Every real estate investor knows there are three primary ‘net’ expenses associated with real estate: Property tax, building insurance and maintenance. Under most types of lease structures, the property owner bears responsibility for these expenses while the tenant pays rent and utilities. It’s a structure that’ll serve you in most of the rental properties you own.
But, because the three net expenses can be unpredictable, there may be months (or years) when a property owner fails to generate a profit. It all depends on the property and the situation. A string of unfortunate events could skyrocket your property maintenance costs, for example. It’s part of the risk every investor needs to factor into their property ownership plan.
There is, however, one lease structure that allows the property owner to pass on the responsibility of these three expenses to the tenant: The triple-net lease.
Get to know the triple-net lease
Under a triple-net lease agreement, the tenant pays for property tax, building insurance and maintenance, as well as rent and utilities. It sounds too-good-to-be-true, right? Well, it’s very much a real thing!
These are typically long-term agreements with commercial tenants, lasting as long as 10 or even 20 years. They’re only possible when a single tenant occupies the building. And, generally, they’re only something to consider if you have a prime piece of real estate or one that may become highly in-demand with future development.
Additionally, there are significant drawbacks property owners should be aware of prior to signing an agreement—we’ll discuss these later on.
If you believe you’ve found the right property and the right long-term tenant, triple-net lease agreements could help you earn a dependable passive income with relatively little effort. Before you sign anything, make sure you’re thoroughly considering the pros and cons of the situation. Ultimately, a triple-net lease is something you’ll be working with for a decade or more.
The benefits of a triple-net agreement
The most obvious benefit of a triple-net agreement is its predictability. When a tenant assumes responsibility for the flexible costs associated with real estate, you can sit back and collect passive income. This is ongoing for the vast majority of the time of the lease agreement.
Because the terms of the lease agreement are laid-out in advance, there’s a stable source of passive income flowing out of your investment property. You’re collecting the same amount of rent every month, with small increases built into the terms of the long-term agreement. You can depend on this income to continue, so long as your tenant is fiscally sound.
Triple-net agreements also remove many of the complexities of real estate investment. If you have a building under a long-term triple-net lease, you’re not expected to maintain the building. You also don’t have to worry about drawing up new lease agreements every year, or every five years. While your triple-net lease is active, all you have to do is sit back and worry about how you’re going to reinvest your passive income.
Triple-net tenants are the epitome of a set it and forget it investment, which is why they’re so hard to come by. But, if the variables line up and you’ve got a trusted tenant ready to assume these responsibilities, it’s a no-brainer to draw up a triple-net agreement.
The drawbacks of triple-net leases
Positives and benefits aside, triple-net leases are far from perfect. There are several key pitfalls to be aware of before investing in a triple-net property.
First and foremost, triple-net properties require you to depend on a single commercial tenant for as long as a decade. While this can be a great situation if you’re working with a well-established, financially sound tenant, it’s impossible to predict what the market may look like 10 years from now. If your tenant fails, it may be extremely difficult to secure another triple-net tenant. Many new tenants will demand you make improvements to the building before they move in and assume responsibility of maintenance.
It’s also important to understand that triple-net lease agreements significantly limit your flexibility as a real estate investor. For instance, if you own a triple-net leased property and your local real estate market picks up significantly, you won’t be able to raise the rent or sell off the asset until the end of the lease. You’re locked in!
While it’s true most triple-net leases include marginal rent increases, these typically only add up to 1-5 percent each year. The low-risk associated with a stable tenant is usually offset by a lower reward in this case.
Choosing a triple-net tenant
If you have a commercial property you think is suitable for a triple-net lease, carefully consider the type of tenant that you enter into an agreement with. It should be a business with a history of stability and success, as well as measurable demand and proven patronage. After all, you need them to stay in business and flourish for the next decade and beyond.
First, take a look at the business’ credit rating. If they have an ‘investment-grade,’ credit report from a major credit reporting agency, they may be worth considering for a triple-net lease. If they don’t have investment-grade credit, however, don’t pursue their tenancy any further. When you offer a triple-net lease, you’re essentially investing in the strength of their business.
You should also have a careful look at their balance sheets. They should have enough assets on-hand to immediately meet any debt obligations, and they should have a strong long-term outlook. It’s important to have frank, up-front discussions with potential tenants about the health of their business. It’ll impact their ability to competently cover property taxes, maintenance and building insurance.
Is triple-net for you?
Pursuing a triple-net lease agreement can be a great way to easily and consistently generate passive income. Be sure, however, to properly analyze prospective tenants, and understand the risks associated with this lease structure before making an investment.
The right scenario can land you a steady income with few-to-no headaches; a rushed deal could stick you with a tenant or a property that’s nothing but trouble.