A commercial real estate lease is a legal agreement between a property owner and tenant that governs, among other things, how a space can be used and how much monthly rent is charged. In most cases, a tenant’s required monthly payment consists of a base rental amount plus some portion of the expenses required to operate the property. The exact amount of operating expenses that a tenant is responsible for is dependent upon the type of lease used, of which there are four.
Gross or Full Service Leases
A Gross Lease, also referred to as a Full Service lease, is one where the tenant pays a base rental amount and nothing more. The property owner is responsible for the operating expenses associated with the leased space, which includes property taxes, insurance, maintenance, and/or utility costs. To protect themselves from rising costs, the property owner may negotiate an “expense stop” which puts a cap on the amount of expenses that they are required to pay. If actual expenses exceed the cap, the tenant may be responsible for the overage.
On its face, the Gross Lease structure may seem to be very favorable to the tenant. But, the reality is that they typically come with a higher base rent amount so the owner can recoup some portion of the operating expenses they are required to pay.
Modified Gross Lease
A Modified Gross Lease is one of the most common types because the tenant is responsible for payment of a bass rental amount; plus some portion of the expenses required to operate the property. These expenses are referred to as the “Common Area Maintenance” or “CAM” charges and they are typically in proportion to the percentage of space that the tenant leases. For example, if a tenant leases 25% of the total space in a property, they may be responsible for 25% of the Common Area Maintenance charges.
The exact expenses and the exact percentage that the tenant is responsible for may vary widely from one lease to another and is highly dependent on the type of property and its location. For example, a tenant leasing space in Denver may be responsible for their share of snow removal costs whereas a tenant in Miami will have no such expense.
In a Net Lease, the tenant is responsible for paying a base rental amount plus some portion of the three major operating expenses, insurance, taxes, and maintenance. There are four variations of the Net Lease that align to the amount of operating expenses paid:
- Single Net Lease: In a Single Net Lease, the tenant pays a base rental amount; plus the property’s taxes. This is not a commonly used structure.
- Double Net Lease: In the Double Net Lease, the tenant pays a base rental amount; plus the property’s taxes and insurance. This is a much more common net lease type.
- Triple Net Lease: In a Triple Net Lease, the tenant is responsible for base rent; plus property taxes, insurance, and other operating expenses. Triple Net leases are particularly popular with investors who want a more passive approach to property management because the tenant handles the bulk of the work.
- Absolute Net Lease: Finally, in the Absolute Net Lease, the tenant is responsible for a base rental amount plus all operating expenses and maintenance.
Net Leases tend to be more owner friendly because it places the risk of rising operating costs on the tenant. We like Net Leased properties for this exact reason and seek them out as part of our core investment strategy. But, it is important to understand that the Net Lease structure also reduces the base rental amount that can be charged to the tenant because they are responsible for so many of the operating expenses.
Finally, the Percentage Lease is a structure where the tenant pays a base rental amount; plus a percentage of their sales on a monthly basis. Percentage leases are particularly common with retail tenants who rely on heavy foot traffic to produce sales.
Why Lease Structure Matters
Commercial properties are valued on their Net Operating Income, which is defined as their income less expenses. The higher the Net Operating Income, the higher the value of the property.
To accurately model income, it is important to understand how it is divided between base rental income and operating expense reimbursements. The same goes for expenses, it is critical to understand exactly which expenses the owner is responsible for paying versus what the tenant is responsible for paying. Knowing these details go a long way in modeling investment returns accurately.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
Prior to making an acquisition on behalf of our investors, we carefully review all tenant leases and build the details into our financial models.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.
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