Triple net leases are a great way to lock in a safe, fixed return on a property. But they also have some unique risks that should always be considered before investing in this asset type. So what are the traps to watch out for that can damage your investment return or even return of principal?
Locations that actually lose value over time
Triple net leases are typically built around long durations of time – often 10 to 15 years. Therefore, it’s critical that you only invest in properties that will appreciate in value over time, and not become less valuable. Take, for example, a post office triple net lease of a building on Main Street in a small town. They triple net lease the building for 15 years, and everything appears fine. However, when the lease ends, the small town downtown area is blighted and the building is only worth a fraction of what you paid. The moral is that, even in triple net leases, success is all about location, location, location.
Tenants that default
Just about the worst thing that can happen with a triple net lease is for the tenant to default on paying their rent and moving out. That’s because you have bought into the investment at a low cap rate with the promise that there will be no disruption in the flow of rent or sudden capital expense needs. To guard against this, you must only engage in triple net leases with strong, stable tenants. Don’t even think about triple net leasing with any tenant who has no track record or has a weak financial statement.
Instability of interest rates
Real estate is all about leverage. Most investors put down 20% to 30% and obtain a loan at 70% to 80% LTV. Since triple net leases are typically at lower cap rates, they often are only marginally above the interest rate on the loan. The problem, therefore, is if the loan matures or resets with higher interest rates as a result of instability in the credit markets. You cannot afford to have the interest rate go up while your triple net lease payment remains fixed.
Obsolescence of design
Consumer tastes are always changing, and so are the specifications that are in demand for triple net tenants. For example, modern warehouses have higher ceilings due to advances in forklifts and how merchandise is stored. Older buildings with shorter ceilings are no longer in demand, and that has a huge impact on values. Even retail buildings on a triple net basis run the risk of changes in design that can impact values.
Triple net lease investing can be safe and profitable – as long as you know what the dangers are and how to mitigate them. This list will help you identify the potential traps in this unique form of investing.