Triple Net Leases: An Investment Opportunity Fraught with Peril
As a CPA and a federal agent, I appreciate the importance of maintaining a current understanding of the proper application of accounting principles and the ever-evolving accounting landscape. Once you have a firm understanding of how legitimate businesses operate, fraudulent enterprises can become more apparent. This is true for lease agreements too.
by William “Billy” E. Ebersole, CPA, JD, CFE Mar 2, 2020, 14:05 PM
As a CPA and a federal agent, I appreciate the importance of maintaining a current understanding of the proper application of accounting principles and the ever-evolving accounting landscape. Once you have a firm understanding of how legitimate businesses operate, fraudulent enterprises can become more apparent. This is true for lease agreements too.
It is critical to develop an understanding of lease accounting, the potential for abuse associated with triple net leases, and how a change in lease reporting can help better detect fraud and protect investors. CPAs are on the forefront of this effort.
Lease Reporting Requirements
In a 2005 study, the Securities and Exchange Commission (SEC) found that there were about $1.2 trillion in commercial leases that did not have to be reported on balance sheets under existing accounting rules for operating leases.1 Currently, it is estimated that balance sheets do not disclose about 85 percent of leases. The failure to list leases on the balance sheet can undermine an investor’s or lender’s ability to make a sound decision about the financial viability of an investment.2
To provide investors and lenders with transparency and comparability, the Financial Accounting Standards Board (FASB) promulgated new accounting rules for the recognition of leases on balance sheets, which is known as Accounting Standards Update (ASU) 2016-02, Leases (Topic 842). ASU 2016-02 will be fully implemented by 2019, with early implementation permitted. It requires companies, with limited exceptions, to recognize a right-to-use (RTU) asset and a liability associated with each lease on the balance sheet. The FASB recognizes two types of leases: operating and finance.3
The International Accounting Standards Board (IASB) also promulgated updated standards for leases. The IASB and FASB agree that leases should be on the balance sheet, but IASB standards are not converged with FASB standards. The IASB recognizes only one type of lease: a finance lease.4
As companies begin to implement the new guidance for lease accounting, accountants and other stakeholders should be aware of the potential for breaches in commercial loan covenants. For example, a bank may require a company to maintain a certain debt-to-equity ratio. With the addition of leases to balance sheets, it is possible that a loan covenant can be violated once the lease is added to the balance sheet, although the breach may not be intentional. Fraud associated with triple net leases, however, can result from the intentional manipulation of commercial appraisals.
To provide investors and lenders with transparency and comparability, the Financial Accounting Standards Board (FASB) promulgated new accounting rules for the recognition of leases on balance sheets, which is known as Accounting Standards Update (ASU) 2016-02, Leases (Topic 842). ASU 2016-02 will be fully implemented by 2019, with early implementation permitted. It requires companies, with limited exceptions, to recognize a right-to-use (RTU) asset and a liability associated with each lease on the balance sheet. The FASB recognizes two types of leases: operating and finance.3
The International Accounting Standards Board (IASB) also promulgated updated standards for leases. The IASB and FASB agree that leases should be on the balance sheet, but IASB standards are not converged with FASB standards. The IASB recognizes only one type of lease: a finance lease.4
As companies begin to implement the new guidance for lease accounting, accountants and other stakeholders should be aware of the potential for breaches in commercial loan covenants. For example, a bank may require a company to maintain a certain debt-to-equity ratio. With the addition of leases to balance sheets, it is possible that a loan covenant can be violated once the lease is added to the balance sheet, although the breach may not be intentional. Fraud associated with triple net leases, however, can result from the intentional manipulation of commercial appraisals.
Triple Net Leases: Vulnerable to Fraud
A triple net lease requires a tenant to pay the landlord rent and to be directly responsible for property taxes, insurance, and maintenance. They are often found in conjunction with a sale of real estate, followed by a lease back of the same property by the seller so that the seller can continue in his/her business. Investors often evaluate a triple net lease based upon its “cap” or capitalization rate. For example, if an investor decides to purchase a commercial property for $1 million and expects to receive annual rental payments of $100,000, the “cap rate” would be 10 percent.
A triple net lease can be used by successful franchisees to expand business opportunities. A franchisee could identify an additional location from which to conduct the franchised business. Short on capital, the franchisee would simply sell the real estate associated with the primary franchise location and lease the same property back. After the sale and lease back, the franchisee can use the remaining sale proceeds to purchase a second location, obtain a second franchise, and earn even more income.
Central to selling the property would be obtaining someone willing to purchase the commercial real estate associated with the triple net lease. Any purchaser or lender would want to see a commercial appraisal that supports the selling price. Commercial appraisals are based upon a variety of factors: the length of the lease, monthly rental payments, any escalation clauses that increase rental payments, and any extension periods that may be exercised by either party at the end of the lease. Also, the financial strength of the tenant would play a part in the commercial appraisal.
Triple net leases are a legitimate investment vehicle, but their appraised value too often are manipulated by fraudulently altering the terms of the lease or misrepresenting the economic strength of the future tenant. For example, a tenant who can barely afford to pay $1,000 per month in rent over the course of five years could fraudulently increase the appraised value of the property by signing a lease that called for monthly rental payments of $5,000 over the course of 20 years, with a 2 percent increase in monthly rent each year.
In real estate fraud conspiracies, it is not unusual for victims to report high-pressure sales tactics, guaranteed returns well beyond the market rate, and participation in real estate ventures of which the victim and his or her advisers had little familiarity.
Entering into a triple net lease with a deceptive tenant can have catastrophic consequences. Not only would the investor be deprived of monthly rental payments, but the investor is now on the hook for property taxes and insurance, as well as any maintenance expense.
A triple net lease can be used by successful franchisees to expand business opportunities. A franchisee could identify an additional location from which to conduct the franchised business. Short on capital, the franchisee would simply sell the real estate associated with the primary franchise location and lease the same property back. After the sale and lease back, the franchisee can use the remaining sale proceeds to purchase a second location, obtain a second franchise, and earn even more income.
Central to selling the property would be obtaining someone willing to purchase the commercial real estate associated with the triple net lease. Any purchaser or lender would want to see a commercial appraisal that supports the selling price. Commercial appraisals are based upon a variety of factors: the length of the lease, monthly rental payments, any escalation clauses that increase rental payments, and any extension periods that may be exercised by either party at the end of the lease. Also, the financial strength of the tenant would play a part in the commercial appraisal.
Triple net leases are a legitimate investment vehicle, but their appraised value too often are manipulated by fraudulently altering the terms of the lease or misrepresenting the economic strength of the future tenant. For example, a tenant who can barely afford to pay $1,000 per month in rent over the course of five years could fraudulently increase the appraised value of the property by signing a lease that called for monthly rental payments of $5,000 over the course of 20 years, with a 2 percent increase in monthly rent each year.
In real estate fraud conspiracies, it is not unusual for victims to report high-pressure sales tactics, guaranteed returns well beyond the market rate, and participation in real estate ventures of which the victim and his or her advisers had little familiarity.
Entering into a triple net lease with a deceptive tenant can have catastrophic consequences. Not only would the investor be deprived of monthly rental payments, but the investor is now on the hook for property taxes and insurance, as well as any maintenance expense.
Lease Default: Investigative Tips
In the event of a lease default, or because of some other red flags, a forensic accountant may be called upon to investigate the circumstances surrounding the tenant’s execution of the triple net lease before any civil litigation or criminal inquiry. Like any other fraud, evidence of a commercial tenant having requisite intent (mens rea) when signing the triple net lease is often difficult to prove. CPAs should consider implementing the following investigative strategy to understand the current financial status and situation of the tenant to provide information and guidance to stakeholders. The following steps can be taken in any case where you think fraud has occurred regarding triple net leases. After a lawsuit commences, however, you will be guided by counsel and the discovery process during your investigation.
Conduct a comprehensive interview of your client or victim – This interview may be conducted over the course of several days to ensure that all details have been elicited. Where possible and appropriate, obtain consent to interview the client’s or victim’s banker, attorney, or CPA to obtain additional insight into the suspect transaction.
Conduct a logical investigation of all available Internet sites for evidence of other defaults by the tenant – Examples include social media, county court dockets for eviction proceedings, and websites of state regulatory agencies that investigate licensed real estate brokers and agents for unethical or illegal sales practices. Forensic accountants should fully document any defaults on leases by the suspect tenant that occurred prior to the default experienced by your client. Evidence of a prior default by the suspect tenant can indicate insufficient resources to comply with the lease terms agreed upon by your client or victim. Proven inability to comply with the terms of the lease, prior to signing, is a powerful indicator of the tenant’s intent to defraud.
Research of county court documents – These may contain real estate transactional records for other sale/lease-back transactions to which the tenant was a party. Helpful records would include deeds, sales agreements, and the triple net lease documents associated with that transaction. Property tax records should be carefully reviewed to identify delinquent taxes, which may further evince a tenant’s inability to pay the rent at your client location. Discussions with courthouse personnel can be a valuable source of information, at the appropriate time, regarding the suspect transaction because courthouse personnel may be able to provide insight into the reasonableness of the transaction, locations of potential assets subject to recovery proceedings, and the identity of key witnesses. In the sidebar case example, investors could have easily identified numerous real estate transactions throughout the United States which, when viewed collectively, would have identified the tenant as being substantially overextended from a financial perspective.
Review secretary of state filings – This is another valuable source of information as they identify officers, directors, partners, and registered agents for corporations and limited partnerships who may be associated with the suspect tenant. Interviews of these individuals can provide additional insight into the tenant’s business practices and ability to honor the terms of the lease signed with your client.
Determine if the tenant used the same appraisal and/or escrow company for multiple transactions – Although using the same company does not necessarily indicate fraudulent intent, evidence may be developed that suggests that the appraisal or escrow company personnel may not be independent. If collusion with the suspect tenant becomes apparent, the commercial appraisal and closing documents should be reviewed carefully for indicia of fraud, such as commercial appraisals making unsupported economic assumptions or escrow documents that reflect the diversion of payments for overdue rent to another landlord.
It is possible that the tenant will assign the lease to a special purpose entity (SPE). An SPE can be formed to take on a high-risk investment and protect the parent entity from liability. In the event that the tenant defaults on a particular lease, the SPE can file for bankruptcy protection without compromising other company assets.6 In the sidebar case, investors and lenders could have avoided considerable loss had they identified SPEs and insisted on consolidated financial statements.
Docket entries in U.S. Bankruptcy Court cases should include schedules of various assets, related companies, related bankruptcy filings, and a listing of leases. In addition to finding other locations where a suspect tenant defaulted, you may be able to find additional related entities and witnesses for interview. Also, false statements contained in filings may be subject to prosecution for a bankruptcy crime or predicate acts for civil litigation. In the sidebar, over $1 million in real estate holdings identified on balance sheets provided to investors and lenders were not listed on the bankruptcy schedules. From an investigative standpoint, this opens up a line of questioning: “When were you lying: on the financial statements or the bankruptcy schedules?”
Any suspect lease should be reviewed and key terms compared with similar leases in the same geographic area. Suspect leases that call for excessive rent, abnormally high escalation clauses, and long terms may be considered commercially infeasible, and are further evidence of an inability to comply with the lease terms from the very beginning. If possible, other landlords associated with the suspect should be interviewed, but this is not always available in a civil action. However, separate research can be performed on these leases to derive some information.
Forensic accountants are always leery of marketing materials that advertise investment opportunities that are too good to be true or are guaranteed to not lose value. Consequently, victims or clients should be asked to provide all of the marketing materials they were given by a suspect tenant and the tenant’s representative (such as a real estate agent). Marketing materials can be used to form the basis for a criminal prosecution or civil litigation.
Most importantly, the financial statements, and perhaps the underlying details that made up the financial statements, that were provided to the victim or client need to be analyzed. Ascertain if the statements were audited, reviewed, or merely compiled by an accountant to assess the degree of reliability and completeness. Representations in the financial statements, both implicit and explicit, about the tenant’s ability to operate as a going concern should be carefully analyzed. Also, special attention should be paid to the tenant’s reported revenues, as they may be exaggerated to cover the cost of inflated rents.
New FASB rules require financial statements to reflect the lease in the form of an RTU asset and a related liability. The new lease rules reflect FASB’s understanding that investors and lenders need to see a complete picture of a company’s financial obligations. In addition, notes to the financial statements should include a discussion of a company’s lease obligations. As an FBI agent and a CPA, I need to continually update my understanding of a wide variety of accounting topics to spot fraudsters. As practicing CPAs, the same level of comprehension is needed to protect your clients before they fall victim to frauds.
Conduct a comprehensive interview of your client or victim – This interview may be conducted over the course of several days to ensure that all details have been elicited. Where possible and appropriate, obtain consent to interview the client’s or victim’s banker, attorney, or CPA to obtain additional insight into the suspect transaction.
Conduct a logical investigation of all available Internet sites for evidence of other defaults by the tenant – Examples include social media, county court dockets for eviction proceedings, and websites of state regulatory agencies that investigate licensed real estate brokers and agents for unethical or illegal sales practices. Forensic accountants should fully document any defaults on leases by the suspect tenant that occurred prior to the default experienced by your client. Evidence of a prior default by the suspect tenant can indicate insufficient resources to comply with the lease terms agreed upon by your client or victim. Proven inability to comply with the terms of the lease, prior to signing, is a powerful indicator of the tenant’s intent to defraud.
Research of county court documents – These may contain real estate transactional records for other sale/lease-back transactions to which the tenant was a party. Helpful records would include deeds, sales agreements, and the triple net lease documents associated with that transaction. Property tax records should be carefully reviewed to identify delinquent taxes, which may further evince a tenant’s inability to pay the rent at your client location. Discussions with courthouse personnel can be a valuable source of information, at the appropriate time, regarding the suspect transaction because courthouse personnel may be able to provide insight into the reasonableness of the transaction, locations of potential assets subject to recovery proceedings, and the identity of key witnesses. In the sidebar case example, investors could have easily identified numerous real estate transactions throughout the United States which, when viewed collectively, would have identified the tenant as being substantially overextended from a financial perspective.
Review secretary of state filings – This is another valuable source of information as they identify officers, directors, partners, and registered agents for corporations and limited partnerships who may be associated with the suspect tenant. Interviews of these individuals can provide additional insight into the tenant’s business practices and ability to honor the terms of the lease signed with your client.
Determine if the tenant used the same appraisal and/or escrow company for multiple transactions – Although using the same company does not necessarily indicate fraudulent intent, evidence may be developed that suggests that the appraisal or escrow company personnel may not be independent. If collusion with the suspect tenant becomes apparent, the commercial appraisal and closing documents should be reviewed carefully for indicia of fraud, such as commercial appraisals making unsupported economic assumptions or escrow documents that reflect the diversion of payments for overdue rent to another landlord.
It is possible that the tenant will assign the lease to a special purpose entity (SPE). An SPE can be formed to take on a high-risk investment and protect the parent entity from liability. In the event that the tenant defaults on a particular lease, the SPE can file for bankruptcy protection without compromising other company assets.6 In the sidebar case, investors and lenders could have avoided considerable loss had they identified SPEs and insisted on consolidated financial statements.
Docket entries in U.S. Bankruptcy Court cases should include schedules of various assets, related companies, related bankruptcy filings, and a listing of leases. In addition to finding other locations where a suspect tenant defaulted, you may be able to find additional related entities and witnesses for interview. Also, false statements contained in filings may be subject to prosecution for a bankruptcy crime or predicate acts for civil litigation. In the sidebar, over $1 million in real estate holdings identified on balance sheets provided to investors and lenders were not listed on the bankruptcy schedules. From an investigative standpoint, this opens up a line of questioning: “When were you lying: on the financial statements or the bankruptcy schedules?”
Any suspect lease should be reviewed and key terms compared with similar leases in the same geographic area. Suspect leases that call for excessive rent, abnormally high escalation clauses, and long terms may be considered commercially infeasible, and are further evidence of an inability to comply with the lease terms from the very beginning. If possible, other landlords associated with the suspect should be interviewed, but this is not always available in a civil action. However, separate research can be performed on these leases to derive some information.
Forensic accountants are always leery of marketing materials that advertise investment opportunities that are too good to be true or are guaranteed to not lose value. Consequently, victims or clients should be asked to provide all of the marketing materials they were given by a suspect tenant and the tenant’s representative (such as a real estate agent). Marketing materials can be used to form the basis for a criminal prosecution or civil litigation.
Most importantly, the financial statements, and perhaps the underlying details that made up the financial statements, that were provided to the victim or client need to be analyzed. Ascertain if the statements were audited, reviewed, or merely compiled by an accountant to assess the degree of reliability and completeness. Representations in the financial statements, both implicit and explicit, about the tenant’s ability to operate as a going concern should be carefully analyzed. Also, special attention should be paid to the tenant’s reported revenues, as they may be exaggerated to cover the cost of inflated rents.
New FASB rules require financial statements to reflect the lease in the form of an RTU asset and a related liability. The new lease rules reflect FASB’s understanding that investors and lenders need to see a complete picture of a company’s financial obligations. In addition, notes to the financial statements should include a discussion of a company’s lease obligations. As an FBI agent and a CPA, I need to continually update my understanding of a wide variety of accounting topics to spot fraudsters. As practicing CPAs, the same level of comprehension is needed to protect your clients before they fall victim to frauds.
Investigative Qualities
Individuals have fallen victim to fraud schemes since the beginning of time. Many have been able to avoid victimization by possessing key investigative qualities:
- Confidence – Trust your instincts! If a deal sounds too good to be true … it is.
- Independence – Avoid reliance on sellers who want to use their own escrow agents, appraisers, or accountants. Select and retain your own professionals.
- Knowledge – Know your accounting. Pro forma and prospective financial statements, along with SPEs, estimates, and the going concern assumption are part of generally accepted accounting principles, and should be used by business entities in an appropriate manner.
- Diligence – Read an appraisal carefully. Investors and advisers should pay close attention to the significant assumptions in the appraisal and make sure they are commercially reasonable for the area. Also, harvest as much business intelligence from social media, blogs, and company websites as possible.
- Savvy – Conduct a surprise inspection. Pay close attention to the level of business activity to determine if rental payments can actually be made.
- Steadfastness – Prudent business advisers will insist on a complete financial picture of a business opportunity and will resist pressure to provide a quick “thumbs up” on the deal.
Triple net leases can be a valuable investment opportunity for those who are represented by competent business advisers. In the event of a default, distressed investors will turn to forensic accountants to carefully collect evidence to support damage control and possible recovery. As such, accountants and stakeholders should learn the new rules for leases promulgated by the FASB and the IASB, and advise clients regarding these changes.
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A Triple Net Lease Scam
You are a successful professional who has obtained a fair measure of financial security by purchasing residential real estate properties.5 One day, a commercial real estate sales person approaches you and advises that a triple net lease may provide an even better real estate opportunity. The sales person convinces you to sell off your residential real estate and invest the proceeds in commercial real estate with a “can’t lose” tenant. The seller plans to continue operating at the location, so essentially the seller is offering a sales/lease-back opportunity with the ensuing lease being triple net. You are given copies of the seller’s financial statements, which seem to indicate a strong future tenant. The sales person assures you that the triple net lease is “guaranteed” to make you money and preserve your investment.
Once the sales agreement is signed, you set up escrow using an escrow officer recommended by the seller. The sales agreement requires you to escrow in excess of $1 million, which represents an out-of-pocket down payment of more than $200,000 and a commercial mortgage of about $800,000. At closing, your future tenant signs a 20-year lease, which calls for a 2 percent increase in monthly rental payments every year. You leave the attorney’s office feeling confident in your financial future.
After a few months, your monthly rent checks get later and later. Eventually, the rent check is for a reduced amount but with promises of full payment with penalty and interest. Finally, you receive notification from the U.S. Bankruptcy Court that your tenant has filed for bankruptcy. At a meeting of creditors you learn that your tenant defaulted on dozens of leases nationwide that were for properties purported to be “substantially undervalued.” In reality, the properties were “flipped,” causing the purchase price you paid to be fraudulently inflated. Furthermore, you learn that the commercial appraisal provided was artificially inflated. By agreeing to pay impossible sums, your tenant manipulated the valuation process and caused a much higher appraisal to come about. In this example, the victims paid purchase prices that were 300 percent or more in excess of the real estate’s actual value.
A valuation expert suggests that your tenant pocketed a large amount of money from the inflated sales price and, based upon income noted in the bankruptcy filings, likely was using the sale proceeds to pay rents to other victims since the tenant only generated a limited amount of income. Much like a Ponzi scheme, this conspiracy required the tenant to bring in additional funds from inflated sales to pay investment returns, in the form of rents, to prior investors.
Unfortunately, any reimbursement from the bankruptcy estate would likely be limited, take time, require substantial attorney fees, and entail navigation of a bureaucratic quagmire to obtain it. The frustrated investor now turns to civil remedies by filing suit against the commercial tenant who has become a suspect.
In the above real-life example, investors and lenders lost about $20 million, just on the purchase price.
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Once the sales agreement is signed, you set up escrow using an escrow officer recommended by the seller. The sales agreement requires you to escrow in excess of $1 million, which represents an out-of-pocket down payment of more than $200,000 and a commercial mortgage of about $800,000. At closing, your future tenant signs a 20-year lease, which calls for a 2 percent increase in monthly rental payments every year. You leave the attorney’s office feeling confident in your financial future.
After a few months, your monthly rent checks get later and later. Eventually, the rent check is for a reduced amount but with promises of full payment with penalty and interest. Finally, you receive notification from the U.S. Bankruptcy Court that your tenant has filed for bankruptcy. At a meeting of creditors you learn that your tenant defaulted on dozens of leases nationwide that were for properties purported to be “substantially undervalued.” In reality, the properties were “flipped,” causing the purchase price you paid to be fraudulently inflated. Furthermore, you learn that the commercial appraisal provided was artificially inflated. By agreeing to pay impossible sums, your tenant manipulated the valuation process and caused a much higher appraisal to come about. In this example, the victims paid purchase prices that were 300 percent or more in excess of the real estate’s actual value.
A valuation expert suggests that your tenant pocketed a large amount of money from the inflated sales price and, based upon income noted in the bankruptcy filings, likely was using the sale proceeds to pay rents to other victims since the tenant only generated a limited amount of income. Much like a Ponzi scheme, this conspiracy required the tenant to bring in additional funds from inflated sales to pay investment returns, in the form of rents, to prior investors.
Unfortunately, any reimbursement from the bankruptcy estate would likely be limited, take time, require substantial attorney fees, and entail navigation of a bureaucratic quagmire to obtain it. The frustrated investor now turns to civil remedies by filing suit against the commercial tenant who has become a suspect.
In the above real-life example, investors and lenders lost about $20 million, just on the purchase price.
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1 Wesley R. Bricker, deputy chief accountant, SEC, “Remarks before the 2016 Baruch College of Financial Reporting Conference” (May 5, 2016).
2 Steve Burkholder, Bloomberg BNA, “FASB Issues Lease Rules; Will Have Big Balance Sheet Impacts” (Feb. 25, 2016).
3 Ibid.
4 Ibid.
5 For this example, based upon an actual case, the author removed transactional information and focused on the modus operandi of the actors to assist the readership in preventing fraud.
6 Denise L. Evans, JD, and O. William Evans, JD, The Complete Real Estate Encyclopedia, McGraw-Hill (2007).
William “Billy” E. Ebersole, CPA, JD, CFE, is a special agent with the Federal Bureau of Investigation and a member of the PICPA Forensic and Litigation Services Committee. Please direct questions on this article to journal@picpa.org. The opinions expressed in this article are those of the author and not the FBI or the U.S. government.
2 Steve Burkholder, Bloomberg BNA, “FASB Issues Lease Rules; Will Have Big Balance Sheet Impacts” (Feb. 25, 2016).
3 Ibid.
4 Ibid.
5 For this example, based upon an actual case, the author removed transactional information and focused on the modus operandi of the actors to assist the readership in preventing fraud.
6 Denise L. Evans, JD, and O. William Evans, JD, The Complete Real Estate Encyclopedia, McGraw-Hill (2007).
William “Billy” E. Ebersole, CPA, JD, CFE, is a special agent with the Federal Bureau of Investigation and a member of the PICPA Forensic and Litigation Services Committee. Please direct questions on this article to journal@picpa.org. The opinions expressed in this article are those of the author and not the FBI or the U.S. government.
