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.
BIO : Paul Getty
Paul Getty is a licensed real estate broker in the state of California and Texas and has been directly involved in commercial transactions totaling over $2 billion on assets throughout the United States. His experience spans all major asset classes including retail, office, multifamily, and student and senior housing.Paul Getty’s transaction experience includes buy and sell side representation, sourcing and structuring of debt and equity, work-outs, and asset and property management. He has worked closely with nationally prominent real estate brokerage and investment organizations including Marcus Millichap, CB Richard Ellis, JP Morgan, and Morgan Stanley among others on the firm’s numerous transactions.Paul Getty also maintains a broad network of active buyers and sellers of commercial real estate including lenders, institutions, family office managers, and high net worth individuals.
Prior to founding First Guardian Group/FGG1031,Paul Getty was a founder and CEO of Venture Navigation, a boutique investment banking firm specializing in structuring equity investments made by institutions and high net worth individuals. He possesses over 25 years of comprehensive worldwide business management experience in environments ranging from early phase start-ups to multi-billion dollar corporations. His track record includes participation in IPOs and successful M&A activity that has resulted in investor returns of over $700M.
Paul Getty holds an MBA in Finance from the University of Michigan, graduating with honors, and a Bachelor’s Degree in Chemistry from Wayne State University. He is a member of Institute of Real Estate Management (IREM), a Certified Property Manager Candidate (CPM), and a member of the US Green Building Council.Paul Getty holds Series 22, 62, and 63 securities licenses and is a registered representative with LightPath Capital Inc, member FINRA /SIPC .
Paul Getty is a noted speaker, author, and actively lectures on investments and sales and management related topics. He is author of The 12 Magic Slides ,Regulation A+: How the JOBS Act Creates Opportunities for Entrepreneurs and Investors , and Tax Deferral Strategies Utilizing the Delaware Statutory Trust (DST), available on Amazon and other retail outlets.
This material is not intended as tax or legal advice so please do speak with your attorney and CPA prior to considering an investment. This material contains information that has been obtained from sources believed to be reliable. However, FGG1031, First Guardian Group, LightPath Capital, Inc., and their representatives do not guarantee the accuracy and validity of the information herein. Investors should perform their own investigations before considering any investment. There are material risks associated with investing in real estate, Delaware Statutory Trust (DST) and 1031 Exchange properties. These include, but are not limited to, tenant vacancies, declining market values, potential loss of entire investment principal.
Past performance is not a guarantee of future results: potential cash flow, potential returns, and potential appreciation are not guaranteed in any way and adverse tax consequences can take effect. The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. All financed real estate investments have a potential for foreclosure. Delaware Statutory Trust (DST) investments are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments. Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions. Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits.
IRC Section 1031, IRC Section 1033, and IRC Section 721 are complex tax codes; therefore, you should consult your tax and legal professional for details regarding your situation. Securities offered through registered representatives of LightPath Capital, Inc. Member FINRA / SIPC. FGG1031, First Guardian Group, and LightPath Capital, Inc. are separate entities.
DST 1031 properties are only available to accredited investors (generally described as having a net worth of over one million dollars exclusive of primary residence) and accredited entities only (generally described as an entity owned entirely by accredited individuals and/or an entity with gross assets of greater than five million dollars). If you are unsure if you are an accredited investor and/or an accredited entity, please verify with your CPA and Attorney prior to considering an investment. You may be required to verify your status as an accredited investor.