Triple Net Leases: Safe, 6-9% Cash Yields With Tax Advantages?

Includes: NNN, VER
by: Mike the PhD

One problem facing investors today is that there is simply too much cash out there. The flood of money coming from a recovering economy and flowing out of savings accounts and into investment assets has driven the prices on assets of all sorts to multi-year highs. Even alternative "investments" like stamps and old cars have risen dramatically in value according to a recent CNBC report. Given that the objective of any investor is to find assets where the resulting future cash flows justify the current purchase price, this flood of money has made life very unpleasant for cautious investors.

In times of "high sentiment" like today, economics researchers have found that less liquid investments tend to be slower to appreciate in price because capital flows are slower into these assets; in subsequent periods however, these low liquidity assets tend to outperform higher liquidity assets. Translation: assets that are less liquid should do better on average in the next few years because their prices haven't run up as much.

With that in mind, I went through a list of various types of assets looking for those that had the lowest levels of price appreciation while still offering direct cash returns (e.g. Twinkies don't count as an investment - granted they are illiquid, but they don't pay investors anything to hold them). One asset class in particular stood out to me: Triple Net Leases.

Triple Net Leases are a form of real estate investment that basically works as follows: An investor buys an existing commercial property, let's say a Walgreen store. That Walgreen store has a long term lease in place when the investor buys it under which Walgreen agrees to continue to lease the store for a specific period of time (say 25 years), at a given rate per year with periodic rent increases built into the lease (say a 5% rent increase every 5 years). Now most sensible investors would almost immediately say 'Wait a minute, I don't want to be responsible for maintenance, taxes, and utilities on a Walgreen store!' However, with triple net leases, the store owner is not responsible for any of these things. The rent the owner collects is net of all expenses for the store including maintenance & upkeep, property taxes, and utilities (thus the triple net in triple net leases).

What's more, while many investors are understandably concerned about investing in fixed rate debt, because triple net leases frequently have rate adjustment clauses, and the investor owns the property after the long term lease is complete, the securities can offer significant protection from inflation and rising rates.

Further, triple net leases offer investors significant tax advantages just as traditional rental real estate properties do. This is particularly true if the individual has significant assets such as a house or business that they are selling for a large gain. (In these circumstances, triple net leases can be used in a 1031 tax free exchange to avoid capital gains taxes.) And while real estate rental property has become a hot investment in the last couple of years and is recommended by my investment commentators, triple net leases are still below the radar by and large.

Triple net leases are highly illiquid just like most real estate property, and the buildings frequently cost several million dollars to buy. As a result, the markets are very thinly traded which has made prices slow to rise. That's the downside of holding these investments. But the upside is that while the properties are illiquid, the leases are usually many years, and they are frequently held by very safe companies; Walgreen, Kohls, Advanced Auto, Walmart, even the US Post Office. OK… perhaps given the recent decline in mailing, that last one might not be as safe as it once was, but all of these companies sign extremely restrictive lease agreements on these properties which makes defaulting on the rent very, very difficult for the company.

Cap rates, as the yields are called on triple net leases, currently run from around 5-6% for very safe tenants like Walgreen to upwards of 9% for riskier tenants and private companies. Further, given the tax advantages from depreciating the building over time, much of this income is tax free on the front end of the lease.

Again though, these properties cost several million dollars, so while they are great for high net worth individual investors, what is the more typical retail investor supposed to do? Well, you could buy into a company that specializes in holding triple net leases like National Retail Properties (NYSE:NNN) or American Retail Capital Properties (ARCP). But these stocks are liquid and easy to invest in, so like most of the other stocks out there, over the last year, their price has run up tremendously, turning once attractive opportunities into more hum-drum investments that are not overly appealing. One alternative to this is for investors to sit out on the sidelines in cash and hope for a better entry point eventually. That alternative lacks appeal for a variety of reasons. But there is another choice: Non-traded REITS.

Non-traded REITS are companies that are not listed on exchanges, but their shares are traded in private markets by some brokers occasionally. The result of this lack of liquidity is that the price on these REITs is much less transparent than on exchange listed REITs. This can lead to either a good deal or a bad deal for an investor depending on how well informed the buyer and the seller each are. In many respects, investing in non-traded REITs is a lot like investing in individual bonds - the lack of liquidity can lead to significant give and take in price negotiations between buyers and sellers. Not all non-traded REITs invest in triple net leases of course, but there are several that do.

One such non-traded REIT that has been in the news lately is Cole Credit Property Trust. The firm was the subject of an acquisition attempt by American Realty Capital Properties recently, but the Cole board declined the offer. Cole's shares and similar non-traded REIT firms can offer investors a good deal and easy access to the otherwise very expensive triple net lease market, but investors will probably need to check with several local brokers to find one that has suitable non-traded REIT shares for sale at an appropriate price.

Since the purpose of this article is educational rather than to recommend specific brokers of triple net lease properties, and non-traded REITs, I won't give specific recommendations on where you should buy these types of investments. However, there are many firms out there that specialize in these alternative investments, and a simple internet search should bring up several that are close to you.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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