The Property Management Shop

Don�t Trade Your Rentals for Triple Net Properties

by Marc Wilson

Q. My wife and I own a 21-unit apartment building in San Francisco. We are both in our seventies, and we would really like to get out of the apartment building management business. Most of our income is derived from the property. Last week, I went to a seminar on the topic of triple net properties. My real estate broker seems to think that I can increase my income and abolish all my management hassles if I trade my current property for a Burger King, Jack in the Box or Walgreens. What do you think?

A. The market for triple net leased properties is extremely hot right now. A triple net leased property is usually a commercial building with a single tenant. The typical lease stipulates that the tenant—for example Denny’s, Walgreens, or McDonalds—pays all the expenses associated with the property. In most cases, the tenant is responsible for the property taxes, liability and fire insurance, roof repairs, building repairs and parking lot maintenance. In short, the tenant covers absolutely all expenses. These deals are attractive to the average investor because the rate of return is higher than apartment building investments, the income stream appears to be safe and there are no management responsibilities. Many former stock market investors have fled to the triple net property market in search of a reasonable return. A 7 or 8 percent capitalization rate looks pretty good to someone who has recently been playing around with Enron or United Airlines stock. Triple net properties have become a form of safe harbor in an investors’ storm.

There is, of course, more to the story. There are three inherent problems with 98 percent of all triple net properties currently on the market for sale. First, the leases usually stipulate a fixed rental amount for 10, 15 or even 40 years. You are, in effect, trading all future upside for a currently higher than average return. You can buy a San Francisco apartment building for a measly 5 percent return, but over the long haul you will partake in any upside in the rents. Not withstanding rent control, your 21-unit apartment building will get plenty of turn over during years of heavy rent inflation. Take a look at your tax return from ten years ago. I think you will find that your income has increased dramatically. Triple net properties will not give you that kind of income appreciation.You can buy a Walgreens today at a 7 percent return, and that is exactly the same return that you will have ten years from now.

Second, single-tenant triple net properties have no income diversification. Your income stream is dependent on the performance of a single tenant. Your broker will tell you that Walgreens is a “AAA” risk company and that they will never, ever go bankrupt. If I remember correctly, some real estate agents said the same thing about Kmart ten years ago. One of these days, Sam Walton’s heirs are going to want to retire. When they do, they are going to sell the company to a couple of cowboys with a big bank loan. Throw in a bad economy with some old fashioned poor management, and you won’t get your income anymore. We all know what happens when a single tenant in a 21-unit apartment building goes broke: you simply evict the tenant and re-rent the apartment. Your San Francisco apartment building gives you a diversified income stream and upside potential. Most triple net properties give you a single, relatively high risk income stream and no upside potential.

Last, most triple net properties in today’s market are horribly over priced. The current yields do not reflect the aforementioned problems. Also, the price for this type of real estate is crazy relative to replacement cost. You can pay $300 to $400 per square foot for a Walgreens that cost only $100 per foot to build, including land value. You see, all of the property’s inherent value is related to the tenant and the rent that the tenant is currently paying. Most triple net properties that are currently available are worth far, far less than their asking price if the tenant ever leaves or goes bankrupt.

Of course, there is a possibility for mitigating these risks. The only way to safely play the triple net property game is to diversify, diversify, diversify. You should either have no more than 15 percent of your total net worth invested in a single triple net property or you should own multiple triple net properties with tenant profiles that represent all kinds of locations and industries. Most of my clients do not have the net worth for any of the aforementioned approaches and apparently neither do you. At this time, trading your equity into a triple net property would definitely be unwise. You should instead hire a property management company. This way you can get out of the property management business, maintain your income and not assume more risk.

The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of the SFAA or the San Francisco Apartment Magazine. Marc Wilson has been managing and selling San Francisco apartment buildings for over 15 years. Please send your questions concerning property management issues to Marc Wilson at 1699 Van Ness Avenue, SF, CA 94109. He can be reached at 415-229-1275. Copyright © 2003.