“It is easier to build two chimneys than to keep one in fuel.” – Benjamin Franklin
“Why did we spend so much money last month?” I asked my accountant.
“We paid the property tax bill,” he replied.
“Why was that bill double what it was last year?”
“When you bought the building, they re-calculated it based on the new sales price.”
It was annoying. And, as a beginning investor back then, it was an expense I’d not anticipated. Much of the expected profit for the year would go to the government. One more reason a “how-to” crash course in commercial real estate would have been helpful. I was not happy.
The next time I brought a commercial property, I was ready. I bought the company that owned the property instead of the property itself. No instant tax hike. I’d been a clever boy.
But once Katrina hit, gas prices went through the roof, along with my electric bills. While small in the grand scheme of things, they seemed to go up about 50 percent – thousands of dollars for some of my properties. For instance, the electric bill for an office building I owned went from $2,000 to $3,000 a month. I had to eat those costs until I could re-lease the units at higher rents. Another annoyance.
In retrospect, my problems with unexpected costs could have easily been avoided by the simple use of something called a Triple-Net (NNN) lease.
I’d heard of Triple-Net leases, but never thought much about them. I mistakenly thought they were for big-box single-tenant leases or “class A” offices in a new fancy building – both types of properties I usually stay away from. (I don’t like single-tenant properties due to the risk of the tenant moving. And class A office space is usually bought by the MBA crowd spending someone else’s money. They can outbid you on everything, and don’t care if the building cash flows.)
Then one day I found a potential investment – a shopping center down in South Florida. It had NNN leases.
“So what?” I thought.
But my broker, Raul, was very excited. “Toby, that means the tenants pay for everything.”
I wasn’t impressed. “Big deal,” I thought. “With the buildings I have now, I can pass on some repair expenses to the tenants after a year or so. As far as the bottom line is concerned, it will work out roughly the same as a standard lease.”
Boy, was I wrong.
Under NNN leases, the tenant is responsible for all expenses related to the building – repairs, taxes, insurance, etc. On some properties, it may not make much difference over a standard lease where the owner pays most of the expenses. For example, if the expenses on a property are low and the tenant is paying a high rent, a standard lease may not cost you more money. But during times of inflation – or in a building requiring multiple, expensive repairs – the Triple-Net lease is a lifesaver.
The expenses of running NNN properties are accounted for on a balance sheet under “Common Area Maintenance”(CAM) costs. Tenants pay their share of CAM as a proportion of the rental space they lease in the building.
We went ahead with the due diligence on that Triple-Net shopping center in South Florida. I noticed that there was no management fee included. (The sellers had been managing the property themselves, and had offered to stay on in that capacity for us.) I was grumbling to myself that I’d have to pay a management fee out of my profits on the center – but my broker interrupted me. “Management fees are usually included in CAM,” he said.
It was like a light bulb went on in my head. I had thought NNN was just about the building expenses!
I started thinking, “What else could I put into CAM and have the tenants pay for? What about leasing commissions? Can I include those?”
Well … I found out I couldn’t.
Many of the leases on the property were due in the next couple of years, and I didn’t want to get stuck having to pay some hefty re-lease commissions. So I asked the seller, “If we paid you more for management, could you throw in leasing for free?”
“Sure,” he replied.
NNN leases were starting to become a whole lot more interesting to me. And during the financing process, they sounded even better.
“What happens if the roof blows off?” some underwriter with a thick New York accent whined.
“Tenants pay. Their problem,” I replied.
The underwriter had to take all the “reserves” (the projected “just in case” costs underwriters calculate into deals when they evaluate them) out of his calculations. And suddenly the property got a whole lot more finance-able.
As soon as I took possession, the manager suggested we raise the CAM fees to anticipate a rise in property taxes. The tenants moaned, and I didn’t blame them – but it wasn’t my fault … it was the government’s. And since the terms of their leases were clear, the tenants knew I wasn’t passing on unnecessary costs.
“One of the AC units is on the way out. Can I replace it?” the manager asked.
“Sure. And put a nice one in,” I said.
What a relief not to worry about the cost of a new air conditioner. And what a joy to have those extra profits pour into my bank account to buy that new car or book a vacation for my family.
With all these cost-saving benefits, can you understand why I plan to renew all my tenants on NNN leases whenever possible? And why, when I’m looking for new properties, I now give extra attention to those with NNN leases in place. (And about a third of all properties listed have them.)
If you’re sick of repairs and rising prices – or if you’re simply interested in a property with predictable expenses and profits – you should look for properties with NNN leases. Making the tenants legally pay for everything is just one of the many reasons why commercial properties are far more lucrative than residential … and can be much easier to buy.
Now that houses and condos in many cities are starting to linger on the market like a bad smell in the basement, it’s a better time than ever to see the money you’ve been missing in commercial real estate.] [Ed Note: Toby Unwin is an active commercial real estate investor and creator of the groundbreaking One Deal From Retirement commercial real estate course.
As an ETR reader, you can receive a free copy of Toby’s $300 Deal-Maker Pro software that quickly analyzes the profit potential of any commercial property – but only if you act within the next 72 hours.Keep reading to find out how to get your copy.]