What to Look for and What to Avoid

As a seasoned expert in the 1031 exchange space, I’ve seen many investors assume that triple net (NNN) leases are a guarantee of a hassle-free investment. However, this assumption can lead to costly mistakes. In reality, NNN leases require just as much due diligence as any other type of investment property. In this post, we’ll explore the key factors to consider when evaluating a triple net lease property for a 1031 exchange, as well as common pitfalls to avoid.

Understanding the Different Types of Net Leases

Before we dive into the due diligence process, it’s essential to understand the differences between triple net (NNN), double net (NN), and single net leases.

• Triple Net (NNN) Lease: The tenant is responsible for paying all property expenses, including taxes, insurance, and maintenance. This type of lease is often preferred by investors seeking a passive income stream.
• Double Net (NN) Lease: The tenant is responsible for paying property taxes and insurance, while the landlord covers maintenance costs.
• Single Net Lease: The tenant only pays property taxes, with the landlord responsible for insurance and maintenance expenses.

Remaining Term in the Lease

One of the most critical factors to consider when evaluating a triple net lease property is the remaining term of the lease. A longer lease term can provide a more stable income stream, but it also increases the risk of tenant default or changes in market conditions. When reviewing the lease, ask yourself:

• How many years remain on the lease?
• Are there any options to renew or extend the lease?
• What are the penalties for early termination?

Escalators in the Lease

Escalators, also known as rent bumps, are provisions in the lease that increase the rent over time. These can be tied to inflation, market rates, or other factors. When reviewing the lease, look for:

• The type of escalator used (e.g., CPI, fixed percentage, or market-based)
• The frequency and amount of rent increases
• Any caps or limits on escalations

Financial Strength of the Leasee

The financial health of the tenant is crucial to the success of a triple net lease investment. When evaluating the leasee’s financial strength, consider:

• The tenant’s credit rating and history
• Their financial statements and debt-to-equity ratio
• Industry trends and the tenant’s market position

Other Key Factors to Consider

In addition to the remaining term, escalators, and financial strength of the leasee, there are several other essential factors to review when evaluating a triple net lease property:

• Lease restrictions: Are there any restrictions on the use of the property or the type of business that can be operated?
• Insurance requirements: Are there any specific insurance requirements or limitations that could impact the investment?
• Maintenance and repair responsibilities: Who is responsible for maintenance and repairs, and are there any limitations on the landlord’s liability?
• Default and termination provisions: What are the consequences of default, and are there any termination clauses that could impact the investment?

Common Pitfalls to Avoid

Based on my experience in the 1031 exchange space, here are some common mistakes to avoid when evaluating a triple net lease property:

• Assuming a NNN lease is foolproof: As mentioned earlier, NNN leases require just as much due diligence as any other type of investment property.
• Failing to review the lease terms: Don’t assume that the lease terms are standard or that you can rely on the seller’s representations. Carefully review the lease agreement to ensure you understand all the terms and conditions.
• Ignoring the tenant’s financial health: The financial strength of the leasee is critical to the success of the investment. Don’t assume that a large or well-known tenant is automatically a good credit risk.
• Overlooking potential risks: Consider potential risks such as market changes, tenant default, or changes in local regulations that could impact the investment.

Conclusion

Evaluating a triple net lease property for a 1031 exchange requires a thorough and detailed review of the lease terms, remaining term, escalators, and financial strength of the leasee. By understanding the differences between NNN, NN, and single net leases, and avoiding common pitfalls, investors can make informed decisions and minimize risk. Remember, a triple net lease is not a guarantee of a hassle-free investment, and due diligence is essential to achieving success in the 1031 exchange space.