The Safest Way to Invest in High-Income Real Estate
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Protect your downside by offloading onerous expenses to lessees
I’ve done my fair share of reading and writing about real estate investing. I’ve even helped put together a marketing campaign for a training course on real estate investing. So you could say that I’ve got a bit of background in helping people make smart decisions as real estate investors.
But most of my work has focused on maximizing the upside of real estate investing. One crucial element that I’ve thus far overlooked — particularly for those who’d rather let their money work for them and not be bothered by leaky pipes, costly renovations, difficult tenants, and burdensome taxes — is limiting the downside of real estate investing.
Real Estate is Risky
Data expenses for individual landlords can be hard to come by, but the National Apartment Association’s 2017 survey of multi-unit rental communities found that the rental property operated by its members generated roughly $13,941 in annual rent for 2016, but required $8,445 in annual operating expenses, and an additional $2,095 in annual capital expenditures.
Those expenses sucked away profit in the form of insurance, taxes, utilities, management and administrative fees, marketing (to bring in new renters), contractor services, repair and maintenance costs, and salaries for the personnel required to keep the place running.
As an independent real estate investor, you’re not likely to spend much (if anything) on anyone’s salary. But every other line item on that list of expenses is a burden with which any real estate investor would be all too familiar.
Subtracting the $1,500 spent per unit on salaries leaves us with $6,945 in annual expenses to maintain a rental property, which leaves us with $6,996 in annual operating profit on the typical rental unit. That’s an operating margin of 50%.
Can you handle your investment property’s mortgage costs with half of its annual gross rent? Do you want to spend your free time calling up contractors, looking for new tenants, and making sure your taxes and insurance always get paid? Do you want to hire a property manager to take care of these things, in exchange for another hefty chunk of your gross rent income?
If not, real estate investing may not be for you.
Unless… you offload most of the onerous expenses of investment property ownership onto your lessee with a triple-net property.
Triple-net properties explained
A triple-net, or NNN, property, is a property offered for lease in the world of commercial real estate.
In addition to paying rent and handling the typical utility costs, an NNN’s lessee is also responsible for handling:
- property insurance,
- maintenance expenses, and
- real estate taxes.
This removes two of the three largest and most time-consuming expenses (taxes and maintenance) from a property owner’s plate, and gets their tenant to handle an additional expense that can often rise much higher for many commercial properties than it would for a residential property (insurance).
On top of taking responsibility for insurance, maintenance, and taxes, a triple-net tenant will also frequently sign leases that are much longer than those requested by lessees of other types of investment property. It’s not uncommon to see an NNN tenant sign a lease to occupy a property for five, ten, or even twenty-five years.
The upside of a limited downside
Sounds great, doesn’t it? But you’re probably thinking to yourself, “what’s the catch?”
Well, the “catch,” or catches, are these: in exchange for taking on the burden of nearly all the property’s ongoing costs, your lessee will typically expect a lower lease payment. And since your tenant could be sticking around for decades, you won’t be able to capture any real upside in rising rent costs for that property’s neighborhood. You may be able to bake a marginal amount of yearly growth in rent rates into your lease, but the key word here is marginal. Also, you’ll still be responsible for reporting taxes levied on the building, even though you’re not paying them.
And, since you’re so reliant on a single tenant in a specific location for such a long stretch of time, the value of the property is more tied up in the tenant and the location than in the property itself. Should your lessee go belly-up or the neighborhood’s Walter White wannabe happen to blow up your building while trying to make some meth, it can prove very hard to get another high-quality tenant into the building to cover your loan. If you did take out a loan to purchase the property, the payment will still be due every month, whether you’ve got someone in the building or not.
It’s important to keep in mind, however, that your typical triple-net lessee is going to be an extremely high-quality tenant. You can’t lease a property to just anyone for decades, after all. These lessees will often be retail franchise locations, such as restaurants (think Papa John’s, not Random Joe’s) or banks. They’ll be well-capitalized and may very well be backed by professional analysts who will go over the potential of your property and its location with a fine-toothed comb before the boss signs on the dotted line.
Oh, and that tax reporting burden? It might not be such a bother once you learn that NNN properties can help you take advantage of 1031 exchanges, which is a part of the IRS Code that allows you to defer your taxes when using the proceeds from a real estate sale to purchase more of the same type of property.
You can also depreciate pretty much everything on the property, which in addition to the building itself can include roads, landscaping, equipment, machinery, and any improvements or additions you make. NNN property became even more appealing for many investors this year when the Tax Cuts & Jobs Act went into effect. A number of its provisions provide larger tax advantages to real estate investors than were available previously.
With an NNN property, you give up the opportunity to capture the upside of rising property values and the associated growth in rent rates — at least for the duration of your tenant’s lease term.
But in exchange, you avoid having to hire plumbers to deal with leaky toilets, having to scramble to fill your property with a new tenant every year or two when the previous tenant bails, and having to risk dealing with the potential nightmare tenant who destroys your stuff and doesn’t pay.
In fact, you may not have to bother finding a lessee at all.
In many cases, particularly when dealing with major franchise-based businesses, you’ll be able to pick up the tenant along with the property. Many NNN lessees become lessees by selling their property to someone else who will then extend a lease to the now-former owner, in an arrangement known as a sale-leaseback. Such lessees pursue these sale-leasebacks as a way of converting their illiquid real estate into accessible liquid capital, which can then be used to fund franchise expansion, share repurchases, or some other growth-oriented outcome.
Points to ponder before buying
Owning a triple-net property can be a great way to do the least possible amount of work to generate long-term profit in real estate. If you’ve got a job or a business that keeps your nose to the grindstone so frequently that you simply don’t have time to deal with the hassles of property ownership, NNN properties are one of the easiest ways to invest a sizable chunk of capital, outside parking it in an index fund or buying bonds.
In order to maximize your chances of success, you’ll have to do some research and analysis of your own. Here are the questions Financial Samurai suggests you answer before agreeing to buy any triple-net property:
- How easy would it be to replace the tenant in the property’s location?
- How reputable and well-capitalized is the tenant?
- Is your tenant a small franchisee or a national chain?
- How much time is left on the lease (for sale-leasebacks)?
- Has the location done well financially?
- What terms can you get on the mortgage or loan for the property?
- What kind of rent growth is baked into the lease?
- Is there anything that would make it hard to sell later?
Any investment, particularly one that requires a large capital outlay, deserves careful consideration to determine if it’s right for you.
But, once you’ve become a triple-net investor, you probably won’t need to spend too much time on your investment for a few years. The taxes? You can get your accountant to handle them. You do have a CPA, don’t you?