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The Risks and Rewards of Owning NNN Investments – By Cliff Hockley, President, Bluestone & Hockley Real Estate Services

Posted on 01. Nov, 2016 by in all, Magazine Articles

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As real estate investors retire, many choose to reposition their assets out of management-intensive investments (such as apartments, office buildings, storage, and mobile home parks) and into lower maintenance single-tenant NNN investments.

As a result of the aging Baby Boomer Generation, there is a growing appetite for NNN investments, and many retail businesses are taking advantage of this demand to expand their national footprint.  Businesses such as fast food restaurant franchises (Chick-Fil-A), mobile carrier storefronts (T Mobile), convenience stores (7 Eleven), pharmacy chains (Walgreens), and numerous banks are using this financial energy to help fund their growth. More stores mean better distribution, more sales, better purchasing power and more advertising efficiency, all things that growing retailers see as plusses. Before plunging in to purchase these attractive offerings, investors should take time to understand the companies they plan to start this long term landlord/tenant relationship with. 

Risks

NNN tenants come in one of three ownership styles: corporately owned, franchise owned and operated, or locally owned and operated. Sometimes this distinction is not initially clear. Investors need to know who in this chain is guaranteeing the rent, and that answer will determine the risk involved.

Depending on the type of business and their product line, many of these retailers face competition from the internet. Online based retailers appeal to consumers with their ease of access. Operationally they can offer more products with less overhead than brick and mortar retailers. To compete, established retailers have launched their own online stores with the benefit of in-store pickup. This is a potential advantage over online retailers who levy shipping charges. Retailers without a strong online presence like Radio Shack, and K-Mart for example, have lost market share to the likes of Target and Walmart who have made the decision to have a two-pronged marketing plan, with both brick and mortar and internet stores.

Clothing stores have the added volatility of being trend dependent. They can be popular one day and outdated the next. A style that impresses on the runway or in LA may not fly off the shelves in suburban Portland, leaving the retailer with a glut of unwanted goods and a loss on the balance sheet. Clothing stores with just-in-time inventory control systems have a better chance of adjusting to changes in fashion than those that order a year ahead.

Restaurant chains and franchises shoulder different risks, both from outside competition, and from within their own operations. The location of the restaurant factors heavily into this. Does the area have a larger lunch crowd or dinner crowd? Are there many competitors? A location on a crowded ‘restaurant row’ may not be bad, since people tend to flood those areas in search of food. If a chain is placed beside a local favorite with a similar concept, however, it may not do as well since some national restaurant chains suffer from the perception that they carry lower quality ingredients than smaller local businesses.

There are grounds for this. Due to their distribution model, food used in large chains can spread nationwide, and contaminated food can result in highly publicized recalls (witness Chipotle.) Due to this and other health concerns, public sentiment regarding fast food has changed in recent years, and as restaurants innovate to meet the demands of a new consumer, investors may question if they will sustain a long term lease. One way to figure this out is to track the per-store sales volume. QSR Magazine regularly rates such restaurants. 

Research and Resources

Investors should pay close attention to all aspects of an investment. Though NNN investments seem deceptively simple and turnkey, investors should prepare for the possible eventuality of a tenant turn.  Pay attention to market rental rates.  If one tenant does not succeed at that location, will another tenant pay the same national rental rate for that location? Even though NNN investments are considered less volatile, the NNN investor should have a contingency plan if a store closes and/or does not stay the full term of its lease or chooses not to exercise its renewal options. An investor should understand the content of the leases, if it is NN, NNN, or ground leases, what renewal options are offered, and what the tenant obligations are given those lease terms. Each one has a different impact on the bottom line.

Lease terms are also an interesting issue. Is it better to have a long term 15 to 30-year lease, or a shorter term lease? When are lease increases scheduled? Every year? Every five years? Every ten years? In addition to the timing of the lease increases, the percentages of increase must also suit both the business and the landlord. Differences could vary from two percent every year to ten percent over ten years. A landlord needs to understand the brand and how much money each store needs to make in order to stay open. Only then can they determine if the tenant will continue to perform. An experienced broker or asset advisor may help interpret the intricacies of a lease and the suitability of the property.

For landlords who prefer to delve into the research themselves, the following are some sources for determining per store revenue that can serve as benchmarks for store profitability:

Other resources include trade associations, who often compile industry data and distribute publications applicable to a given market.  Their annual surveys generally feature statistics on member retailers by sales volume, square footage, trade area size, and store type.

If the tenant is a publicly traded company, investors have the ability to review their annual report. Whether posted on their company website, a business news site, or provided by request, the annual report may not necessarily provide their average sales per square foot but it may give enough clues to reach an estimate.

For demographic insights, try The United States Census Bureau. The Retail Trade Economic Data features sales by industry, annual survey results, as well as shopping centers retail sales per square foot by state. 

Return on Investment

An investor may like a property, like the tenant, but if the investment fails to make a return, both of those feelings may change.

The property needs to generate enough cash on cash return to remain a sound investment. Consider the cap rate. Does the property require 30% or 50% down to make the deal cash flow?

Not everyone has the time or acumen to understand the nuances of the finances. A motivated broker will run the financial analysis, and provide comparisons of other like properties. Double-check the numbers with a banker or CPA. Lastly, a property manager can translate the lease details and handle that end of the business.

 Location, Location, Location

Every company thrives in a specific environment. Retailers have a list of required criteria for their chosen locations. The highest demand is for locations in major metro areas with a high traffic count. Second and third tier locations can be profitable as well depending on the retailer and their target market. Smaller markets, however, also run the risk of lower demand and less room to share.

For example, the only fast food restaurant in a newly developed area will likely have booming sales the first year, and gradually less as other chains move in around it to capitalize on the new market. If the services grow faster than the population, the same investor who once had a monopoly on the area’s fast food, may quickly regret the decision to invest in the third tier.

 Financing

Once an investor has vetted a tenant and property, it may come as a surprise to learn that obtaining financing is not the same for all NNN properties. Corporately owned stores are easier to finance than stores owned and operating by a franchisee.  Stores that are run by franchisees with fewer than ten stores make financial institutions nervous as well. Finally, NNN investments with short term leases are much harder to finance than locations with longer term (ten years plus) leases. In order to adjust for the risk, financial institutions might ask for higher down payments or higher fees and interest rates.

 The Rewards

Choosing a NNN property with a responsible tenant who makes the most profitable use of the space will pay off in the long run. A good product in a great location can still fail without sound and responsible management. Learn about the company, its structure and sales, and if all factors align, the investment will likely be a safe, long term, low maintenance profit maker.

 

Clifford A. Hockley is President of Bluestone & Hockley Real Estate Services, greater Portland’s full service real estate brokerage and property management company..  He is a Certified Property Manager and has achieved his Certified Commercial Investment Member designation (CCIM).  Bluestone & Hockley Real Estate Services is an Accredited Management Organization (AMO) by the Institute of Real Estate Management (IREM). 

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