Steering Clear of Net Lease Land Mines

Blaise Bennet of Stan Johnson Co. on avoiding the most common and damaging errors when negotiating net leases.
Blaise Bennet  Photo courtesy of Stan Johnson Co.

With growing uncertainty regarding the future of our economic environment, property owners and developers must be mindful in order to maximize the value of their net lease portfolios. Outlined below are some of the most common and damaging mistakes that are made when negotiating leases with tenants, along with tips on how to avoid these missteps.

Real Estate Tax Increases

Tenants are starting to push back against taking responsibility for any increases in real estate taxes due to a sale or refinance. This can be very problematic for a net lease investor as it often results in the landlord having to come out of pocket to cover the increase in taxes, and thus can have a significant impact on the asset’s value. In some instances, it can render a deal unsellable. When you do encounter such a provision, it is important to limit the exposure as much as possible. This can be accomplished in a variety of ways such as allowing a specific number of transfers or property sales within a given time period to keep the tenant responsible for real estate taxes.

Assignment Language

If assignment language allows the lease guarantor to shift to a lesser credit tenant, the value of the asset can be jeopardized, and the landlord may risk being able to collect rent if the new tenant or entity experiences hardships. If a tenant is adamant about being released from liability upon an assignment, there are several ways to limit this risk. One of the more successful strategies is to require the assignee’s net worth to meet specific threshold amounts.

Tenant Purchase Options

Pay close attention to purchase option provisions in leases, as these can severely impact a property’s value, especially if the purchase option price is pre-determined. It’s important to understand the methodology behind purchase options and ultimately how the purchase price is determined. Clearly outlining a mechanism to determine purchase price, required deposit, purchase timeline, and other details will help avoid any ambiguities. If you cannot avoid a purchase option, a first right of refusal may be a good alternative.

Fair Market Value Terms

Whether it’s tied to purchase options or future rental rates, fair market value terms can have a significant impact on the real or perceived value of a property. If buyers fear that lower market rents are on the horizon, for example, they may not consider your asset as desirable as one with a predetermined escalation amount. One way to limit exposure to fair market value terms is to tie the rental rate to a set value or amount. Using language like “greater of fair market value or a fixed amount above the previous year,” helps ensure the rental rate will not decrease to a lower level than the previous year’s rent, for example.

No Financial Reporting

Generally speaking, net lease investors and lenders would prefer a tenant’s financials to be highly transparent. Insight via annual financial or sales reporting is extremely beneficial and provides security that rent obligations will be met. Tenants will often push back on reporting provisions, however for some net lease properties, it is vital to have a reporting requirement in the lease, especially if you are working with a smaller, private tenant or a franchisee credit profile.

Tenant Lease Entity

Be mindful of the exact tenant entity that is signing the lease and guaranteeing the rent. Too often we see the tenant and parent company of that tenant viewed interchangeably, and that’s not always accurate. This mistake can lead to credit concerns when it comes to underwriting. Study the financials and gain as much insight as possible into the entity’s credit profile. It’s critical to fully understand which entity is guaranteeing the lease and how it may impact the asset’s value if the lease is not being guaranteed by a larger parent corporation. A personal guaranty can sometimes help overcome this concern, however, it only benefits the credit profile if the financial strength of the guarantor is substantial and you have on-going financial reporting requirements in the lease.