How DSTs Can Help Investors Mitigate the Risks of Owning NNN Properties

Intro

Real estate investing 1031 exchange DSTs is for real estate investors ultimately decide they want to cash out and become passive real estate investors. They sell some or all of their holdings and then, using a 1031 exchange, will roll the proceeds into a triple net leased property that allows them to be largely hands-off. The 1031 exchange allows them to defer paying capital gains taxes, while NNN property passes costs and management obligations on to the tenant.

At first glance, this strategy seems like a no-brainer.

However, this ignores the fact that there are still many risks associated with owning triple net properties – especially if those are leased to a single tenant. In this article, we look at some of the complexities and challenges associated with owning NNN assets and why investing in Delaware Statutory Trusts (DSTs) are an attractive alternative. Real estate investing 1031 exchange DSTs

What is a Triple Net Leased Property?

A triple net leased property, often referred to as a “NNN property” or simply a “triple net property,” is a commercial real estate investment where the tenant bears the majority of the operating expenses in addition to paying the base rent. These properties are commonly sought after by investors looking for stable and passive income streams.

In a triple net lease (NNN lease), the tenant is responsible for paying:

• Property Taxes: The tenant is obligated to cover property taxes associated with the leased property.
• Insurance: Tenants are required to maintain insurance coverage for the property, which typically includes liability insurance and may also include property insurance.
• Common Area Maintenance (CAM) Expenses: CAM expenses are the costs associated with maintaining and operating the common areas of the property, such as parking lots, landscaping, shared utilities, and other communal facilities. Tenants are responsible for their pro-rata share of these expenses, which are often outlined in the lease agreement.
• Utilities: In some cases, NNN leases may require tenants to pay for utilities like electricity, water, gas, and sewage separately.
• Property Maintenance: Tenants are typically responsible for the upkeep and repairs of the interior and sometimes even the exterior of the leased space.

The key benefit of triple net leased properties for investors is that they offer a relatively predictable and steady income stream. Since the tenant is responsible for many of the property’s operating expenses, the landlord’s income is generally more stable and less subject to the volatility of operating costs. Additionally, these leases can be long-term, providing investors with a dependable source of passive income over an extended period.

Triple net leased properties are commonly found in various commercial real estate sectors, including retail, office, industrial, and even some types of medical facilities. Investors are often attracted to these properties due to their potential for low management involvement and a reduced risk of unexpected expenses.

Single Tenant Net Lease (STNL) Properties:
NNN properties can have either a single tenant or multiple tenants. Multiple tenants offer a diversified income stream and provide the owner with some insulation in the event of vacancies. When a tenant leaves, only one portion of the building becomes vacant rather than the entire building—which happens when a tenant leaves a single-tenant net lease (STNL) property.

Here are some of the key characteristics of STNL properties:

• Single Tenant: As the name suggests, there is only one tenant occupying the entire property. This tenant is typically a commercial entity or business.
• Long-Term Lease: STNL leases often have long-term durations, commonly ranging from 5 to 20 years or even more. This extended lease period provides investors with a predictable income stream.
• Net Lease Structure: The lease agreement in an STNL property is typically structured as a net lease. This means that the tenant is responsible for paying most, if not all, of the property’s operating expenses in addition to the base rent.
• Stable Income Stream: Because the tenant is responsible for covering property expenses, STNL properties often provide investors with a stable and predictable income stream. Investors can receive rent payments without having to worry about many of the property’s operational costs.
• Low Management Involvement: Since there is only one tenant occupying the property, there is generally less management involvement compared to multi-tenant properties. This can be attractive to investors seeking a more passive investment.

STNL properties are commonly found in various commercial sectors, including retail, office, industrial, and medical real estate. Tenants often include well-established businesses, national retail chains, banks, pharmacies, and other similar enterprises.

Real estate Investors investing  in 1031 exchange DSTs are often drawn to STNL properties with the promise that these assets will provide long-term, stable income without the management headaches associated with gross leases. However, as we’ll show, STNL assets can also be very risky and are far from management-free.

Risks That Come with Owning STNL Properties
While there is some initial appeal to investing in Single Tenant Net Leased (STNL), such as stable income streams and reduced management involvement, there are also many risks to consider. It’s essential for investors to be aware of these risks before considering an investment in STNL properties. Some of the key risks include:

• Tenant Credit Risk: The financial health and creditworthiness of the tenant are critical factors in STNL investments. If the tenant encounters financial difficulties or goes bankrupt, they may be unable to meet their lease obligations. This could lead to missed rent payments or lease termination, potentially leaving the property owner without rental income. Deciphering the creditworthiness of a tenant can be challenging, even for the most sophisticated investors. Some tenants, for example, do not carry debt and therefore may be otherwise strong tenants but will not be credit rated. In other situations, a credit-worthy tenant might face financial ruin due to larger macroeconomic changes—such as companies that become obsolete as technology changes (think: Blockbuster).
• Lease Renewal Risk: While STNL leases are often long-term, there is still the risk that the tenant may choose not to renew the lease at the end of the term. If the tenant decides to vacate the property, the owner may face the challenge of finding a new tenant or dealing with prolonged vacancy periods. In the meantime, the owner will be responsible for all expenses. If they cannot carry those expenses (e.g., mortgage, taxes, insurance, maintenance), then they risk defaulting on the property or being forced into a sale.
• Industry-Specific Risk: The success of the tenant’s business can be tied to specific industries. For example, a retail tenant’s performance may be closely linked to consumer spending habits. If the tenant’s industry faces challenges or economic downturns, it can impact the tenant’s ability to pay rent and, consequently, the property’s income.
• Market Risk: The location of the STNL property can affect its performance. Changes in the local real estate market, including shifts in demand and property values, can impact the property’s value and potential rental income.
• Property Condition and Maintenance: While tenants are responsible for many property expenses in an STNL lease, the landlord still has a vested interest in the property’s condition. Failure to properly maintain the property could result in decreased tenant satisfaction, lease violations, or even lease termination.
• Interest Rate Risk: Like other real estate investments, STNL properties can be affected by changes in interest rates. Rising interest rates can increase financing costs, potentially reducing the property’s cash flow and overall return on investment.
• Lack of Diversification: Investing in STNL properties often means concentrating your investment in a single asset with a single tenant. This lack of diversification can increase the risk if the tenant faces financial difficulties or other challenges.
• Lease Clauses and Terms: The specific terms and clauses of the lease agreement can significantly impact the property’s risk profile. For example, the lease might have clauses that allow the tenant to make changes to the property without landlord approval, potentially affecting the property’s value.

9 Ways DSTs Mitigate STNL Property Risk

Given the risks associated with owning STNL properties outright, people may want to consider using a  Real estate investing 1031 exchange DSTs, instead. Here are 9 ways that DSTs can prove to be more advantageous than buying single tenant net leased property.

1. A Truly Passive Investment: Unlike STNL properties, DSTs are truly passive real estate investments. Owning a STNL asset still requires checking in with the tenant from time to time to ensure they are paying their taxes and maintaining the property appropriately. A tenant’s failure to do so will impact the property’s value, leading to real financial consequences for the owner.Instead, those who invest in a DST become fractional owners of a professionally managed trust. They have virtually no responsibility for property management decisions. Investors in DSTs are relieved of property management responsibilities, including tenant interactions, property maintenance, and lease negotiations. This will prove to be appealing to investors who want an entirely hands-off approach to owning real estate; one that frees them wit the responsibilities associated with direct property ownership.
2. 1031 Exchange Eligibility: The 1031 exchange is a great tax-deferral strategy that allows investors to defer capital gains taxes on the sale of an existing property by reinvesting in a like-kind property. This tax benefit can be a significant incentive for investors looking to preserve their investment capital. However, 1031 exchanges are highly regulated and if all rules and timelines are not followed, the transaction becomes ineligible. For instance, sellers only have a narrow window to identify and then close upon the like-kind asset. Any hiccup in that process can derail the 1031 exchange.

Investing in a DST is easy and can be done in as little as 2-3 days. By rolling some or all of the proceeds of your 1031 exchange into a DST, you can ensure that your capital investment is protected.

3. Professional Asset Management: DSTs are typically managed by experienced real estate professionals or sponsors. These entities have the expertise to identify, underwrite, acquire, manage, and improve properties, potentially leading to better investment outcomes than one would achieve by owning a STNL property outright.
4. Thorough Due Diligence: Tenant risk is perhaps one of the largest risks associated with owning STNL property directly. The owner must carefully consider the tenant’s credit history, current credit profile, market position, market competition, and more. This can be challenging for even the most sophisticated real estate professionals—let alone, individual investors looking to buy their first STNL asset. Investing in a DST is a great way to mitigate this risk. DSTs are adept in conducting thorough due diligence when selecting properties – and tenants – for the trust. They assess the property’s financial performance, potential for income growth, location, tenant quality, and overall suitability as an institutional-grade asset.
5. Access to Institutional-Grade Properties: By pooling funds from multiple investors, DSTs can access economies of scale. This means they have the financial capacity to acquire larger, institutional-grade properties that offer potential cost efficiencies and better risk diversification. Investing in a DST provides individual investors with access to Class A properties that they likely would not be able to acquire on their own.
6. Reduced Risk of Tenant Vacancy: DSTs often invest in properties with long-term leases in place. While NNN leases also typically have long terms, DSTs can offer a higher level of tenant diversification, reducing the risk associated with the financial health of a single tenant. Tenant diversification spreads the risk associated with tenant turnover or financial difficulties, helping to maintain consistent cash flow for investors.
7. Regular Cash Flow: DSTs typically invest in income-producing commercial properties, including but not limited to retail center, apartment complexes, or office buildings. These properties generate rental income from diversified tenants, which provides stable and predictable cash flow for investors. Moreover, DSTs often acquire properties with long-term lease agreements in place. These leases can have terms ranging from several years to a decade or more, ensuring a consistent stream of rental income even amid otherwise changing market conditions.
8. No Financing Risk: Those who invest in STNL properties often utilize financing to acquire or improve the asset. Floating-rate debt can be problematic if the owner can no longer afford those financing costs. When a tenant unexpectedly vacates a STNL property, the owner is then responsible for carrying the mortgage until they find another tenant.Investing in a DST is a great way to mitigate against financing risk, like obtaining and servicing their loans, including interest rate fluctuations and financing restrictions.
9. Diversification: DSTs often provide investors with an opportunity to diversify their real estate portfolios. Instead of owning a single NNN property, investors can participate in a DST that holds a portfolio of properties in different locations and asset classes. Alternatively, they can invest in multiple DSTs with different sponsors who have different business models or investment objectives. This diversification can spread risk and reduce the risk associated with owning a single property.

Conclusion

Of course, Real estate investing with 1031 exchange DSTs investments carry some risks of their own. These may include limited control over property decisions, potential restrictions on liquidity, and varying levels of risk depending on the specific DST offering and sponsor. Additionally, not all investors qualify for 1031 exchanges, which are commonly used in conjunction with DSTs.

Ultimately, the choice between investing in a DST or buying a single tenant NNN leased property depends on an individual’s investment goals, risk tolerance, and preferences. Investors should carefully evaluate both options, conduct thorough due diligence, and consult with financial and real estate professionals to determine which strategy aligns best with their specific circumstances and objectives. Those who are ready for a stable, hands-off investment will certainly find DSTs to be a great vehicle to consider.

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