What Net Lease Investors Look For

A net lease shifts a building's operating costs, including property taxes, insurance and maintenance, to the tenant on top of rent. The owner receives a largely passive stream of income. In the most hands-off version, sometimes called absolute triple net, the landlord has very little to do at all. NNN investing, as triple net investing is often called, is built around that simplicity.

This guide is written for you as the seller, not for someone thinking of buying such a property. When you sell your building and lease it back, the investor is buying your lease as much as your building: the income is only as good as the company paying it. What follows is what that buyer will test, and what you can do about each point before you go to market.

The first risk an investor thinks about is that your business will struggle and stop paying rent, leaving it with an empty building. So a buyer looks hard at the company. In its discussion of sale-leaseback diligence, law firm FBT Gibbons lists what is commonly reviewed:

• Current and past operating statements, and sometimes results at your other locations.
• Financial projections, especially when there is little operating history at the site.
• Net worth and liquidity of the tenant and of any parent giving a guaranty.
• Whether the tenant entity has substance, or is a single-purpose entity that would need a stronger parent behind it.
• Ability to carry ongoing costs, including insurance, upkeep, and major roof and HVAC repairs.
• Bankruptcy, judgment, tax lien and litigation searches, which can reveal contingent liabilities and past disputes.

You do not need a public credit rating for a buyer to consider you. Weaker credit paired with strong real estate may still work, though a buyer may price it with re-leasing in mind. The practical takeaway is to prepare clean financials and a straightforward explanation of any bad year before a buyer finds it.

The second item is the income itself. Investors examine lease length, rent escalations and how expenses are split.

• Term. A longer lease means a longer period of contracted income. Torys, a law firm, puts typical sale-leaseback lease terms at 10 to 20 years, with extension options that can run much longer. As a lease gets shorter over time, the buyer pool, financing and pricing may shift with it, so an investor also thinks about who could buy from it later.
• Escalations. Scheduled rent increases help protect the investor's income against inflation. A Torys example assumes 2% annual increases, which is an illustration and not a standard.
• Expense structure. The more costs that sit with the tenant, including the roof and structure, the fewer surprises the owner faces. Expect to be asked for this, and expect it to be negotiable.
• Assignment and go-dark rights. Investors look at whether you can transfer the lease or stop operating, since both affect what the landlord may inherit.

Everything an investor likes about a lease has a cost for you. A longer term and tighter expense clauses can improve your price, and you will live with them long after the money has been spent.

Credit tells an investor what happens while you pay. The real estate tells it what happens if you stop. One way to frame it is that a net lease has an income side (tenant, term, escalations, guaranty) and a real estate side (site, building utility, market depth, zoning). Buyers want strength in both, and a credit rating, where there is one, speaks to credit and not to location.

Questions you should expect a thoughtful buyer to ask:

• Who could actually occupy this building if the tenant left?
• What would it be worth vacant?
• How much would it cost, and how long would it take, to re-lease it?
• Are the improvements generic or built for one purpose?
• Is the location able to support the current tenant, or another one?
• Do zoning, title or recorded restrictions limit other uses?

Investors also weigh how important the building is to your operations. A site your business truly depends on is one you are less likely to abandon. And a building's reuse value matters more as the lease runs down, because near the end of the term the real estate may matter more than the credit.

It may seem that a buyer would simply want the highest rent you will agree to. Careful investors are wary of that. A high sale price paired with an above-market rent can strain your profitability and make the building harder to re-lease if you leave. Strong credit does not fix this: if contract rent is higher than a replacement tenant would pay, the investor's downside includes a rent reset as well as vacancy. Buyers may test your rent against the local market, and against your own earnings, for that reason.

This works in your favor. If you explain that the rent is one your business can comfortably carry and one the market supports, you are making the investor's case for it.

• ✓Do we have reliable financial statements for recent years, with explanations for unusual items?
• ✓Which legal entity will sign the lease, and will a buyer accept that entity's credit without a parent guaranty?
• ✓What rent can we carry in a weak year, based on our own earnings?
• ✓How would we describe why this building matters to our operations?
• ✓What would a second user of this building want, and what would stand in its way?
• ✓Are environmental reports, surveys, title documents and roof and system records in order?
• ✓Which lease terms are must-haves for us, such as renewal, assignment and alteration rights, before we hear a buyer's view?

TAG represents the seller who becomes the tenant, not the investor. Understanding what investors underwrite helps us present your company and building accurately, and decide which requests to concede in exchange for price and which to hold because your business needs them for years to come.