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What is A fee simple NNN Lease?

Net Lease Properties are the traditional real estate investment with no management obligation for the owner. In its purest form (called a NNN - Triple Net Lease) the tenant manages the property, doing everything from paying all the operating expenses, property taxes, utilities, insurance premiums, maintenance and repairs. The landlord gets to collect monthly net rental income just as he or she would with a traditional real estate investment.

NNN’s are typically purchased on a cap rate. A cap rate is essentially a yield which is determined by dividing the tenant’s annual rent by the purchase price. For example, if Walgreens is paying $350,000 annually and the purchase price is $4,375,000, the cap rate is 8% ($350,000/$4,375,000).

A NNN Property can either be a single or multi tenant investment like a shopping center, office building or a free standing building. A NNN Leased investment gives you total (fee-simple) ownership of a commercial property, which is pre-leased to a high credit retail tenant – (Walgreens, Burger King, Lowe’s, or Dunkin Donuts, etc.) – on a long-term basis (usually between 10-25 years), providing you with a stable, long-term cash flow. NNN leased property can be an excellent replacement property in completing a 1031 real estate exchange transaction.

Build-to-Suit
Lease form is designed for a single tenant build to suit transaction, where the landlord builds the entire premises for the tenant. The rent payable by the tenant is pegged to the total construction and financing costs of the project, and is usually subject to percentage increases in specified years. This basically allows the tenant to move in and occupy the property with zero costs up front. Once the tenant & developer execute a lease, the developer acquires the land and constructs the property with his owns funds. This enables the tenant to have new construction, including the cost of the land acquisition, without actually using any of its own capital or credit in land and buildings. With no mortgage or other indebtedness to be carried as debt on the tenants balance sheet, the book value of the company’s assets is effectively understated — enhancing the company’s Return on Assets (ROA). The rent is fully deductible over the lease term, making the tenant's after-tax cost less than with alternative forms of asset-based financing. The owner of the property can depreciate the building because you own the building and the ground.

A lease of land only, on which the tenant usually constructs the building (usually required to build as specified in the lease) with their own funds and owns the building during the term of the lease. Such leases are usually long-term net leases; the tenant's right and obligations continue until the lease expires or is terminated through default. In its most basic terms, a ground lease is a method for separating ownership of the improvements (building) from the ownership of the underlying fee (ground). If you own a ground lease, you own a fee simple interest in the ground (not the building). The owner cannot depreciate a ground lease because you don't own the building, so you have nothing to depreciate.

The reason ground leases are desirable is because the tenant is only paying to rent the land and use their own funds for all of the improvements. If the tenant leaves, the owner of the land gets the improvements and since the rent is so low (because the tenant paid for all of the improvements and was only paying to rent the land) you should easily be able to increase your return on investment. So it could actually end up benefiting a buyer if the tenant exits. Ground leases trade at a lower CAP Rate because they are usually lower price points and below market rent.

A commercial ground lease is usually defined as a lease of land (typically the land is not improved), for a relatively long term (e.g., 25 to 99 years), where all expenses of the property are the obligation of the tenant (e.g., taxes, repair and maintenance expenses, insurance costs, and financing costs), and which allows for tenant financing for the construction of the project to be constructed on the land either by leasehold financing, and/or so called “fee subordination” financing. Ground leases, therefore, are not only leases in the traditional sense of the word but are also financing instruments.

There are two major advantages for a tenant entering into a ground lease, as opposed to purchasing the land.

Typically ground leases are long term and include set rent escalations, foreclosure rights should the lessee default, and a reversionary right, which means improvements on the property revert to the landowner at the end of the lease term. While such lease terms do not particularly favor developers, ground leases offer some distinct advantages.

Whichever is better depends on what the investing goals are for the property owner....both involve low maintenance, and low management; however, there are tax consequences which would effect the owner's bottom line.

Subordinated & Unsubordinated
Ground Leases
The term “subordinated ground lease” refers to a ground lease in which the landowner has agreed to permit a lien to be placed against the owner’s fee simple interest in the land to secure the payment of the loan made by the construction lender or a subsequent lender to the tenant. The lender has a lien against both the fee simple interest of the landowner and the leasehold estate of the tenant. If there is a default under the loan, the lender may foreclose against both the fee title and the leasehold estate, in which case the owner loses its land.

In an unsubordinated ground lease, no lien is placed against the fee simple title to the land. Instead, the leasehold estate is the primary security for the loan.

Reasons Why a Landowner Might Agree to Subordination
It is not typical in current arms length transactions for the owner to subordinate its fee interest, but there may be instances in which an owner is willing to do so. For example, an owner may be willing to subordinate its fee in order to enable the tenant to obtain financing to develop the property, particularly if the financing will permit enhanced development of the property or development of the property in a manner that will enhance the value of the owner’s adjacent or nearby property. Or, the owner may be willing to mortgage its fee interest in exchange for participating in the project’s profits.

There are very specific 1031 exchange identification requirements for identifying potential like-kind replacement properties in your 1031 exchange transaction. The prospective like-kind replacement properties that you identify as part of your 1031 exchange do not need to be under contract or in escrow when you identify them.

Identification Period: A seller must identify another replacement property that he proposes to buy within 45-day period from the date he sold his relinquished property. The 45-day timeline is very rigid and does not allow any variances (even if the 45th day should fall on a weekend or holiday.) Note that during this period, the proceeds from the sale of the relinquished property are in the custody of the qualified intermediary.

Exchange Period: An individual has 180 days from the date of selling their property that was the basis for the 1031 to receipt of the newly-acquired property.

The period within which the person who has sold the relinquished property must receive the replacement property is referred to as the “Exchange Period” under 1031 of the IRC. This period ends at 180 days after the date on which the person transfers the property relinquished or the due date for the person's tax return for the taxable year in which the transfer of the relinquished property occurred, whichever is earlier. A word of caution: Many ill-advised or careless investors see the language referring to the due date for their tax return and assume they can wait until the last minute to purchase the new property. Remember – the deadline is the EARLIEST of the two scenarios. If an individual were to sell their 1031 property in May, the deadline for acquiring a new property (180 days) would fall well before their tax return in the spring of the following year.

While the utilization of 1031 exchanges can be an extremely valuable tool for maximizing tax savings, it is a very complex process and often difficult to navigate.

Identification Rules and Exceptions
1031 Exchange ID Rules

You must comply with at least one of the following identification rules or exceptions when completing the identification of your like-kind replacement properties:

It's advised that you get a purchase agreement set up and a replacement property in mind before starting the 1031 process. This is because "The three-property rule" (under 1031 tax exchange regulations) declares that the exchanger of a relinquished or replacement property may identify up to 3 replacement properties, regardless of their value.

Three (3) Property Identification Rule
The three (3) property identification rule limits the total (aggregate) number of like-kind replacement properties that you can identify to three (3) potential like-kind replacement properties. The vast majority of Investors today use this three (3) property identification rule.

You could acquire all three of the identified like-kind replacement properties as part of your 1031 exchange, but most Investors only acquire one of the three identified properties. The second and third identified properties are merely identified as back-up like-kind replacement properties in case you can not acquire the first property.

You will skip the three (3) property identification rule and use the 200% of Fair Market Value Rule if you are trying to diversify your investment portfolio and wish to identify more than three (3) like-kind replacement properties.

200% of Fair Market Value Identification Rule
You can identify more than three (3) like-kind replacement properties as long as the total (aggregate) fair market value of all the identified like-kind replacement properties does not exceed 200% of the total (aggregate) net sales value of your relinquished property(ies) sold in your 1031 exchange. The limitation is only on the total (aggregate) identified value. There is no limitation on the total number of like-kind replacement properties.

For example, if you sold relinquished property(ies) in the amount of $2,000,000 you would be able to identify as many like-kind replacement properties as you want as long as the total (aggregate) value of the identified like-kind replacement properties does not exceed $4,000,000 (200% of $2,000,000).

95% Identification Exception
If more than three properties have been identified, and their total fair market value exceeds 200% of the value of what was sold, the exchange may still be valid if 95% of the total cost of all properties on the list are purchased. This means if there are properties costing $100,000 on your list, then you must purchase at least $95,000 of them.

At Solid Investments we can assist you in locating a like-kind property for a 1031 exchange and ensure a smooth and successful transaction.

The balance sheet of your business is improved greatly and you retain control of the property. Since you will be leasing the property you can defer a good portion of the tax liability. With a lease you can write off the full payment each month whereas with a regular loan only the interest payment can be written off. When you complete this transaction you are always guaranteed the full market value of your property, so you don’t risk losing any money in equity.

The other benefit is that you can get a lease for commercial property for up to 25 years, which can lower your monthly payments considerably. This gives you more operating capital each month since your monthly payments will go back down some.

Real estate sale leaseback transactions are becoming more popular because they generate capital for immediate use within your business. It unlocks the value in your real estate. With real estate you can get more capital because of how fast it grows. Some businesses do sale and leaseback transactions for equipment as well.

What kind of property can be made into a Zero Cash Flow Deal?
A Zero Cash Flow Deal is constructed like a bond. It must be backed by investment grade rated credit (AAA to BBB+), a very long-term lease (generally at least 20 years); and have tightly drawn lease provisions making the tenant responsible for effectively everything relating to the leasehold.

Why would I ever do a Zero Cash Flow Deal?
You are concerned that Cap Rates may go back to historic levels and want to protect your equity. If Cap Rates just go back to 8% from current 6% levels that will represent a 33% reduction in property values. If you own property and have a loan of 67% or greater, you will be wiped out. To repeat, YOUR EQUITY WILL BE WIPED OUT. By contrast, in a Zero Cash Flow Deal the income is “pre-sold” to the lender in the current low rate environment. Cap Rate and interest rate changes do not impact the value of Zero Cash Flow Deals. Why not let a willing lender take this risk?

You want to grow your portfolio in the safest, most riskaverse possible way. A Zero Cash Flow Deal let’s you leverage your tenant’s investment grade rating; and the Zero Cash Flow Deal structure to buy property worth 10 times your equity without personal recourse; with debt structures that generally don’t balloon for at least 20 years; and often are fully amortized by the tenant’s rental payments over the lease term.

When was the last time an investment involving a “zero cash flow” sounded appealing?
For most of us, that time would be never. However, there are times when “Zero Cash Flow” property can be of the most instrumental use. If used properly, they can allow someone to leverage a property with (if you can believe it) 90% debt. Of course that debt comes at a cost, namely all those rent checks that would normally be going to you, instead go to your lender (hence zero cash flow). However, after you are done paying off the debt, you would be left with a property completely paid off, most likely highly appreciated in value, and a deferment of the impending capital gains taxes.

Cons to a Zero Cash Flow Deal
Phantom Income: Phantom income is any income that is reportable as taxable income but that does not generate cash flow for the investor. In other words, the investor does not actually receive phantom income, but is taxed on it nevertheless. Earnings from limited partnerships often arrive in the form of phantom income. Phantom income can also come from zero coupon bonds, which do not pay interest but are instead sold at a discount and accrue “income” over the course of their lives. Phantom income can also occur in the form of a loan that was forgiven, whether by a business (such as a credit card company) or by a private party. The borrower is thus liable for tax on this phantom income.