Net Leases versus Ground Leases: a primer
Cecile Babcock, 27 September 2021
Though ground leases are still relatively uncommon in North America, net leases are a well-known type of credit tenant lease (CTL) that is experiencing robust demand from institutional investors as they look for hedges against rising inflation. There is considerable overlap between ground leases and triple net (NNN) leases in particular—enough overlap, in fact, that ground leases are considered a type of specialised NNN lease by regulators and ratings agencies. However, there are a few key differences, one of the most significant being the duration.
What are net leases?
- Single net: the tenant pays rent and property taxes.
- Double net: the tenant pays rent, property taxes, and insurance premiums.
- Triple net: the tenant pays rent, property taxes, insurance premiums, and all costs associated with structural maintenance and repairs.
Similar to a ground lease, the lessor of a NNN lease assumes a lower degree of risk and a hands-off role in terms of maintaining the building, and the duration is such that the asset class is considered long income in the US and Canada. Here, however, “long income” indicates 15-20 years, not 75 to 99, meaning that a bonded net lease portfolio will have a much shorter weighted average loan term and resemble real estate more closely than fixed income.
This is also true in terms of returns: NNN leases both carry more risk and are much more liquid, which is reflected in typically higher IRRs. Where a ground lease is overcollateralised through the leaseholder maintaining possession of the building (between 20-40% of the fee simple value), the NNN lessee has no capital tied up in the real estate, theoretically making it less financially punishing to walk away in the case of a default.
The NNN lease market, in addition to being more liquid, is more varied in terms of geography, sector, and especially ticket size. Transactions run the gamut from a $500,000 Dollar General in rural Iowa to $200m-plus life science facilities in the gateway markets, which allows for a high degree of specificity when building a portfolio. The market is active enough that that it would be possible, for example, to build a portfolio entirely of $5-10m supermarkets across the Pacific Northwest—a task considerably more difficult with ground leases given that the asset class is still nascent.
Another difference is that a NNN lease will have a single tenant, whereas a ground lease on an office building can have a dozen more depending on the square footage, and this is often seen as an advantage because of the security afforded by the diversification. As such underwriting the lease is essentially underwriting the credit of the tenant—often a more straightforward exercise than forecasting market shocks 99 years into the future. What has made net leases such an appealing investment as of late, however, is exactly what attracts pension funds and insurance companies to ground leases, which is the fact that they are usually inflation-linked.
For investors who are looking to build a ground lease portfolio to hedge for inflation but concerned about lower returns and illiquidity, net leases offer a way to augment IRRs and reduce duration in exchange for slightly higher risk. As Long Harbour expands its North American footprint, the team continues to work closely with dedicated US-based origination partners with extensive networks and experience in the net lease space and would be happy to discuss this opportunity further.
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