Triple Net Lease Risks: What DST Structure Handles for You

Triple Net Lease Risks Overview

The Core Risks of NNN Investing

NNN properties carry five primary risk categories. Tenant credit risk is the most significant: in a single-tenant property, default or bankruptcy eliminates 100% of cash flow overnight. The property is either fully leased or fully vacant. Re-tenanting costs and vacancy follow tenant departure. Commercial re-tenanting typically requires six to eighteen months of downtime, with broker commissions (4-8% of lease value), tenant improvement allowances ($10-50+ per square foot), and rent concessions. During that period, the landlord pays debt service, taxes, insurance, and maintenance. Location and market deterioration affects even strong locations over time. Lease complexity creates risks that most investors miss: early termination options, rent reduction clauses, expense reimbursement caps, and below-market renewal terms are buried in long lease documents. Exit timing and liquidity constraints apply to all commercial real estate. DST interests have no established secondary market. Capital remains committed for the full projected hold period, typically five to ten years.

Why Direct NNN Buyers Face These Risks Alone

Individual buyers lack institutional resources for comprehensive risk assessment. Time pressure during 1031 exchanges, particularly the 45-day identification deadline, forces reliance on seller-provided information. Single-property concentration magnifies every risk. When problems arise, direct owners must hire expertise on an ad hoc basis. DST structure shifts management burdens to sponsors with institutional resources and experience, though it does not eliminate the underlying risks.

Tenant Credit Risk

What Happens When Tenants Default

Tenant default eliminates rental income immediately. In a triple net structure, the landlord also loses reimbursements for property taxes, insurance, and maintenance. Those expenses become the landlord's responsibility overnight. Property value declines because commercial real estate value is tied directly to the income stream; a vacant property has significantly less value than one with a creditworthy tenant under a long-term lease. Legal proceedings, including eviction, lease enforcement, and collection, add cost and uncertainty. Recovery depends on guarantee structure. Parent company guarantees provide recourse to the tenant's broader resources, while subsidiary-only guarantees limit recovery. Blockbuster and Borders Books went bankrupt, leaving NNN landlords with vacant properties and zero income while covering all holding costs. Fraud amplifies the risk further. An FBI special agent and CPA documented cases where investors lost approximately $20 million after tenants fraudulently inflated appraisals by signing leases they could not afford, then defaulted within months.

How DST Sponsors Vet Tenants

Professional sponsors conduct credit analysis using S&P, Moody's, and Fitch ratings. Investment-grade ratings (BBB-/Baa3 or higher) indicate lower default probability but come with lower cap rates. Non-investment-grade tenants offer higher yields with higher credit risk. Financial statement review provides deeper insight when available; public companies disclose audited financials. Industry position assessment evaluates business model durability: retailers facing e-commerce disruption carry more risk than necessity-based businesses.

Guarantee structure receives careful attention. Some tenants assign leases to special purpose entities that can file bankruptcy without affecting the parent. Quality sponsors negotiate for parent-level guarantees. Location-specific performance matters as much as overall tenant health. Sponsors evaluate sales data and positioning for the specific property, not aggregated results.

What Investors Can Review

Offering documents disclose tenant credit in the PPM property description section. The lease summary should specify whether the parent or a subsidiary guarantees the lease. Quality sponsors provide detailed credit analysis; generic "strong tenant" statements without support suggest insufficient due diligence. Investors should verify credit rating and guarantee structure independently.

Re-Tenanting Costs and Vacancy Risk

The Expense of Finding New Tenants

Broker commissions (4-8% of lease value), tenant improvements ($10-50+ per square foot), and free rent concessions make re-tenanting expensive. Downtime averages six to eighteen months. Total costs can reach hundreds of thousands of dollars on a single property. Tenants who are directly responsible for maintenance may defer it to cut costs, leaving a deteriorated asset at lease end. Quality lease structures require preventive maintenance contracts and minimum standards.

How DST Sponsors Handle Re-Tenanting

Sponsors maintain established broker relationships across national markets, providing access to tenant prospects and market intelligence. Market knowledge from managing multiple properties allows competitive pricing and reduces vacancy duration. Negotiating leverage from multiple properties provides advantages individual owners cannot match. Reserve funds for re-tenanting must be established at acquisition because DST structures prohibit raising new capital after the offering closes.

Distribution Impact During Vacancy

Distributions decline or stop during vacancy. Reserves may cover short-term gaps, typically three to six months, while the sponsor secures a replacement tenant. Extended vacancy directly reduces total return. Eighteen months vacant in a ten-year hold represents 15% vacancy and can meaningfully reduce Year 1 projected distributions over the life of the investment. When evaluating NNN returns, vacancy scenarios should be modeled explicitly. Sponsor communication during re-tenanting varies. Quality sponsors provide regular updates on marketing and negotiation status.

Location and Market Risk

Why Location Matters for NNN

Demographics, competition, and local economic shifts affect tenant performance and re-tenanting prospects. Investment-grade credit does not protect against location risk. Strong national tenants close underperforming locations and do not renew. Market conditions determine whether vacant space re-leases quickly and at what rents.

How DST Diversification Helps

Portfolio construction across multiple DST offerings spreads location risk across geographic markets. Different markets have different economic drivers and vulnerability to specific shocks. Broad downturns affect multiple markets simultaneously, but region-specific issues such as natural disasters, industry downturns, and regulatory changes affect markets differently.

Minimum investment amounts of $50,000 to $100,000 allow investors to build diversified portfolios at capital levels that would buy only one direct property. An investor with $500,000 can acquire five DST interests in five markets rather than concentrating capital in one location.

Market Research You Should Review

Offering documents should include detailed market analysis for the property's trade area: population and employment trends, competitive property analysis, and tenant position at the location. Generic regional statistics suggest inadequate analysis. Markets that have added population and jobs consistently suggest ongoing demand. High vacancy in competitive properties suggests weak conditions that could affect re-tenanting.

Lease Complexity and Negotiation Risk

Hidden Lease Provisions

Early termination options, co-tenancy or sales-based rent reductions, expense reimbursement caps, assignment rights, and below-market renewal terms can erode returns. These provisions are buried in long lease documents. Maintenance obligation allocation varies significantly across NNN leases. Tenants directly responsible for maintenance may defer it to cut costs, leaving a deteriorated asset at lease end. Quality lease structures require preventive maintenance contracts with approved vendors and minimum standards.

How DST Sponsors Negotiate Leases

Institutional backing provides negotiating leverage individual buyers lack. Sponsors acquiring multiple properties annually have relationships with major national tenants. Experience reviewing hundreds of leases allows sponsors to identify problematic provisions quickly.

What to Look for in Lease Summaries

Critical elements include remaining lease term (longer provides more certainty), renewal options and terms (market-based renewals protect better than fixed), rent escalation structure, termination provisions (any early exit right is material), guarantee structure (parent versus subsidiary), and expense reimbursement details. Properties with five years or less remaining carry meaningful near-term re-tenanting risk.

Exit Timing and Liquidity Risk

The Illiquidity of NNN Properties

Commercial real estate transactions require months to complete. Marketing periods run 90 to 180 days, due diligence adds 30 to 60 days, and closing takes another 30 to 60 days. DST beneficial interests have no established secondary market. Capital is committed for the full projected hold period, typically five to ten years. Personal circumstances that create a need for funds do not accelerate disposition. This inflexibility makes DST inappropriate for capital that may be needed on short notice.

How DST Sponsors Manage Disposition

Sponsors track comparable sales, cap rates, and buyer demand throughout the hold. Broker selection begins six to twelve months before the anticipated sale. Marketing strategies vary based on property type and buyer profile. Sale negotiation and due diligence management require active sponsor involvement through closing.

What Happens If Markets Turn

Hold periods may extend when market conditions do not support attractive pricing. During 2022-2024, commercial property values declined approximately 23% from peak, and cap rates expanded roughly 190 basis points. Transaction volumes collapsed to $244 billion in 2023 from $589 billion in 2021. Distribution continuation during extended holds depends on tenant performance. Unrealized value loss affects total return at disposition.

Risks That Remain Even with DST Structure

Sponsor Risk

Investment success depends heavily on sponsor competence and financial stability. Sponsor distress affects all offerings under that sponsor simultaneously. Management capability varies widely. Some sponsors have decades of experience spanning multiple cycles; others entered recently and lack downturn experience.

Seven operational restrictions imposed by IRS Revenue Ruling 2004-86 limit how trustees respond to changing conditions. These prohibit raising new capital after closing, refinancing debt except in narrow circumstances, entering new leases or modifying existing leases outside tenant bankruptcy, and making capital expenditures beyond normal maintenance. These "seven deadly sins" prevent adaptation to opportunities or threats. Even competent sponsors cannot refinance at lower rates, renegotiate leases to retain tenants, or pursue major renovations. This structural rigidity is the price of maintaining 1031 exchange eligibility.

Interest Rate Risk

Rising rates push cap rates higher and reduce property values. NNN cap rates increased from roughly 5.25% to 5.5-7% during 2022-2024, contributing to the 23% decline in commercial property values. The correlation between Treasury yields and cap rates has varied significantly. Morgan Stanley analysis found five-year rolling correlation fluctuated between -0.82 and 0.79 from 1983 to 2013. Investors cannot rely on simple assumptions about how rate changes affect values.

Debt refinancing may be required if debt matures before disposition. Refinancing at higher rates reduces cash flow and distributions. Exit cap rates may differ materially from acquisition cap rates. Properties purchased when cap rates were 5.5% may sell when cap rates have expanded to 7%, reducing proceeds and total returns.

Market Value Risk

Property values fluctuate with market conditions regardless of ownership structure. Exit values may differ materially from sponsor projections. Total return depends on both income during the hold and appreciation or depreciation at exit. Distributions that meet projections can be offset by sale proceeds below projections.

Tax Law Change Risk

1031 exchange rules and DST tax treatment (IRS Revenue Ruling 2004-86) could be modified or revoked. Capital gains rates may change. The tax advantages of DST investing depend on current law continuing. These risks apply to all 1031 strategies, not only DST.

How to Evaluate Sponsor Risk Management

Investors evaluating DST sponsors should assess specific risk management practices. Tenant vetting process documentation should detail how the sponsor evaluates credit and determines acceptable risk levels. Location and market selection criteria should explain what factors the sponsor weighs and why specific locations were selected. Lease provision requirements should specify what terms the sponsor negotiates for or refuses. Parent-level guarantees, no early termination, and market-based renewals demonstrate rigor.

Risk factor communication in offering documents should be detailed and specific. The PPM risk factors section reveals how honestly the sponsor evaluated potential problems. Extensive specific disclosure suggests careful analysis. Minimal generic disclosure suggests inadequate consideration.

Track record during market downturns provides the most meaningful performance indication. How sponsors managed through 2008-2009 and 2020 reveals more than bull-market performance. Ask specifically how offerings performed relative to projections during these periods. Reserve policy adequacy should match property type, tenant quality, and lease term.

Anchor1031's Risk-First Approach to Sponsor Selection

Anchor1031's designated broker-dealer, Great Point Capital, conducts due diligence on DST offerings before they are made available to investors. This process reviews sponsor assumptions, tenant credit quality, lease provisions, property fundamentals, and risk factors to assess whether an offering's financials are reasonable relative to current market conditions.

Areas of review generally include tenant credit analysis, lease provision evaluation, sponsor track record assessment, fee structure comparison, and market analysis. The goal is to identify offerings built on conservative, supportable assumptions rather than optimistic projections. This due diligence does not guarantee investment outcomes, and all DST investments carry risk including potential loss of principal.

Direct NNN Ownership vs DST: Making the Right Choice

Direct NNN ownership can make sense for investors with the resources and expertise to conduct thorough due diligence, the time to manage tenant relationships and handle issues, and capital to absorb re-tenanting costs ($100,000 to $500,000+). Direct owners must respond to tenant requests, manage lease compliance, and address disputes. They need cash reserves or credit access to cover re-tenanting expenses when a tenant leaves. Direct ownership provides control over disposition timing, lease modifications, market response, and capital decisions.

DST structure makes more sense for investors who prefer professional risk management. The sponsor handles tenant vetting, lease negotiation, property management, and disposition. Investors receive distributions and K-1s but do not participate in operational decisions.

Portfolio diversification across properties, tenants, geographies, and sponsors becomes achievable at capital levels that would purchase only one direct property. An investor with $500,000 can acquire five DST interests in five markets rather than concentrating capital in one location with one tenant.

Sponsor expertise in lease negotiation, tenant vetting, and market analysis provides value individual investors cannot easily replicate. Professional sponsors evaluate dozens or hundreds of properties annually and have pattern recognition from extensive experience. This matters most for investors who lack commercial real estate background or cannot dedicate significant time to due diligence.

1031 exchange qualification without complexity makes DST valuable for investors facing exchange deadlines. DST interests are pre-vetted replacement properties available immediately, eliminating the 45-day property hunt. The trade-off is reduced control and dependence on sponsor competence.

Frequently Asked Questions

Next Steps for DST Investors

Triple net properties carry meaningful risks. DST provides professional management and diversification that mitigate many of them, but not all. Understanding these risks helps evaluate specific offerings. Because NNN DST investments involve both tax planning and real estate analysis, consulting with a CPA or tax advisor familiar with your situation is an important step before committing capital. Building a diversified DST portfolio across sponsors, property types, and markets reduces the impact of any single underperformance.