We have noticed triple net leases with shorter lease terms are growing in popularity. As an investor, how should I think about these relative to the typical 10 to 15+ year leases when underwriting private real estate strategies?
First off, for anyone less familiar with triple net leases, imagine a lease where the tenant not only pays the rent but also takes on the lion’s share of the property’s expenses. Welcome to the world of triple net leases (“NNN”). In this setup, tenants cover property taxes, insurance, and maintenance costs, earning the lease its “triple net” moniker. This strategy shifts most financial responsibilities from the landlord to the tenant, making it attractive for property owners who want steady income with less management.
That said, it is important to understand that not all triple net leases are the same. Each lease is unique and tailored to the specific agreement between the landlord and tenant. Most NNN lease terms are 10-15 years on average, some even more. But many leading owner operators of new economy real estate, such as industrial real estate and data centers, are employing shorter term leases to enhance outcomes for their investors.
On the surface, there are attractive benefits of longer-term leases – most notably predictable and stable rental income over an extended period reduces financial uncertainty.
But there are trade-offs. Like any investment that requires a long-term lock up of one’s funds, it’s important to consider who you’re signing up to live with for the next 10-15 years… and what could have been achieved if those dollars had not been locked up. Let’s take a look:
Market adaptability & defensiveness:
In dynamic markets, a short-term lease enables landlords to capitalize on potential increases in property value or shifts in tenant demand. In periods of inflation, cost pressure can be dilutive and shorter term NNN leases may better preserve NOI with higher, more frequent contractual rent bumps. By way of example, shorter term leases can see up to 3 – 5% annual contractual bumps versus the typical retail NNN lease tends to have 1 – 2% annual bumps.
Opportunity for capital appreciation:
Owner/operators can more frequently assess opportunities to make improvements or changes to the property sooner, increasing the value of the property itself in addition to being able to demand higher rents going forward. By nature of its long life, returns of a long-term NNN lease depend entirely on the ability of the tenant to fulfill their financial obligations (rent + operating expenses). There is little opportunity for capital appreciation.
Asset type and location:
Shorter term NNN leases tend to be on infill, generic reusable assets that can lease to a wide array of potential tenants. By contrast, longer term NNN leases tend to be with specialized retail tenants in less in demand locations.
All else equal, we believe the flexibility – both to respond to market conditions as well as tenant conditions – favor new economy real estate strategies that focus on shorter term NNN leases with high quality tenants as opposed to a more concentrated portfolio of longer dated NNN lease properties.
