• These two types of lease agreements shift the burden of certain costs from property owners to tenants.
• The potential profitability of a real estate investment can be affected by gross lease vs net lease agreements.
• Understanding these agreement structures can help investors better evaluate commercial real estate opportunities.
Lease agreements for commercial real estate have certain variances in their structures. One of the most notable exists in the manner by which rent calculations are accomplished. In this regard, leases usually fall into one of two categories — gross lease vs net lease agreement structures. The two different lease types are explained below, as well as what they can mean for investors.
Fundamentally, a gross lease is one in which the agreement stipulates a set rental rate, which incorporates all the associated costs of the property. These include property taxes, insurance, utilities, maintenance and repairs to the facility — though not necessarily the equipment a tenant must install to operate their business.
The advantage to the tenant is the month-to-month predictability regarding the expenditures they will make to occupy the property. This makes budgeting far more easily accomplished. After all, they’re only tasked with paying a predetermined rate, while the property owner covers all associated costs from the rental payment.
The tradeoff here is that the monthly rental payment is likely to be set at a higher rate to ensure that the landlord is capable of covering all potential costs while earning a profit on their investment. This, too, can be a double-edged sword, however. In an instance in which the property owner encounters an unaccounted-for price increase in one of the variables, they could find the costs exceed the rental payments for a given period, which could result in less profit than anticipated — or perhaps an outright loss.
Gross leases can be divided into a pair of categories as well — full-service vs modified. The nature of the full service gross lease is described above. A modified gross lease is one tailored to meet certain specific needs of the landlord or the tenant.
For example, a modified gross lease agreement might contain a stipulation to the effect that the landlord is entitled to impose a surcharge for expenses exceeding “base year” costs. Under this circumstance, the property owner audits the annual costs of operating the facility and passes all expenses above those designated as base costs back to the tenant. The base is established by totaling the expenses incurred over the course of a preceding year. This gives the property owner a form of insurance against unexpected increases in highly variable costs such as utilities.
One of the most common types of gross lease is the Industrial Gross Lease. These contracts usually assign the responsibility for taxes and insurance costs (up to those of the benchmark base year calculations) to the landlord, while the tenant agrees to shoulder utility expenses as well as any increase in property taxes and insurance beyond the base year calculations. Common area maintenance expenses can often fall to tenants as well for multi-unit properties.
A net lease, as perhaps may now be surmised, is the exact opposite of a gross lease where the responsibility for expenses is concerned. The property owner establishes a rate and the tenant assumes responsibility for all tax, utility, repair and maintenance costs associated with the facility. These can also include insurance, as well as operating and service expenses.
The advantage here for the tenant is a lower fixed cost, while the property owner is relieved of the burden of the operating costs of the facility. Moreover, the tenant can institute cost-saving measures to reduce variable costs, such as performing energy conservation efforts to lower utility bills. A net lease also gives a tenant more control over repair and maintenance costs, as they might have the ability to acquire those services at a lower rate than the landlord would stipulate in a gross lease agreement.
Triple net leases hold tenants responsible for their share of property taxes, property insurance, common operating expenses and common area utilities. The term triple net (sometimes abbreviated as NNN) is derived from the three most common net costs: property taxes, insurance, and maintenance.
Under the terms of these agreements, operating costs are borne by all tenants of a facility in proportion to their percentage of occupancy. In other words, tenants who have more square footage than others will, accordingly, pay more. Common area maintenance costs are typically apportioned according to the degree of occupancy as well. Tenants are held individually responsible for any specific costs associated with their tenancy alone. This can include pro-rata property taxes and custodial services, as well as utility costs.
Double net leases hold multiple tenants responsible for their share of rent plus a prorated share of property taxes and insurance. Utilities and custodial services associated with their spaces are borne on their own. The property owner covers the costs of structural repairs and common area maintenance.
Under the terms of a single net lease, the tenant pays rent, plus a prorated share of property taxes (based upon their percentage of occupancy), as well as their own utility bills and fees for janitorial services. All other building-related costs are borne by the owner of the property.
The type of lease agreement offered to tenants can, to a significant extent, affect the potential profitability of a commercial real estate investment. In an instance in which two buildings are of equal value, equal occupancy and command equal rents, a building with a modified gross lease agreement in place could deliver less income than a building with a triple net lease agreement structure.
The modified gross agreement can leave the property owner responsible for a vast array of operating expenses such as taxes and insurance as well as variables such as utility, sewer and water costs. The expenditures associated with building maintenance, such as repairs, cleaning services and landscaping, can also fall to the property owner under a modified gross lease agreement.
Meanwhile, the property operating under a triple net agreement passes those costs onto the tenants. Thus, more of the rental payments can be looked upon as net operating income, as the variable costs described above are not a factor.
This underscores the importance of considering the type of lease structure associated with a property before investing in it as means of achieving portfolio diversification. It is next to impossible to get an accurate reckoning of the potential profitability of a building without doing so.
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