TYPES OF LEASES

by | Jun 23, 2023 | Advanced Knowledge, NNN Investing 101, Passive Real Estate Wealth

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Investors often think of STNL as generally passive but do not have as clear of an understanding to the types of lease structures available and what that means.

Here are the various types of leases you might come across when searching for a NNN STNL property.

Absolute NNN
This is where the tenant pays for everything with a property, and the landlord is completely passive. The tenant takes care of insurance, property taxes, maintenance to the property, etc.

This structure is highly desirable to landlords as they want more hands off investing. If investors wanted to be more hands on they would look at other types of asset classes for investment choices.

NN (Double Net)

This type is a little more tricky. Some tenants try to write in some responsibility to the landlord in the leases. Often newer developers, unsophisticated land owners, etc. can be taken advantage of by seasoned business tenants with negotiating the lease.

Some business tenants only agree to NN leases and not absolute NNN no matter what. I have seen exceptions where the location is super strong (A+) and many tenants are competing to go on that site for their business. In those cases the landowner can usually dictate their terms and hold firm. The landowner can simply move to another tenant on the waiting list, who wants the site, if discussions break down with the current potential tenant for the lease up of the property.

With NN, when it’s a new building, there is often a roof warranty of 15 years that transfers to the new purchaser when proper steps are followed. NN can still be good if the lease calls for just roof and structure as landlord responsibility and if it is a newer type of building. In that case an engineer completes an inspection that examines the building to make sure it’s in good condition for the properties’ intended use.

Sometimes there can be a bad lease where the NN landlord is responsible for roof, structure, parking lot, windows, HVAC, utility lines, etc. Basically the NN lease is working almost like a gross lease where the landlord is typically responsible for everything with the property. That gets away from the whole purpose of investing in the STNL NNN asset class. My clients and I usually stay away from NN leases that act like gross leases because you have fixed rental increases with the lease. This means you do not want variable expenses that could affect the expected cash flow of the property.

Ground Lease
A ground lease is where the landlord owns the land but not the building. The land owner it is common to provide utilities to the site for access and then the tenant pays to construct the building themselves.

A couple of positives to the ground lease.

  1. If the tenant does not renew the option period after the primary term of lease ends, the landlord usually gets the building for free. The landlord could then possibly convert the next tenant to an absolute NNN lease for higher rent with the land and the building.
  2. A ground lease can be an affordable option to a buyer looking to purchase a NNN type property in an area they might not be able to manage due to price. As an example, say a buyer can afford a 3 million property but wants to be in an urban core area where absolute NNN goes for 5 to 6 million. By purchasing a ground lease at lower rents for just the land the buyer may now be able to own in the area with a 3 million ground lease property for the quality tenant they want.

A few negatives to a ground lease.

  1. Since the investor only owns the land and has no ownership of improvements then there is not usually any physical property to depreciate for tax purposes.
  2. Ground leases sometimes require a lower loan-to-value (LTV) on the property and some NNN lenders prefer loans on absolute NNN properties only.
Leasehold
In this scenario a developer locates a piece of land they would like to buy and build on. The landowner however does not want to sell the land and wants to lease the land instead. So the developer agrees to sign a ground lease with the land owner and then construct the building themselves and lease to the tenant. When the developer (seller) of the building wants to sell the property the building is subject to the underlying ground lease. This creates two payments— one to the land owner and one to the building owner.

Positives to a Leasehold

  1. Since the leasehold owner owns the building and not the land they can typically depreciate 100% of the purchase price instead of using a land/building percentage ratio.
  2. The yields can often be higher since more risk is involved.

Negatives to a Leasehold (there are many)

  1. You only own the building for a set period at which time it could possibly revert back to the land owner if the tenant does not renew the option periods.
  2. Since there might be two payments, it can cause issues with a lender. The lender for the buyer of the building may want the land owner to make their rights secondary to the building loan lender. Often times the land owners will balk at this provision. If the mortgage holder of the building foreclosed they can sometimes take the land away from the land owner as well. The landowner would therefore want an unsubordinated lease to protect their rights.
  3. The structure of the land lease might not be optimal for the building owner and cause big problems in the future. One KEY is to check the land lease ahead of time before looking to buy a leasehold and see how many years are remaining on the lease before options and if there is an option for the building owner to buy out the land lease.
  4. Leaseholds represent a smaller part of the NNN market and not many buyers are looking for them which can make your interest in the property harder to resell in the future. These properties often trade at higher cap rates but also can be fraught with risk.


Sale Leaseback
A sale leaseback is where the owner of the property would like to now sell the property on proposed terms and pay rent to the new owner. It can be a great way for a business to recapitalize to re- image existing locations on the outside and inside or grow and add new locations.

Since the lease is not yet created the tenant offers what terms they would like to see in a proposed lease. The buyer for the property can propose their own terms as to what they would like since the lease at this point is negotiable. A sale leaseback can give the buyer great flexibility to get better than market terms if the business owner is highly motivated on the sale leaseback . The buyer needs to understand and structure the lease so it is desirable for another buyer to purchase in the future and so that financing can easily be obtained on the property if so desired.

With sale leasebacks you have to be careful that the tenant is doing a sale leaseback for a good reason. You have to look for warning signs such as the tenant is over-leveraged financially, they are wanting to sell the business to a weaker tenant, the terms they are offering on the leaseback are not within market values, etc. If a buyer is not careful they could purchase a sale leaseback only for the property to go dark shortly thereafter.

Build to Suit (BTS)
This is an agreement between landlord/developer and tenant to construct a building on their property to the tenants’ specifications.

The landlord/developer usually owns the land already or will acquire the land sought after by the tenant to build on.

Since the property is not yet built (early in the process) and the tenant has yet to take occupancy and be open for paying rent these types of situations may not be optimal for a buyer’s 1031 exchange. Construction timelines may be delayed. Build costs may go higher requiring the lease to be altered as well as the price which might not now fit the buyer’ goals. If delivery is delayed then financing to the end purchaser might change for the interest rate, the amount of the required downpayment, and the length of the fixed loan term.

A buyer has to be patient on a build to suit and be comfortable with all the variables involved that could happen purchasing from a BTS Landlord/Developer.

Zero Cash Flow property (ZCF)
This is where all the monthly payment in rent from the tenant goes to pay down the mortgage each month. The loan usually is tied to the primary years on the lease term from the investment grade tenant. This way when primary term ends before the option periods start, the property will be paid off free and clear.

Positives

  1. It can be a fast way for a property owner to build equity in the property.
  2. There can be accelerated tax benefits early on with ownership that run with the property. A ZCF lease falls under IRS code section 467. Structured depreciation has the ability to show a tax loss which can more than cover principal payments for the first 10 to 15 years of the loan. It is important to check with your tax professional about your individual situation tax and how a ZCF property might work for you.
  3. There is a pay-down/re-advance feature. This can allow you to buy into the property with less of a down-payment than is normally required on NNN properties. Under normal circumstances most lenders want 30% down or more to buy a NNN property. With these ZCF properties since all the payments are going toward the mortgage some lenders allow 80 to 90% LTV. This can result in a buyer purchasing a NNN ZCF property with as little as 10% down. In most cases the ones being sold have had a few years come off the lease so equity down payment is more toward 15 to 20% down. The re-advance feature can allow you to take excess funds above the equity down payment requirement and re-advance back out tax free cash to re-deploy how you see fit.

Example: A CVS pharmacy with 15 years remaining is a Zero Cash Flow property. You have 1031 exchange proceeds of $2,500,000. The property is a $5 million purchase and equity down payment requirement is $1,000,000. You can put down the $2,500,000 and instruct the lender prior to closing to re-advance those additional funds of $1,500,000 from the exchange. There are time restriction covenants of the mortgage that must be followed to make the request. It is important that a buyer uses a commercial real estate attorney well versed in ZCF properties so that proper procedures are followed and all is in compliance.

Negatives

  1. The main negative is possible phantom income when the subject property no longer amortizes at a loss. At that point the owner can incur more taxes with the principal pay-down of the loan. This usually happens later on in the advanced years of the primary term of the lease.
  2. The property is illiquid with the special pay down of the loan and has a smaller pool of buyers looking for ZCF properties.