Triple Net Properties

Which is the BIGGEST RISK in purchasing income producing property?

a)  The loss of the tenant.

b)  A tenant who is paying an above-market rental rate.

The answer is counter intuitive and surprising.  You won’t hear this from many brokers and certainly not from any sellers.  As you can guess by now, the answer is b).  It would seem like a great deal to have a tenant (like the famous coffee shop) who is paying a far greater rental rate for a particular location than anyone else in the marketplace would pay.  It is a good deal, just not for you, the one purchasing the investment.  It’s a great deal for the seller.

We’re not here to tell you to stay away from all investments that are occupied by our favorite coffee shop.  It’s not the tenant you need to worry about.  It’s what they’re paying in rent that should be fully analyzed prior to purchasing an investment property.   If a tenant is paying substantially more than the REAL market rental rate for the immediate trade area, then there will always be the looming risk of substantial income stream reduction and an overall diminution of investment value.

HERE’S WHY.  The purchase price of an income producing investment property is based upon two items.  1) The going rate of return that’s acceptable to an investor (the capitalization rate) and 2) The net operating income (NOI.) Whatever cap rate is acceptable to you, that’s your choice.  We don’t take issue with what defines an acceptable rate of return for you.  It can be different from investor-to-investor.  However, if the NOI is inflated because of an above-market rental rate, that translates in to an inflated purchase you’re paying.  When you overpay for an investment, you’ll have a hard time making the numbers work in your favor, especially in the future.

At the end of the tenant’s lease term, or worse, if the tenant moves out early or files bankruptcy, the property will go back on the market for lease.  If the prior tenant was paying a rental rate that was above the REAL market rental rate, you will not be able to FULLY REPLACE the income stream.  Any reduction in the income stream (or NOI) translates in to an immediate loss of investment value.  Just in the 1st quarter of 2013 we have spoken to three investors who have had rental rate adjustments between 30% and 50% when their primary tenant moved out.  They soon discovered that no other tenants in the in the market would pay a rental rate that was remotely close to what the prior tenant had been paying. That reduction in rental income translates in to a 30%-50% reduction in the value of the investment overnight.