Now the second common strategy for 1031 exchange investors is shower head a more passive investment option, involving 1031 exchanging into a triple net lease or NNN property. So this is where you would 1031 exchange out of for example, a 15-unit apartment building and 1031 exchange into a building that’s occupied or leased by a company like McDonald’s or Starbucks or maybe Amazon or FedEx or Chipotle on a long-term basis, typically anywhere from 5, 10, 15 to 20 years. These companies, as long as they are solvent, will potentially be paying you, the landlord, rent every single month.
However, there are also potential problems with this type of 1031 exchange strategy as well. Specifically, while many people think that NNN properties are completely hands-off assets and 100% passive investments, they’re really not. For example, many NNN landlords face potential issues with reimbursements. Let’s say one of these tenants is responsible, per the lease agreement, for paying the property taxes, insurance, and other various maintenance costs. However, in many cases, the lease is written so that you, the landlord, pay the property taxes or the insurance premiums and then submit it to the tenant for reimbursement. Oftentimes, these tenants are large Fortune 500 companies, and their staff and processes are always shifting and moving. For example, let’s say you pay the property taxes on your building, and submit it to the tenant for reimbursement, and a month goes by, three months goes by, six months goes by, you’re still not reimbursed for that property tax amount.
Even though the tenant is ultimately liable for that property tax payment, sometimes they are terribly slow at honoring those terms of the lease, or maybe they are such a behemoth of a company that it just takes a really long time due to corporate red tape and approval processes mixed with staff turnover which is often found at these large companies.
Another example is if the parking lot needs to be repaired which the tenant is responsible for per the lease but you as the landlord must perform the work and submit for reimbursement. You, as landlord and owner of the property, are still going to be responsible for tracking down those tenants for reimbursements, inspecting the property, and having to fix the parking lot and other items on the lease. Needless to say, this situation is far from a passive investment, and unfortunately, a lot of investors go into this type of 1031 exchange thinking its totally hands-off, when in reality it’s just not.
Finally, another issue with triple net properties is the potential for over-concentration of risk. Let’s say an investor has a net worth of $4 million, and they’re selling their 10-unit apartment building and doing a 1031 exchange into a NNN with McDonald’s or Starbucks, or Burger King as the tenant. That 1031 exchange investment now represents half of their net worth, which translates to over-concentrating their investment into one property with one tenant in one location. To make matters worse, one of the horror stories with triple net properties is if at the end of the lease term, the tenant decides to vacate the building. Now you as the owner have to go out and re-tenant that building if you’re lucky enough to find another tenant that wants that space. Then you are going to have to pay out tenant improvement allowances, leasing commissions, and so on. The whole process can be costly. Add to this situation that your previous national tenant was paying $20 a square foot and now the market might be $9 a square foot, or ostensibly half of the rent they were paying cutting your potential monthly cash flow in half.