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Net Leasing Trends in Commercial Real Estate

A net lease rental property requires the tenant pay for some or all the property expenses that would normally be paid by the rental property owner. Tenants who have a single net lease pay only the property taxes in addition to rent. Tenants with a double net lease pay the property taxes and insurance premiums. Tenants having a triple net lease, also referred to as an “NNN lease,” are obligated to pay rent, property taxes, and insurance plus additional property expenses as specified in their lease.

Investor interest in net lease properties generally remains strong in 2018. Per research by National Real Estate Investor (NREI), sales volume of retail, office, and industrial net lease properties increased by 3.3% from 2016 to 2017 and comparable volume is expected in 2018.*

According to NREI, investors are generally shifting away from retail into industrial, medical, and office properties. The growth of e-commerce sales is primarily responsible for reduced investor interest in retail properties as a growing number of traditional brick and mortar retailers are seeing sales volume and profits erode as shoppers increasingly make their purchases online. Growing internet sales are a key reason behind the heightened interest in industrial properties which include warehouses that can speed delivery of online purchases which people have come to expect. Per NREI, 50% of surveyed net lease investors reported that the industrial segment is their preferred area in the coming year – and this growing demand has already shrunk industrial property cap rates to historical lows.

Net Leasing History

Prior to the rise of interest in properties structured as a Delaware Statutory Trust (DST), net lease properties were the primary “go-to” investment for investors seeking stable, relatively hassle-free income. The combined benefits of long-term leases (in most cases), few management worries, and generally steady income continue to attract investors to net lease properties.

However, in recent years, changing buying patterns, the growth of e-commerce, and the rise of speedy low-cost delivery have created greater uncertainty regarding the future value of especially retail related net lease properties. In 2016-17 for example, the following notable retailers filed for bankruptcy protection: Toys R Us. Radio Shack, Gander Mountain, Vitamin World, Gymboree, Eastern Outfitters, Golfsmith, Pacific Sunwear, Sports Authority, among many others.

Risks of Net Lease Properties

The biggest risk in owning net lease properties is that, if the tenant leaves, occupancy and income go to zero while expenses and mortgage payments continue and quickly cause the investment to go underwater. While re-tenanting can be an option to restore income, the related costs and delays can easily overwhelm investor resources. Loan recourse can also be triggered if debt service can no longer be paid adding further stress to an already bad situation.

Because of issues associated with net lease properties, we have seen a growing number of former net lease investors shift their investments into DSTs due to the similar benefits that DSTs share with net leased properties e.g., generally stable income, low management responsibilities, 1031 in/out, etc. Not unexpectedly, net lease investors who are considering DSTs are often initially attracted to DSTs composed of net lease properties since this is an asset class that they are familiar with. There are however some potential issues that may arise with DSTs that are composed of one or more net lease properties.

Issues with DSTs and Net Lease Properties

DSTs having loans typically have loan maturities of 10 years. Also, loans on DSTs usually have prepayment penalties which may cause trustees to decide to sell the DST closer to the loan maturity date when the pre-payment is minimal or even is no longer in effect. Investors in net lease DSTs need to consider the possibility that the exit value of their DST may be negatively impacted by the reduced lease term that remains on the net lease properties at the time of sale.

For example, if a net lease DST included properties with an average remaining lease term of 15 years at the time of acquisition, there would less lease term remaining at the time of sale and buyers might discount the value of the properties to less than the original investment. An investor in this scenario might therefore not receive 100% of their initial invested capital at the time of sale.

Many net lease DSTs are portfolios of multiple properties that typically have a similar use e.g., drug stores, dialysis centers, urgent care centers, etc. If the DST offering has a loan, investors need to see if the properties are cross-collateralized as security for the loan. If so, the lender would typically require that all properties in the DST would need to be sold at the same time and properties could not be sold off individually. The investor should consider the possible added risk that future buyers may value the portfolio at time of sale for less than the acquisition price due to finding some of the properties to be less desirable than others. There are examples of buyers paying premiums for portfolios as well – but this is not a given and should not be automatically counted on.

Some sponsors of net lease portfolios promote an option whereby they can purchase the assets at a future date through an affiliated REIT and provide investors with REIT shares as an exit. We encourage investors to be wary of these types of exit scenarios since 1) gains from a future sale of REIT shares do not qualify for 1031 tax deferrals and capital gains taxes may be due and 2) the future purchase price is not guaranteed and is subject to a great extent on what the DST sponsor is willing to pay at that time. Sponsors using these types of exit strategies due often are required to disclose point out conflicts of interest that exist between strategies to grow an affiliated REIT by acquiring DST interests that they have sponsored.

We Can Help

Most of our investors who have an interest in net lease DSTs favor those offerings that are debt free and that do not have a planned exit scenario whereby the sponsor will be buying back the properties.

While wholly owned net lease properties remain quite popular, especially with investors who wish to have greater control of their investments, DSTs are emerging as a favorable alternative that should be objectively investigated as an option – or perhaps considered as part of a blended investment strategy.

Please contact us to answer your questions, obtain more general information, or to get a list of current offerings either by phone at 866 398-1231 or via email at atinfo@FirstGuardianGroup.com.

*https://www.nreionline.com/net-lease/net-lease-retail-market-showing-shift-higher-cap-rates-and-more-listings