By Alisha Kosareff, Esq. and the Cove Capital Investments, LLC Legal Department and Asset Management Team
Article Summary:
If you are thinking about investing in a Triple Net Lease – NNN property for your 1031 exchange because you believe they are 100% no management investments with zero headaches, think again. Recently, the Cove Capital Legal Department and Asset Management Department gathered their collective minds to create a rundown of actual issues they have encountered over the many years of owning hundreds of thousands of square feet of Triple Net Lease properties. While some of these potential problems may seem obvious, others are more obscure and nuanced. However, all of these issues have the potential to be very costly and time consuming for an individual investor that is contemplating purchasing a Triple Net Lease property on their own, reinforcing why Delaware Statutory Trusts might be the best solution for your 1031 exchange.
Key Takeaways:
- What is a NNN Lease?
- What Type of Easement and Restriction Issues Can Occur with Triple Net Lease Properties?
- How Tenant Work Agreements Can be Problematic for Triple Net Lease Properties
- How Triple Net Lease Properties Can Involve Complicated Layers of Relationships
- Why Title Disputes Can Create Issues with Triple Net Lease Properties
- Stormwater Management Systems can be Problematic for Triple Net Lease Properties
- Triple Net Lease Properties Can Require Expensive Maintenance Issues
- How Historical Preservation Clauses Can Cause Problems for Triple Net Lease Properties
Cove Capital Investments works with many investors who are considering a 1031 exchange. One common scenario we often see is an investor who has spent 20 to 30+ years assembling a portfolio consisting of a handful of single-family rentals and multifamily buildings and now they are nearing retirement and want to step away from the responsibilities of active management and the troublesome three T’s (Tenants, Trash, and Toilets).
Unfortunately, if they completed an outright sale on any of their properties, they often would be hit with a very large capital gains tax bill. Therefore, these clients look to the 1031 exchange to defer those capital gains taxes when they sell and oftentimes, they are approached by their real estate agent about buying a NNN property as a way to complete their 1031 exchange and get out of the active management of their previous rental properties.
In many cases, these investors become interested in purchasing a single NNN leased property for their 1031 exchange because they think this is the only way to move from active ownership to a more hands-free ownership position. However, at this point, it is not uncommon for investors to also begin getting nervous about concentrating such a large percentage of their net worth into one single NNN property. And for good reason.
While it is never a good idea to “put all your eggs in one basket” from an investment perspective, NNN lease properties can have their share of problems, including the risk of vacancies, over-concentration, and a variety of potential legal issues that this article will specifically address. *
However, before we get into some specific challenges of owning NNN properties that we have personally seen at Cove Capital, let’s first start out with a simple definition of exactly what is a triple net lease NNN property?
A Little Bit About NNN Lease Properties
The triple net lease gets its name from the fact that the property tenant is responsible for paying the majority of, if not all, the three main categories of operating expenses: maintenance, property taxes and insurance.
NNN leases may be favored by investors for several reasons, including:
- Leases are often “long-term” (10 years or longer) so the hassles of renegotiating leases and securing renewals are likely infrequent.
- Property management functions are mostly the responsibility of the tenant, so investors can potentially receive income without the time-consuming aspects of managing the day-to-day operations of the property.
- Some triple net tenants are of high-credit quality, which may offer investors peace of mind in the assurance that rent will potentially be paid.
Actual Issues That Can Arise with Triple Net Lease – NNN Properties
All of this looks straight forward and clean next to a couple of bullet points on a piece of paper, but let’s take a closer look at some of the thorny issues and challenges the Cove Capital Legal Team and Asset Management Department uncovered over the years of buying and managing hundreds of thousands of square feet of Triple Net Lease – NNN properties.
- Easement and Restriction Issues with Triple Net Lease Properties
NNN Properties are often affected by easements and restrictions between neighboring owners which can create numerous problems. These can include access disputes, maintenance responsibility challenges, encroachment issues, land use restrictions, nuisance concerns, and enforcement pushbacks to name just a few. Each one of these potential issues can require both extensive legal and property management expertise.
Real Life Example
In this situation, the property had benefited from an easement with the neighboring property, which allowed for an emergency access driveway. This easement, however, was revocable by the neighboring owner, who decided to terminate the easement. The termination of this easement would require the owner of the Triple Net property to spend lots of time and money to address the following issues:
- Relocate the access area.
- Restructure portions of the parking lot and landscaping.
- Obtain new survey drawings.
- Draw up and review plans.
- Review all required governmental and lease requirements for parking.
- Complete the drafting and review of legal paperwork.
The Cove Capital legal team and asset management team completed all of the above while coordinating with the neighboring owners over many emails and via numerous conference calls. For an individual investor (and their family/heirs) to be faced with this situation to handle on their own would be very expensive, stressful and timely. Thankfully our investors in this Delaware Statutory Trust investment did not have to handle any of this work as Cove Capital, as the DST sponsor, stepped in and handled everything.
- Tenant Work and Agreements
In Triple Net Lease arrangements, tenants at the property are generally permitted to perform their own improvement work and contract for their own services such as telecommunications agreements. This can potentially open a host of issues from both a legal and liability perspective.
Real Life Example
We encountered this recently when one of our tenants requested consent to perform work at one of our industrial net lease properties. This proposed work included increasing the size of their dock door, installing a new dock door opening, asphalt and concrete curb work, and three new tractor spaces with striping.
This work required the Landlord’s consent which required significant review and careful attention to detail. For example, we needed to thoroughly review the lease to ensure the Tenant could in fact perform the work and any requirements, and then confirm our insurance requirements to protect our interests. This required the Cove Capital asset management and legal departments to thoroughly review the tenant’s plans and receive a Certificate of Insurance (COI) that conformed to the requirements and name the Landlord as additional insured to make sure we were protected in case anything were to happen during the course of the Tenant’s work.
This same scenario often occurs when a Tenant wants approval for a telecommunications agreement, which enables a third-party vendor to place cables and equipment necessary for the tenant’s telecommunications needs. As the owner of the Triple Net property an investor (and their family/heirs) needs to be ready to handle these types of requests from their tenant as well as ensure that they are protecting their interests and rights through adequate insurance coverage and naming. All which can be costly and again very time consuming.
Lesson for Potential NNN Property Owners to Ponder:
Again, every request by the Tenant needs to be reviewed from both a legal perspective, liability perspective and asset management perspective to ensure the Tenant maintains responsibility for the work and that the Owner is adequately protected from claims by the vendor and from any claims that would arise due to the vendor’s work at the property.
Cove Capital has a fully integrated team of real estate professionals who are experts in their respected fields that include acquisitions, asset management, accounting, real estate review and analysis, investor relations, legal, marketing, and capital markets. Very few 1031 exchange investors have the type of resources like this at their fingertips. The Cove Capital team is appreciated by over 1,600 investors nationwide who have participated in our Delaware Statutory Trust and real estate investments over the years. Our investors don’t have to worry about the time and planning of these asset management and legal items that often arise with NNN properties since they know they have the Cove Capital team as their DST sponsor company and asset manager handling these items.
- Entangled Responsibilities
Triple Net Lease properties can have a lot of moving parts and multiple parties involved in many levels of the real estate. For example, there often are property owners, tenants, property managers, real estate brokers, lenders, developers all interacting with the property, but not always acting in unison.
Real Life Example
For example, we encountered a very unusual situation with one of our NNN properties that was, since newly constructed, running on generator power. The property was built by the Seller from whom Cove Capital purchased the property. Permanent electricity was to be completed by the business park developer. However, a problem arose when the business park developer ran short of funds and could not bring permanent power to the property, despite the fact that the City issued a bond to finance the development. Furthermore, the Seller then indicated that they would not continue to pay for the generator power, which would leave the tenant without their required power to operate and be a breach of the Lease for which the DST as owner would ultimately be responsible for resolving.
To preempt a furtherance of issues and to protect our investors, Cove Capital was able to quickly review the lease requirements, the Purchase and Sale Agreement (PSA), and initiate several calls with the Seller, reiterating our rights under the PSA to require the Seller to pay for the generator power and to resolve the issue. Along with legal rights protecting Cove and its investors, this particular seller has enjoyed working with Cove Capital over the years as we have purchased many properties from them and therefore the seller wanted to keep the relationship intact.
At the end of the day, the Seller was able to handle the situation and provide permanent power to the building. This again was a situation that took specialized legal and asset management capabilities that would cost an individual investor thousands of dollars and countless hours of time and headaches. Fortunately for our Delaware Statutory Trust investors, all items were taken care of in a timely manner by the experienced team at Cove Capital.
Lesson for Potential Net Lease Property Owners to Ponder:
Fortunately, Cove Capital had an established relationship with the Seller of this property. This established reputation within the commercial real estate industry can be a powerful tool to have and helped us negotiate a reasonable solution to this predicament on behalf of our investors. In this situation, we were able to push the Seller to push the developer and the City to resolve the issue.
However, an honest question to ask yourself is if you were the sole owner of a Triple Net property with this kind of issue, could you (or your family/heirs) physically bring the parties together to force movement and ultimately a successful solution? If yes, how many hours and how much money (not to mention how much added stress to you and your family) would you have spent making this outcome a positive one?
- Title Disputes
Sometimes NNN properties can have disputes and misinterpretations with regards to Title. For example, there could be disputes relating to unclear ownership rights, easements and encumbrances, boundary disputes, and zone and land use restrictions.
Real Life Example
As a case in point, one of our NNN properties was recently named by an adjacent property owner who alleged that a portion of land that was deeded to us in the sale by the seller, actually belonged to the neighboring owner. The neighbor stated that going back to a few sales prior to when Cove Capital purchased the property, the neighbor intended to only sell a 50-foot section of the land and not a larger parcel. To make matters even more contentious, the neighbor alleged that the title company altered the legal description and recorded a deed that gave Title rights that were never intended to be sold.
The Cove Capital legal team spent a great deal of time meticulously reviewing every piece of documentation including the allegation, the deeds, all the surveys, and the tenant lease to make our own conclusions as to what was represented to us by the seller, any potential repercussions with the tenant, and the next steps in order to resolve the matter favorably on behalf of our investors.
We then filed a claim with our title insurance company and immediately started to create a new survey and new legal descriptions to be drawn up and that the tenant has all the land intended and is required.
Lesson for Potential Net Lease Property Owners to Ponder:
Land title disputes can be expensive and quickly throw an unknowing owner (and their family/heirs) into an incredibly stressful and expensive situation. Extensive legal research, documentation review, and analysis of property records can involve significant attorney hours and costs. Plus, it is not uncommon for these disputes to require hiring expert witnesses, such as surveyors or land appraisers, to provide professional opinions or testimony, adding to the overall expense. This is assuming that litigation can be avoided, which includes filing motions, attending hearings, and engaging in negotiations, all of which can prolong the legal proceedings and escalate expenses further.
The stakes involved in land title disputes are high because they can determine ownership rights, property values, and development opportunities. Before considering purchasing a NNN property each investor needs to ask themselves if they (and their family/heirs) have the necessary resources and bandwidth to handle a land title dispute, including all of the complexities surrounding property law like intricate statutes, regulations, and case precedents? This is the exact reason that Cove Capital creates Delaware Statutory Trust offerings for 1031 exchange investors that value a highly capable team of real estate professionals handling these types of issues on their behalf.
- Stormwater Management Systems
NNN properties often require government mandated stormwater management systems along with stormwater management agreements and plans. At the bare minimum, these requirements require organizing annual inspections, reporting to the local agency, and making sure the system is properly maintained. However, other times these agreements can involve more work.
Real Life Example
Recently, Cove Capital was contacted by a local government to fulfill the requirements of their stormwater management agreement. This required us to obtain an updated plan, and perform multiple rounds of reviews, recordings, and writing of legal documents to fulfill the stormwater management plan.
Lesson for Potential Net Lease Property Owners to Ponder:
Very few 1031 exchange NNN investors can implement and maintain stormwater management systems on their own because of the costs involved. The costs associated with designing, constructing, and maintaining stormwater infrastructure can be substantial, and the need for specialized engineering expertise, and ongoing maintenance requirements is prohibitive. Thankfully for our DST investors, the Cove Capital team was able to handle this particular issue and continue to send each investor their portion of the monthly rental income that the tenant paid.
- Property Maintenance
Maintenance Issues with Falsely Advertised Net Lease Properties
One of the most troublesome issues that can arise with Triple Net Lease properties involve property maintenance problems. In some cases, brokers will advertise a property as “zero landlord responsibilities” to entice unknowing buyers. However, after carefully reviewing the lease, this is not accurate.
This means that anyone considering purchasing a Triple Net Lease property needs to fully understand all aspects of the lease and which obligations are the landlords and tenants respectively.
Real Life Example
We have seen many examples when a Triple Net buyer acquires but ignored significant findings in third-party reports because they are under the impression these repairs will be covered by the tenant or at the tenant’s cost. In addition, it is the ultimate responsibility of the new landlord to enforce these repairs, even if they are the tenant’s responsibility within the lease. We have seen examples of when the tenant refused to perform necessary maintenance issues and we have had to issue notices to the tenant to perform their work as per the terms of the lease.
Even if a buyer acquires a property with an authentic Triple Net Lease agreement in place, many net lease properties still require the landlord to perform non-routine maintenance of the structural portions of the property. This includes repairs on roofs, foundations, HVAC systems, and parking lots. For example, parking lots need to be resealed and re-striped typically every five (5) years; while roofs often need to be inspected annually, especially in areas with extended periods of inclement weather or those subject to severe weather patterns.
Another area of potential concern involves who is responsible if structural components are damaged under warranty? In many cases, it is the Landlord that is responsible for enforcing all applicable warranties. This can get quite difficult when the contractors who performed and warranted the work may not be responsive to a request for warranty work.
Lesson for Potential Net Lease Property Owners to Ponder:
NNN properties often require some type of maintenance that involves addressing the three C’s: condition, cause, and correction. These maintenance issues can quickly skyrocket and get out of hand drastically affecting the owners cash flow. In addition to costs, there can be an inordinate amount of time consumed to remedy, manage, or enforce vendor and warranty contractors.
- Historical Preservation Clauses
Another overlooked legal snarl for NNN properties can be historical preservation clauses as they can impose restrictions and obligations related to the maintenance, restoration, and alteration of the property. When a historical preservation clause is part of the lease, it can create additional layers of complexity and challenges.
Real Life Example
We encountered this recently after we acquired a property that was a unit of a larger property. The part that Cove Capital owned involved a long-term credit rated net lease tenant.
The entire property included a retail store, a hotel, and a parking structure that was managed by a Homeowners Association (HOA). Our portion of the real estate included an area that was described as a necessary “accessory” which meant it had to operate and adhere to certain operating protocols. One of these protocols was a legal requirement imposed by the city’s Historic Preservation Board that our tenant keep the accessory fully operative.
As the owner, Cove Capital received multiple notices from the HOA that our tenant was not keeping the accessory functional. Eventually, Cove Capital decided to send a letter of default to the tenant as they had multiple opportunities to remedy the issue. Once the tenant received the notice, they immediately corrected the issue and even created a streamlined communications system for quickly addressing future issues.
Lesson for Potential Triple Net Lease Property Owners to Ponder:
Cove Capital maintains a full team of highly qualified real estate professionals that are experts in their respective fields. In this case, we employed our legal team, our asset management team, and our investor relations team. Each arm of these departments spent hours coordinating and documenting the challenge, solution, and execution of the problem. Not many individual investors or their family/heirs have the bandwidth to accomplish this.
In Conclusion:
Investors considering NNN properties for their 1031 exchange might be under the impression that these investments are entirely management free and absent of any complications. Nothing can be further from the truth. That’s why the legal team at Cove Capital Investments compiled these insights based on our extensive experience, highlighting the array of challenges and nuances that have surfaced over time with managing hundreds of thousands of square feet of Triple Net Lease investments.
We encourage all investors that are considering purchasing a NNN property to understand truly what they are getting themselves (and their heirs) into. If an investor understands the potential costs, headaches, asset management and legal implications of owning a NNN property on their own then it possibly may make sense for their situation (but it still begs the questions as to if their heirs are up for the challenge). For many other investors, utilizing Cove Capital Delaware Statutory Trust offerings as a 1031 exchange solution that allows them to not have to handle these types of issues of owning and managing real estate has shown to be a great solution. To view the currently available DST investments sponsored by Cove Capital please register at https://covecapitalinvestments.com/.
* Diversification does not guarantee profits and does not guarantee against losses.
