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GUEST POST: Understanding the Investment-Grade NNN Asset

Estimated reading time: 4 minutes, 6 seconds

Investment-Grade Net Leased Educational Series, Series 1: Understanding the Investment-Grade NNN Asset

What does an Investment-Grade Triple Net (NNN) Lease Agreement mean and how does it apply to commercial real estate?

Investment-grade triple net (NNN) or net leased commercial real estate assets serve as an ideal investment vehicle for long-term investors seeking passive income with competitive risk-adjusted returns, while also benefiting from owning commercial real estate with limited to very little landlord responsibilities. The inherent premium nature of a net leased investment is tied to two integral components, first being the strength of the lease agreement and the second being the strength of the investment-grade credit rated tenant. The essence of an NNN lease agreement maximizes returns by factoring the rental income paid to ownership, net of any property related expense such as taxes, insurance, maintenance and/or utilities. In addition, the stability of the expected rental income generated over the term of the lease is maximized due to the inherent credit quality of the investment-grade tenant occupying the space. A good example of an investment-grade type of tenant would be Walgreens or Citibank. In most cases these lease agreements are also tied to a corporate guarantee further insuring the expected rental income and thereby creating additional value to the property.

So to understand this prime but complex asset, let’s review the first integral component, the NNN lease agreement. The term NNN (Net-Net-Net) lease agreement is defined as a lease agreement between a tenant (“lessee”) and a landlord (“lessor”) on a given particular commercial real estate property whereby the lessee agrees to pay all real estate taxes, property insurance, and property maintenance for the property, in addition to the base rent of the property. Property taxes, property insurance and property maintenance are what corresponds to the three nets or net-net-net. For example, the monthly base rent on a 5,000 square foot building is $2.00 per square foot, and the NNN monthly expense comes out to be $.50 per square foot. The $.50 per square foot NNN expense represents the calculation to cover the annual property taxes, property insurance and property maintenance. The $30,000 NNN expense collected for the year provides the landlord the ability to cover the total annual property tax, insurance and maintenance expenses.

So the value of an NNN lease agreement in essence maximizes the lessor’s base rent value received from the lessee as net of property taxes, net of property insurance and net of property maintenance costs to the building over the entire term of the lease agreement. By having the maintenance and repair costs tied to a NNN lease agreement, it creates an added benefit to the lessor by reducing the amount of active property management duties required of the landlord.

Now that we understand the general “net” term associated with a net lease agreement, let’s review the second integral component of an investment-grade net lease agreement. The second aspect involves the assessment of the “investment-grade” credit quality of the corporation or “lessee” being assigned to the lease. To assess the credit quality of a tenant we analyze the corporate Standard & Poor’s or Moody’s rating assigned to the corporation acting as the lessee. For example, the Walgreens, Co. is assigned a Standard and Poor’s rating of BBB and a Moody’s rating of Baa1, which translates to a commercial real estate value capitalization rate (cap rate) range between 5.73%-6.97%. Therefore, a cash-on-cash return of 5.73%-6.97% would be an appropriate expected average rate of return associated with owning a Walgreens, Co. corporate net leased investment property. So given a Standard & Poor’s and Moody’s corporate rating of BBB and Baa1, a Walgreens, Co. net leased property gains a title of “investment-grade” credit quality because the default risk is currently less than 5% over the period of a 15 year lease term.

By truly understanding these two integral components comprised of an investment-grade net (NNN) leased commercial real estate asset, one can begin to appreciate the value that lies within this type of asset class.

The information provided in this guest post is for educational purposes only and should not be construed as advice of any kind.

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