The major source of income for all REITs are the rents they collect from their tenants, but how much do we know about the leases the business operate under? Most of us are not familiar with those leases and the types, such as a triple net lease.
A triple net REIT is a particular kind of business, and they operate under a specific type of lease that supports the business model and allows them to thrive.
Before investing in REITs, it is instructive to understand the different types of leases, particularly the triple net leases, that REITs, as landlords, use for their businesses.
Each type of leases lends itself to a particular business and helps drive the profitability of both the tenant and the REIT that owns the property.
Rent collection is a central part of each REIT’s profitability, and the terms of those leases have a bearing on each REIT’s success.
In the day and age of Coronavirus, rents have become a central focus of the risks associated with investing in REITs. I thought today would be a great time to uncover leases, particularly triple net REITs, to give us a better idea of the risks associated with REITs
In today’s post, we will learn:
- Four Major Types of Leases
- Common Lease Terminology
- Triple Net Leases
Ok, let’s dive in and learn more about triple net leases and REITs.
Four Major Types of Leases
What is a lease?
A lease is a legal agreement between a landlord, the lessor or in this case, the REIT, and a tenant, the lease, where the tenant agrees to pay rent for a specific time in exchange for the right to use the space to conduct its business.
Most leases require monthly payments of rent, but certain other payments, such as annual premiums, can exist. A lot depends on how the lease is written and the terms agreed upon by both the lessor and tenant.
Along with the lease’s length of the term, which is usually expressed as months or years, different leases structures define the cash flow streams that REITs can expect.
Tenants and landlords negotiate all the leases’ terms, including the term’s length, expressed as lease length, term, or duration. Other items included in the negotiation:
- Who will pay for operating expenses
- Tenant improvements
- Common area maintenance
- Property taxes
Each type of lease apportions different costs to the landlord or tenant and goes a long way to determining a REIT’s success.
There are four major types of leases, as are broadly defined among the REIT industry. Let’s take a brief look at each.
A gross lease is a style of lease in which the tenant pays the landlord a fixed monthly rent, and the landlord assumes the responsibility for paying all the operating expenses, taxes, and insurance associated with the property.
The costs rise, the landlord has to absorb them, which means that the landlord assumes all costs associated with the leases, and the tenant’s rent payments never increase.
Needless to say, this style of the lease agreement is rare and is usually only seen in short periods or lower-quality properties.
A net lease is a style of lease in which the tenant pays a fixed monthly rent to the landlord and is also responsible for paying all or some of the property’s expenses.
Three levels of “net” express which expenses the tenant pays, including the rent.
A net lease generally assumes the tenant will pay rent plus property taxes. In a double net lease, the lessee will pay rent, property taxes, and insurance, with the landlord taking care of the rest of the expenses.
The other, more common form of net leases is the triple net lease, which we will tackle in just a few minutes.
Modified gross lease
A modified gross lease is similar to the double-net lease, often called a gross industrial lease, which details the rent the tenant pays, plus the property taxes and insurance, and the tenant absorbs any increases in those items.
The landlord pays the operating expenses and maintenance associated with the upkeep of the property.
In the case of a multi-use property and the modified gross lease, the landlord may charge the tenant a CAM fee, common area maintenance fee, which divides up the charges between each tenant’s square footage.
These types of leases are common among multi-tenant office buildings, industrial properties, and retail properties.
A full-service lease is a agreement in which the tenant pays the landlord a fixed monthly rent that includes an expense stop calculated off the base year.
The property-owner pays all the monthly expenses associated with operating the property, including:
- Trash collection
The tenant’s advantage is they pay a fixed monthly rent and don’t have to contact the service providers for the other services needed to maintain the property.
These types of leases are often associated with office buildings.
Ok, before we dive into more info regarding the triple net REITs, let’s take a moment to understand the terminology associated with leases.
Common Lease Terminology
Most of us are familiar with paying rent, and have signed a lease at some point in our lives, but what do we recognize about the terms inside that lease and their bearing on our investment?
In this section, I thought we would unravel some common terms associated with leases hoping that it helps you understand more fully the lease terms you encounter in the financial reporting of REITs.
The base year is the twelve months of the lease or the period that lasts the full calendar year that the tenant occupies the landlord’s space. The base year is often used to set the expense stop, more on that in a moment.
Common area maintenance (CAM)
The common area maintenance charges are the expenses that the landlord charges to the tenant for upkeep of the property—often used in multi-tenant buildings such as office building, retail, or industrial properties.
Common areas are spaces that are accessible to all tenants, such as lobbies, shared restrooms, and parking lots.
Included in the expenses for maintaining these common areas are the labor associated with the maintenance, cost associated with a fitness center, or food service area.
CAM fees are in addition to the base rent and are calculated based on the percentage of square footage the tenant occupies and divided among the tenants based on the square footage rented.
For example, if I rent 25% of the building based on my square footage, I pay 25% of the CAM charges each month.
Also known as escalators, are future increases in rent agreed upon during negotiations of the lease. Escalators are expressed in either set dollar terms or percentages based upon increases in revenue for the tenant.
They are also tied to increases in the Consumer Price Index (CPI) or negotiated as a set increase in a certain period.
For example, I might agree to a monthly rent of $500 in year one, and then each subsequent year, I agree to an annual increase of $100 for the duration of the lease.
Expenses stops are items negotiated in the lease and are most common in full-service and modified gross leases we discussed earlier.
The basic gist of an expense stop, the landlord, will bear any CAM and operating expenses up to a certain expense stop limit, and then the tenant is responsible for the difference beyond the expense stop.
For example, suppose the CAM and operating expenses are set at $5 per square foot per the negotiated lease. In that case, the landlord will cover those expenses up to that $5 per square foot, but if it rises above those limits, say $1 per square foot, then the tenant is responsible for that additional $1 per square foot.
These are commissions paid to real estate brokers who represent the tenant and/or the landlord. Typically the broker receives 50 percent upfront and then the additional 50 percent of their fee once the lease is final.
The commission is determined based on a rate between two to eight percent of the base rent of the first year of the contract.
These expenses are associated with operating and maintaining the rented areas of the property. Many of the costs are:
- Real estate taxes
- Property insurance
- Janitorial services for tenant-specific areas
The operating expenses do not include the structural maintenance that is the landlord’s sole responsibility, or interest payments for the mortgage.
All the items considered operating expenses are laid out in the lease negotiations so that it is all laid out.
Square feet refer to the total area rented to the tenant, or total available space available for rent.
- Gross square feet – measures the properties’ total constructed area to the outside of its walls. Gross square feet is generally not used unless the tenant is renting out the total space, in which case this would refer to the total rentable square footage.
- Rentable square feet – is the total of the measurement of square footage available for rent. It also includes the tenant’s pro-rata share of the property’s common areas for CAM.
- Usable square feet – is the amount of space available to the tenants with the space walls. If the tenant rents to the whole space, then this property is the total available rentable space.
Tenant Improvements allowance
Also known as the TI, Tenant Improvements allowance is the amount a landlord is willing to kick in to upgrade a space for an existing tenant or to entice a new tenant.
Tenant improvements that improve the lease ability of a property are depreciated on a different schedule than leasehold improvements, which are on a 15-year schedule, and a 40-year schedule for building improvements.
The tenant improvement schedule for depreciation is on a seven-year schedule.
For newer spaces, or spaces not built out, the TI allowance is generally higher to entice new tenants. The landlords do this because the space is usually a shell and needs to be built out to house any business and entice the landlord to help with the space’s build-out.
Triple Net Leases and REITs
The triple-net lease is common among a specific type of REIT, also known as triple-net REITs.
These REITs are common to these types of businesses:
Remember that net leases include other charges to the rent, such as:
- Maintenance including water, utilities, janitorial, trash collection, and landscaping.
- Property taxes
- Property insurance
In exchange for these extras, the landlord typically charges a lower rent than the property would allow, but the landlord does this in anticipation of attracting tenants that are longer leaseholders.
When times are good, triple net leases drive lower income for the REITs than they would normally collect, but the landlord collects the steadier rents, like bond cash flow.
Most investors view the triple net REIT as a more defensive play than other REITs; they are also the least volatile of the sector, especially during times of economic upheaval.
Triple net REITs, based on their business model, grow externally by acquiring additional properties as internal growth is tied to the nature of their leases, which tend to be longer in length based on the nature of the lower rents charged. Most of the rental income growth is tied to inflation, which is low in the current low-interest-rate environment.
Therefore, the capital strength of the triple-net REIT is paramount to its success, not only its ability to borrow money at attractive rates, but also to maintain its strong credit rating. All of which allows the triple net REIT to borrow money at low rates and allows for lower interest payments, and ensures strong cash flows for dividend distributions.
An advantage that triple-net REITs hold over other REITs is the lower expenses flowing to the bottom line, as the lease structure’s nature allows those REITs to attract longer-term tenants.
Longer-term tenants lend themselves to more consistent cash flows, and more stability allows the landlords to go out and acquire additional properties.
The length of the duration of the lease is fundamental to the long-term strength of the REIT. The lease’s length and structure will help determine the stock price fluctuation during times of economic stress.
As triple-net REITs are often known, the bond proxies have thrived during the current pandemic, as most of them still have 99% occupancy and rent collections have remained strong during this time, as opposed to the mall space, which is struggling to collect north of 75% of its rents.
A few top triple-net REITs to consider for your portfolio, once you do your due diligence first, of course.
- W.P. Carey – WPC
- Realty Income – O
- VEREIT – VER
- STORE Capital – STOR
- Spirit Realty Capital – SRC
Understanding the lease structure of any REIT is paramount to finding a strong REIT that will grow your wealth over the long-haul.
The triple net REIT is currently the strongest REIT as a sector, and these structures of leases have proven to be the most recession-resistant. The reason for this is the structure of the lease and the long-term nature of the lease.
Businesses that are strong businesses with the lower costs on their part help ensure that the business is able to remain solvent during times of economic duress.
The lower rents that the triple net REITs collect might at first blush seem counterintuitive, but lowering the tenant’s costs enables those tenants to survive during times of duress. And preserving cash flows by continuing to receive consistent rents is the key to long-term success for the triple-net REIT.
That is going to wrap up our discussion for today.
As always, thank you for taking the time to read this post, and I hope you find something of value on your investing journey.
If I can be of any further assistance, please don’t hesitate to reach out.
Until next time, take care and be safe out there,