Fundamentally, real estate owners and investors are in the business of generating cash flow from the users of a space, and leases are the legal instruments commonly (but not exclusively) used to define the terms of this arrangement. Knowing what type of leases are in place can make a big difference in understanding the big picture of a property’s financials and potential operating risks.
In its simplest form, a lease is a legal contract where the tenant agrees to pay a certain amount of rent over a specified period in exchange for their right to occupy a space. However, there are a number of ways to structure a commercial real estate lease, and various key terms can have significant bearing upon the financial performance of a property. A lease’s structure and terms not only affect the operating cash flow of a property, but can also significantly change the valuation of a property when it is sold. In this article, we will discuss the different types of commercial lease structures and their key terms, as well as provide some examples of how these structures and terms can impact the financial performance of a real estate investment.
Lease Structures Defined
Leases can take different approaches as to who is responsible – tenant or landlord – for directly paying property operating expenses such as utility bills, maintenance and janitorial expenses, taxes, insurance, etc. The two main categories of leases are a gross lease and a net lease, each of which has its own variations and subcategories.
Gross Lease Structures:
Full-Service Gross Lease: In a full-service gross lease the tenant pays a fixed rent that takes into consideration the fact that the landlord covers estimated operating expenses such as taxes, insurance, utilities, maintenance and repairs. The tenant pays the same rental rate regardless of whether operating expenses end up being higher or lower than estimated. One advantage of the full-service gross lease for owners/landlords is that, since the rental fee is based off of an estimate of the associated costs (created solely at the property owner’s discretion), the property owner may overestimate the costs and pass that to the tenant as a higher rate. This creates potential upside for the owner in the case where operating costs end up being lower than budgeted. The downside risk is that the owner will potentially be responsible for the cost of any unexpected increases in property expenses above budget, such as a spike in utility rates. From a tenant’s perspective, the full-service gross lease is attractive because they can plan on a predictable stream of rent payments. However, since there is an incentive for landlords to overestimate operating costs, many tenants perceive full-service gross leases as a structure in which they are paying a premium rent for predictability.
Modified Gross Lease: Gross leases can be modified to meet the needs of the property owner and/or tenant, or the unique characteristics of a property. One common modification a gross lease may have is a provision that allows the landlord to recoup increases in expenses beyond a benchmark or “base year” expenses. (The base year establishes a basis for which to calculate the increases in subsequent years which can be passed thru to the tenant.) In this case, at the end of each year the owner conducts a reconciliation and any overage in operating expenses could be billed back to the tenant as additional rent. This type of modified gross lease provides a bit of a stop-gap for a property owner on out-of-pocket expenses. One example of a modified gross lease is the Industrial Gross Lease. In the typical industrial gross lease the landlord is responsible for taxes and insurance (based on a benchmark base year calculation), and tenant is responsible for utilities as well as any increase in property taxes and insurance beyond base year expense calculations. Depending on the lease and whether it is a multi-tenant property the tenant in an industrial gross lease also may or may not be responsible for common area maintenance (CAM) expenses.
Net Lease Structures:
Triple Net (“NNN”) Lease: In a Triple Net lease, the tenant is responsible for their proportionate share of property taxes, property insurance, common operating expenses and common area utilities. These expenses are often categorized into the “three nets”: property taxes, insurance, and maintenance, hence “Triple Net”, which is commonly abbreviated as NNN. Tenants are further responsible for all costs associated with their own occupancy including pro-rata property taxes, janitorial services and all utility costs. If the space is part of a larger building, the common area maintenance (CAM) charges will be divided among the tenants of the building, generally based upon the tenant’s square footage percentage of the overall complex.
The primary advantage of the triple net lease for owners/landlords is that most of the burden of operating costs is put on the shoulders of the tenant. This reduces variability and risk for the owner/landlord so they can expect a more predictable stream of rental income as they are not subject to fluctuations in operating costs. It does, however, take away the potential upside associated with overestimating operating costs. From a tenant’s perspective, the triple net lease structure enables them to pay a lower rent in exchange for assuming the risk associated with operating expense variations.
Double Net Lease: In a double net lease the tenant pays rent plus their pro-rata share of property taxes and insurance. Furthermore, the tenant also typically pays utilities and janitorial services associated with their space. The landlord covers expenses for structural repairs and common area maintenance.
Single Net Lease: The tenant pays rent plus their pro-rata share of property taxes (a portion of the total bill based on the proportion of total building space leased by the tenant). Furthermore, the tenant pays utilities and janitorial services associated with their space. The landlord covers all other building expenses.
Example: Impact on Income
The type of leases in place at a building can shift property financials considerably. On a typical office property, the cost differential on a gross lease and a triple net lease can be as much as $7 to $10 psf.
For example, an investor is weighing two investment opportunities that have the exact same purchase price. One is an office building in Phoenix where there is a major anchor tenant in place on a 10-year lease that is paying $30 psf annually on a 100,000 sf space for a total rent payment of $3,000,000 per year. The second office building in Denver also has a major anchor tenant in place on a 10-year lease that is paying the exact same rate. All other factors being equal, the two buildings appear comparable.
Upon further research, we learn that the Phoenix tenant has signed a modified gross lease. The tenant is paying its own electric bill. However, the landlord is paying for the majority of property operating expenses, such as taxes, insurance, sewer and water and building maintenance, such as repairs, cleaning services and landscaping. The tenant’s pro-rata share of those property costs adds up to $600,000 per year, effectively reducing the NNN-equivalent rent to $24 psf.
In comparison, the Denver tenant has signed a triple net lease that makes the tenant responsible for all property operating expenses. So, the $30 psf rent or $3,000,000 in total rental income drops almost entirely to net operating income (typically there are still minor expenses that are not captured in a NNN lease but they are usually less than $1 psf). Comparing this lease back against the Phoenix deal, we now know that that the net operating income for Denver property is almost $600,000 greater than that of the Phoenix property. This is just one of many reasons why two properties may vary greatly in value when, on the surface, they appear similar.
Investor Takeaway:
Different variations of gross and net leases are widely used throughout commercial real estate. In some cases, the prevalence of using a certain type of lease can be influenced by common practice in a region or specific market trends. Fifteen years ago, for example, office building owners in downtown San Francisco primarily used the full-service gross lease structure. However, as more and more space was being leased by tech users, which can have heavy energy needs, many office buildings switched modified gross leases that made the increasingly unpredictable cost of utilities the tenants’ responsibility.
Comparing different types of leases is not apples to apples. It is important to know the type of lease when analyzing investment offerings to have a better understanding of how that lease will impact property performance and also how to use lease data more effectively when comparing and contrasting investment offerings. At the end of the day, the type of lease in place should serve as a roadmap to show more detail on a property’s income and expenses.