De-Mystified: The Importance of Commercial Triple Net Leases

By David Franklin

In the United States, commercial developers build free-standing buildings for companies that do not want to own land or a building, but do want a long-term lease to conduct their business, usually one that lasts for 25 years. The developers sell these properties to investors who will retain them for cash flow and appreciation, or who will re-sell them when the opportunity presents itself.

For long-term leases, there are usually rent increases scheduled in the terms of the lease – for example, every five or ten years – so the rent will increase over the term of the lease. 

Leases can take many shapes and forms. A gross lease is where the tenant/lessee pays the rent and the owner/landlord/lessor pays all the expenses.  A net lease requires the tenant to pay utilities and property taxes; a double net lease adds insurance to the tenant s responsibilities; and a triple net lease adds repairs and maintenance. There are different leases under the triple-net umbrella as well, such as a Ground Lease, in which the tenant leases out the land from the landowner for a specific time period-here, too, the tenant is responsible for any and all improvements and maintenance done to the property. The only item not covered is structural repairs (which may or may not be required while the investor owns the property). Because the tenant is responsible for the repairs and maintenance, the landlord does not need a management company to look after the property. However, the landlord must check to make sure the tenant pays the expenses as they come due.

In all cases, the tenant, on a monthly basis, sends a cheque or wires the rent. The landlord must carry out proper due diligence on the tenant to ensure the tenant has the ability to run a business and maintain payments.  

Some of the free-standing buildings that meet these criteria in the retail area include:

•          bank branches
•          credit unions
•          convenience stores
•          pharmacies such as Shoppers Drug Mart
•          The Beer Store, as it is called in Ontario
•          LCBO or other liquor outlets (The LCBO could be considered to have the Province of Ontario s credit rating of AA-, however, if the province spun it off and had it stand on its own, it would not be credit rated)
•          supermarkets and specialty grocery stores
•          restaurants and food franchisee such as McDonald s and Burger King/Tim Hortons
•          Canadian Tire franchisees
•          Franchisee cable/mobile phone stores (Bell, Rogers, Shaw, Telus, etc.)
•          Dollarama
•          automotive sector retailers

Those tenants that have an investment-grade credit rating, which starts at BBB-, would be unlikely to default on its obligations under its lease, especially as compared to non-credit rated tenants. The highest credit rating in Canada is AAA. The following is a list of some businesses whose credit ratings  are investment grade and above:

•          in the banking sector, RBC and TD Bank AA-; BMO, CIBC, Manulife and Scotiabank A+; Canadian Western Bank A; National Bank A-; Laurentian Bank BBB
•          in the grocery sector: Loblaw BBB-; Sobey s/Safeway BBB-
•          in the discount retail sector: Dollarama BBB

Examples of credit-rated companies below investment grade are Rona at BB-and BurgerKing/Tim Hortons at B+.The credit ratings of the franchisors of Canadian Tire are BBB+, Bell BBB+, Telus BBB+, Rogers BBB and Shaw BBB-, however, since their properties fall under a franchise agreement, the corporate covenant does not apply.

An investor would pay about $500,000 for a Mac s Milk or other convenience store or small retailer, depending on the rent and term of lease. The price of entry for well-known brands can run $1 million or higher.  A credit rated tenant is preferred by lenders and as a result, financing is usually easier to raise and cheaper. The returns for these investments depend on where the property is located and the perceived strength in the marketplace of the tenant.  In Toronto and Vancouver the returns could be quite low, even without a credit rated tenant, at 4% and lower as compared to the rest of Canada where the returns would be at least 5%.

As most Canadian real estate investors know, there are very few free-standing single tenant properties where the tenant has an investment grade credit rating available.  Current mortgage financing is 4.25% -4.5% for a five year term and 5.25% – 5.5% for a 10 year term.

The US offers more opportunities in this area than Canada with investment grade credit-rated opportunities in the retail area and as well as  more favourable tax treatment for foreign investors than other countries. Canadian investors can structure their affairs for these investments so that they can determine their returns  just based at their Canadian tax rates as they receive a tax credit in Canada for the amount they pay on account of their US income tax. If an American invests in Canada and uses a company, the tax rate is above what he would pay in the US because it is taxed as passive income and the American does not get the benefit of the Canadian dividend tax credit. If the property is personally owned, the Canadian tax rates could be higher than what the investor pays in the US depending on the size of the investment, especially if there were other investments in Canada. The American may therefore not benefit from the tax credit received from taxes paid in Canada.

Examples of US rated AA- tenants, the same rating as our top two banks, are 7-Eleven; TD Bank; Sherwin Williams; Chase Bank; PNC Bank; Walmart and McDonald s  rated A; Bank of America and Starbucks rated A-;  pharmacies CVS rated BBB+ and Walgreens rated BBB-; FedEx and Taco Bell rated BBB; Family Dollar rated BBB-.

Investors purchase these investments from developers of the property or from investors who have purchased the investment and want to re-sell it. Financing is available from the US mortgage conduits for two-thirds of the value, and with a credit-rated tenant the mortgage is non-recourse so the investor has no personal liability. The current rates are 4.25% – 4.5% with 25- and 30-year amortizations and terms.

The original term of most of the leases is 25 years and most of the leases have escalations in rent every 5 or 10 years. The yields on the investments with investment-grade tenants range from about 4.25% to 7%. At a 6% cap rate, 30-year amortization at 4.25% with a one-third down payment, the cash flow return would be 6.19% and the average yearly principal repayment for the first 5 years would increase the return by 3.68% to 9.87%. With a 25-year amortization, the cash flow return would be 5% and the return on principal repayment would be 5.01% for a total of 10%. Both of these returns do not take appreciation into account and also the additional income from the rent increases.

At a 5.5% cap rate and 30-year amortization, the cash flow return would be 4.69% and principal return of 3.68% for a total return of 8.37%. With a 25-year amortization, the cash flow return would be 3.5% and principal return of 5.01% for a total return of 8.51%.

In addition to the triple net leases, there are triple net ground leases where the building is built on the land and the tenant leases the land. With this type of lease the investor is not responsible for structural repairs, so it is completely carefree. At the end of the term of the ground lease, the investor owns the building as well. The returns for these investments is usually lower.

For the year ending in 2014, the sales volume was nearly $14 billion and naturally Canadians were buying as well.

These investments are for those investors who want a passive investment in real estate where they get their payments from an investment grade tenant each month and also benefit from appreciation from owning real estate, as the rents increase over the term of the lease. If the property is mortgaged, it is on a non-recourse basis, and the appreciation is greater because of the leverage.

David Franklin, B.Comm, JD, has been practicing law in Ontario for over three decades, specializing in securities, mortgages, tax and real estate, and overseeing and transacting millions of dollars of transactions. Contact David at david@reincanada.com.

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