere. REIT's love buying that stuff because of their fee structure and how they make money. I would not touch such a property unless I knew current tenants were paying way below market rents so if some go out I have upside and not just replacing with expenses being paid out. Sometimes even if rents are close to market but tenants are mom and pop bought at high cap rate then could still win. If tenants stay you blend up high cap rate further and further for higher cash on cash return. If they go out of business and you replace with more regional to national credit tenants with longer and better lease terms then value cap rate on resale can compress to build exit equity higher.

I love retail but I do it everyday. Where people see risk I see opportunity but with knowledge you can see what is a dud and what can be made into a diamond.

Joel Owens · Answer

Hi Gillian,

Hopefully others will chime in. NNN properties like other asset classes receive multiple offers. The good ones anyway. For sure regular office and  multifamily are not comparable to NNN.

In one you are doing a lot of work as an active asset. Multifamily you have residential landlord tenants laws for even more of a headache.

Stabilized multifamily are often trading at lower cap rates than NNN properties. Multifamily right now is over heated in many aspects. Regular office is having a hard time which is why cap rates look higher.

As to what will work out better in the long run nobody can predict the future just look at Coronavirus. There are things that happen in history that nobody can predict or expect to happen. With NNN having long term fixed rate debt of about 10 years can be key with fixed rental increases.

Multifamily rents have been on a bubble bull run the last 4 years or so but won't last forever. Over time they tend to average 1 to 2%.

Often for upside deals it's a game of musical chairs where timing can be everything and you can win big or lose it all.

I don't know how stabilized multifamily has higher cash on cash than NNN in certain price ranges. Now people with multifamily can say you rehab units, increases rents, etc. but that is all theoretical upside money that may never become a reality.

On a comparison basis medical office might have some value add upside. NNN in great locations can have increased dirt value over time.

It's just a personal preference really. If you feel more comfortable and confident in using your hands on approach to increase value then you might want to stick with that. Maybe a medical retail strip center with 1 to 2 spaces to fill would give you some upside but more cash flow going in. The tenants pay above base rent with CAM to reimburse.

Alex Olson · Answer

As I posted on another forum, just closed on one for a 1031 exchange client. They trade at 1.5% point higher than projected multifamily.

Mark H. Porter · Answer

I’M with others.  I own LTR, STR, and a single-tenant NN.  The STNL is the long-term prize.

Ronald Rohde · Answer

Lots of good points already. I'll add two more 1) risk tolerance (inflation, vacancy, etc.) and 2) ability to scale.

The more concerned about inflation you are, you should want fixed expenses and market rents. NNN assure you that even if insurance/taxes double, your returns stay the same, e.g. the tenant will pay. I view my NNN as a hedge against inflation, my rents have escalators, but returns are pretty fixed. If I had a gross property, or even multi-tenant with vacancy risk, I'd worry that my expenses increase faster than my rents.

Finally, I run a very busy full-time law firm and have a young family (2 kids). I want investments that I can scale and easily pop down additional $500k into one property. NNN solves that for me much easier than any gross property that I'd have to answer to the PM every other week.

Andrew Tripp · Answer

Obviously, the more expense you can shift to the tenant, the better generally speaking because that removes some variability.  But one thing to consider with NNN leases that I don't hear talked about nearly enough is that those aren't management-free assets.  Not for smart landlords anyway.  In a multi-tenant set-up, the landlord is collecting pass throughs and paying everything itself and taking care of the common areas. Taxes must be appealed/protested, and service providers managed.  And additional bookkeeping.  Plenty to do from a management perspective, and you'll earn the management fee.  Even with a single-tenant NNN, the landlord will still wants to adminster/pay the RE taxes and property insurance itself itself so that nothing slips through the cracks, especially if you have a mortgage.  You won't have common areas to manage, so maybe the management fee will be lower.

They aren't like a 40 unit apartment complex, but NNN deals aren't quite the coupon clippers some make them out to be.

NNN v. other commercial - which really has the best returns?

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