What is Net Lease?
A net lease is a lease structure that places the responsibility of building expenses on the tenant, in addition to the rent paid. Those operations costs include property taxes, insurance, and maintenance; creating a passive income stream for the landlord.
Who Uses Net Lease?
Retailers, corporate offices, industrial users, healthcare providers, and government facilities utilize net leases for various reasons. Whether they use absolute triple net leases, double net leases or other net lease expense structures, net leases provide a wide range of benefits.
What are the Benefits of Net Lease?
- Developers want to build the property, lease the property, sell the property to an investor, and then reinvest the capital into their next development project.
- Tenants want to focus their time and capital on running their operations, improving their supply chains, and growing their core business – for occupiers that currently own their real estate, the sale of their property to an investor provides capital to reinvest into their core business.
- Investors want a return on their capital, hassle-free property ownership, tax advantages, and reliable cash flow.
What is a Cap Rate?
Most net lease investments are traded based on their capitalization rate, or cap rate. A higher cap rate usually means more risk for the buyer, which justifies a higher return, while a lower cap rate typically means less risk for the buyer, but they’ll pay a premium for the “safer” investment.
Cap Rate = Net Operating Income ÷ Current Market Value (or Sales Price)
Example: A property that generates $60,000 per year and is valued at $1,000,000 would be a 6.0% cap rate ($60,000 / $1,000,000 = 0.06 or 6.0%)
Factors to Consider When Investing in Net Lease
Location
- Is this a location with demographics to sustain the business of the current tenant?
- What type of tenant could take its place if the current tenant vacates?
Tenant Credit
- How likely is the tenant to pay their rent and fulfill the terms of the lease?
Lease Terms
- How long is the lease?
- What type of rent escalations are included?
- What is the expense structure?
Types of Net Lease
Among net lease investment properties, there are sub-types of net leases with different expense structures. Depending on an investor’s needs, different expense structures and levels of landlord responsibility can be leveraged. Lease sub-types include: absolute net lease, triple net lease, double net lease, and single net lease expense structures.
Advantages of Net Lease
(always consult your tax advisor or financial professional)
Passive Cash Flow As described above, an absolute triple net lease structure is a true hands-off ownership structure for the landlord. This is sometimes referred to as “mailbox money” or an “armchair investment.”
Depreciation Tangible assets, like a property, can be depreciated over time allowing investors to lower their tax burdens.
1031 Exchange Reinvesting the earnings of an investment property sale into like-kind real estate allows investors to defer capital gains taxes on the proceeds.
Common Net Lease Investment Strategies
Not all investors share the same strategy. Some are motivated to buy net lease investments for the passive cash flow and hands-off ownership structure, while others are looking to buy, sell, and reinvest the proceeds. Some of the more common strategies for private investors and developers include:
- Buy & Hold – Purchase an asset with no immediate intent to sell it. Investors can depreciate the real estate over time and collect the passive income stream for the length of the lease term. Some investors may choose to purchase an asset in a market or sector with anticipated growth as they seek long-term appreciation for that property.
- Reinvest & Build – Buy a property with the intent to sell it in a 1031 exchange, leveraging those proceeds to purchase a larger asset or multiple properties while reducing taxes. Developers who build net lease assets intend to sell those properties in order to reinvest the earnings into their next construction project.