Retirees can generate passive income by exchanging into a property that requires less active management.
JTC has helped property owners perform Section 1031 like-kind exchanges with many different property types, including single-family, multi-unit, and fractional ownership of commercial portfolios through Delaware Statutory Trusts. Different investors have different needs, so it’s important to understand the advantages of the various types of properties and ownership structures.
A type of lease structure that causes confusion for some is the triple-net lease, which involves greater financial responsibility on the part of the tenant for the use of the land and operation of its business, and creates passive income for hands-off property owners. Let’s go over the basics of this type of lease and why it can be attractive for property owners looking to perform 1031 exchanges as they retire.
What is a Triple-Net Lease?
Typical leases dictate what is the renter’s responsibility and what is the owner’s. For example, in a standard apartment lease, things like electricity, water, and trash are often the renter’s responsibility, but property taxes, insurance premiums, and repairs or maintenance are all the responsibility of the landlord.
There are also “Net leases,” which assign more of these costs to the tenant. They are generally used in commercial situations, often when there is a single tenant. There are single, double, and triple-net varieties. Without going into too much detail on all three, here is a breakdown of what they involve:
Single-net lease: Tenant pays property taxes in addition to rent.
Double-net lease: Tenant pays property taxes and insurance premiums.
Triple-net lease: Tenant pays property taxes, insurance, and maintenance costs.
Our focus is the triple-net (sometimes “NNN”) lease, which is a property where the tenant must pay 100% of the property taxes, insurance premiums, and maintenance costs. Rent is usually lower with NNN because of the increased taxes and insurance premiums, which are often paid to the landlord along with rent payments.
There is also a subset of triple-net known as a bondable net lease. This means the tenant cannot break the lease before its expiration date. A bondable net lease provides extra security for landlords, as the lack of day-to-day oversight means the tenant must be trusted to perform maintenance on their own. If maintenance costs go up, a tenant may no longer like the lease terms, but a bondable net lease ensures they can’t terminate the lease.
What are the advantages of a triple-net lease?
What’s most attractive for property owners (especially those not interested in being hands-on landlords) is that there’s no maintenance involved. That includes everything from the parking lot and roof to plumbing, electrical, and HVAC. None of that is the landlord’s responsibility under a triple-net lease, making this a passive investment.
Another advantage is the lease terms, which are generally longer than standard leases. This means you don’t have to repeatedly find new tenants every couple of years and worry about vetting the financials of an entirely new group of renters. And since most triple-net leases are single-tenant leases, property owners will only have to deal with one renter – a big change for those used to multifamily apartment buildings.
Who are the most common triple-net lease tenants, and why is this arrangement advantageous for them?
Because of the long lease terms and added responsibility, triple-net tenants are usually established businesses. Think chain restaurants, retail stores, banks, etc. While there are some industrial and office triple-net locations, you’re most likely going to be dealing with retail.
Part of the decision for the renter comes down to the building itself: if the tenant thinks maintenance costs will be low, then they’re getting a bargain on rent. However, if they’re wrong about that, the added maintenance costs may hinder the ultimate success of the business.
Tenants also may be gambling when it comes to the number of tenants involved: if you have a single-tenant triple-net lease, the additional costs are absorbed by one lessee. But consider a shopping mall: if all the units are occupied, each renter only has to pay a small fraction of the property taxes; if half the stores are empty, each tenant will have to pay a greater share of property taxes.
Large companies have an established way of doing business, and specific standards. They know how they want the building to look, they’ve got their own repair people, and they don’t want to have to worry about moving to a new location every couple of years. A triple-net lease allows them to secure their space for a long period of time without having to rely on the landlord to perform tasks they’d rather manage themselves. (Imagine you run a retail chain with 250 stores. Would you want to have to keep track of 250 landlords to manage day to day requests at each and every location?)
How long are the lease terms in a triple-net lease? Can I raise rent due to inflation or tax increases?
Most triple-net leases have a primary term of 10-20 years, often with multiple five-year renewal options and built-in rent increases at five-year intervals. With rent increases built into the lease terms, there’s no need to worry about renegotiating rent or unexpected vacancies, as everything is predetermined.
What happens when I want to sell the property?
Some triple-net leases give the tenant a right-of-first-refusal. That means that if the tenant wants to purchase the property, they are guaranteed the first opportunity to do so. Some leases give them the option to match any offer found on the open market, while others may dictate the exact price at which the property can be purchased.
Because you may be dealing with a large company that can afford to buy property at a competitive price, these addendums to your lease matter. Understanding the tenant’s right of first refusal from the beginning will help you maximize your potential gains on the sale. And of course, if you’re planning to carry out another 1031 exchange, you’ll need to acquire a replacement property within the required 180 days.
How can I figure out if a triple-net lease is right for me?
The most attractive element of a triple-net lease is that it offers passive income. This makes it great for property owners who are entering retirement age. Those who used to own management-intensive properties such as apartment buildings or office complexes can perform a 1031 exchange into a triple-net property. They now no longer have to worry about day-to-day management and have guaranteed tenants that will be there long-term.
If your plan is to hold this new property for the rest of your life, you can enjoy receiving income with less work than with traditional rental properties. Triple-net leases can qualify for a 1031 exchange, but the same safe harbor rules apply: you’ll need to identify the replacement property within 45 days and work with a Qualified Intermediary.
JTC’s 1031 Exchange team has decades of experience as a QI for a wide variety of property types, including multifamily residential, commercial, DSTs, and net lease properties such as NNN. Our dedicated client services team is backed by industry-leading technology, including a secure online portal that allows for 24/7 visibility of exchange information. Whether you’re performing a forward or reverse exchange, work with an experienced QI that can handle your unique situation.