Five Critical Mistakes to Avoid When Buying a Triple Net Lease Property

Five Critical Mistakes to Avoid When Buying a Triple Net Lease Property

Buying a NNN Lease Property will be one of the most important financial decisions that you will ever make as an investor, so it is very important that you choose wisely and avoid these 5 common mistakes that could affect your investment in the future. 

So let’s dive deep into our Top 5 most Critical Mistakes to Avoid when Buying a NNN Property.

Mistake #1 – Buying or pretending to buy a NNN Property with a high leverage financing structure.

In the context of a passive income Triple Net (NNN) properties, in which cap rates trend lower, a high leverage financing structure would be a transaction in which the proposed loan to value ratio is above 50%.

And you might immediately think, but why I cannot put just 20% down and get an 80% mortgage? I’m going to explain you why. First and foremost, a Triple Net Lease property is a passive income investment, in which the Tenant takes care of pretty of much everything and your rental income is net. As a result of that fact, the cap rates of NNN Lease properties are going to be lower than a traditional commercial real estate investment property.  

Therefore, in most circumstances, the cap rate will simply not sustain a high leverage financing structure, especially in the current interest rate environment, in which commercial mortgages are still in the 6% and above threshold. In other words, it will make no sense to buy a NNN property with a 5% cap rate to then get a high leverage 80% loan to value mortgage at an interest rate of 6.50%. In a high leverage structure like that the cash flow numbers simply don’t add up, the majority of the rental income will go towards paying the mortgage. 

And the hidden risk lies behind the fact that if by any chance the Tenant might decide to leave early or not renew the lease, the property will rapidly decrease in value as a result of the loss of income, and that will trigger the Bank to jump on your neck right away, asking for a capital contribution to restore the original loan-to-value. 

If you are considering buying a NNN property with financing, you should not leverage more than 50%, and even leveraging only 50% you might still be in a position in which most of your rental income will go towards paying the mortgage, leaving you with not enough passive income return.

In the current high-interest-rate environment that we are still in, I am not recommending my clients to buy a NNN Property with more than 50% financing, and even in that low leverage structure, you should carefully review the numbers and make sure that the cash on cash return will meet your expectations. 

Mistake #2 – Buying or pretending to buy a Triple Net Lease Investment property with a high cap rate, but ignoring or not willing to assume the risks involved.

The cap rate is the first focus of attention for every investor, we all want to buy a property at the highest cap rate possible and there’s nothing wrong with that and it is perfectly understandable. However, the cap rate is in direct correlation to the level of risk involved in a particular transaction.  It is important to highlight a very basic concept of investment that is: “the higher the yield, the higher the risk; and the lower the yield the lower the risk”. This simple concept applies not only to NNN properties but to any type of investment, whether it’s Real Estate, Bonds, Mutual Funds, among others. 

Every property that it’s being offered at an above average cap rate will come with a higher level risk, whether it is just a few years remaining on the lease, or a substandard location or a weak franchisee, among many others. And now the question is: Are you willing to assume a higher level of risk in exchange of a higher cap rante. Every investor has a very different risk tolerance profile. Some investors are conservative and feel more comfortable with low risk passive income investment. While some investors are risk takers and are willing to assume a higher level risk in exchange of a higher cap rate. 

Remember ther key concept here, the higher the cap rate, the higher the risk, and the lower the cap rate, the lower the risk. None of those two extremes are wrong; as an investor you have to determine what is your risk tolerance and set your cap rate expectations according to the level of risk that you are willing to assume.  

Mistake #3: Focusing only on properties that are located in your local state or close to where you live

We all like familiarity; we all feel more comfortable buying a property that is close to where we live, and that’s certainly a value added. However, the best property is not the one that is close to where you live, the best property is the one with the best location, the strongest tenant and the best real estate fundamentals. The property that is closer from where you live could be the worst investment, while a property that is located in another state in a top location might end up being a better investment.

If you can find a property with those characteristics close to where you live, that’s great and would be the ideal scenario for you. However, more often than not, the best property is not close to where you live, so it is important that you keep your possibilities as open as possible, so you can find the best property for you, no matter where it is located.

Mistake #4: Submitting offers substantially below the asking price

We all want to buy a property at the lowest price possible and that’s understandable. But by submitting offers substantially below asking price that will not attract seller’s attention and it will probably be discarded right away as a low blow offer. But the question that you might have is: what could be considered a substantially low offer. As a rule of thumb, in a competitive market, an offer should not be lower than 10% of the asking price, or no more than half percent above the asking cap rate. And a Big However here, there are exceptions to those guidelines; every property and situation is different. There are circumstances in which a 20% below asking could be reasonable..

Certainly there is always room for negotiation; how much room it might be it will depend on several factors, such as how many offers the Seller’s has received for the property. If the Seller has received multiple offers close to asking price, then in that situation if you want the property your offer would have at asking price or closer to have the opportunity that your offer be considered. On the contrary, if the Seller has not received any competent offers chances are that the Seller might be willing to be more flexible in reducing the price.  

The key concept is reasonability, if you are selling your own property and you receive an offer 20% under your asking price, chances are that you are going to discard that offer right away.

As your Buyer’s Broker, we are very diligent and assertive in negotiating offers on behalf of our Buyers. We have the knowledge, expertise and more importantly market connections that give us access to those intrinsic factors that can push the price lower in favor of our clients.

Mistake #5 Buying a NNN property in which the Tenant pays an above average annual rent and rent per square foot

Let’s decompress that situation real quick, and I’m going to give you one simple example of that. A typical Starbucks that occupies a small 2,700 square feet building that it is located in a prime top retail signalized corner. To be in that location Starbucks had no other choice but to pay a hefty annual rent of $200k per year and commit to a 10-years lease. That means that Starbucks is paying a humongous $74 per square foot in that location.

And now the question is, if at the end of the lease, Starbucks might decide not to renew the lease and leave, what are the probabilities for you as an owner to find another tenant willing and able to pay the same $74 per square foot on that building. It would be very difficult considering that there are no other coffee brands with the financial capacity of paying such a high rent. Certainly you could find another Tenant, but it might be another small coffee shop brand that would probably be able to pay just a fraction of the rent Starbucks was paying.

And why that mistake is so costly. Going back to that $200K annual rent that Starbucks was paying, at a Cap Rate of 5%, the value of that property would have been $4M. But if Starbucks leaves and the new Tenant you find can only pay $100k per year, then the value of the property would be half of the price you paid, in other words just $2M. And, ouch, that one is really costly. 

Bear with me on this, always pay attention to how much rent per square foot the Tenant is paying and ask yourself, if the Tenant leaves or not renew the lease, what are the probabilities that I can find another tenant willing and able to pay the same amount of rent.

As I mentioned before, buying a Triple Net (NNN) Lease Property will be one of the most important financial decisions that you will ever make, so it is important that you choose wisely and avoid at all costs those 5 critical mistakes. 

Hiring an experienced and knowledgeable Buyer’s Broker that can assist you navigating the complexities of the market would definitely help you to avoid those critical mistakes. 

At Casablanca, we specialize in representing NNN Lease Buyers and 1031 Exchange Investors. We have the knowledge and expertise to guide you along the way from market research, identifying potential properties, submitting offers and negotiating them, due diligence, up to the closing table. We have helped many NNN Buyers and 1031 Exchange Investors in finding and negotiating the best property according to their investment goals and risk tolerance.

Moreover, we represent our Buyer’s for Free since we get paid from the Seller, and we also offer our buyers up to $10k credit for Buyer’s closing costs expenses. This incentive will offset or cover completely the major Buyer’s closing costs expenses such as Title Fees, Attorney Fees, Recording Fees, among others. We are the Brokers that give you more in exchange for your trust. 

If you have any questions or need guidance with your upcoming Triple Net (NNN) Lease property acquisition, feel free to contact me directly at 407-205-7570 or you can send me an email at [email protected] and I will be in contact with you.