The defining characteristic of a commercial real estate property is that it contains space that is leased to businesses (or individuals in the case of a multifamily property). The rental payments provide income that is used to pay for the property’s operating expenses and debt service. Anything left over is distributed to investors/shareholders.
But, not all commercial real estate leases are created equally. For investors evaluating a potential purchase, it is critically important to understand the two major lease structures used in commercial investment (gross lease and net lease) and their impact on a property’s income and operating expenses.
In this article, we’ll explain the differences between gross leases and net leases, explain the popularity of triple net leases, and outline what tenants and property owners are responsible for paying for in a triple net lease.
Gross Lease vs. Net Lease in Commercial Real Estate
In commercial real estate, the two major types of lease agreements are referred to as “Gross” and “Net.” There are very important differences between gross leases and net leases that have to do with who is responsible for paying the property’s operating expenses and common area maintenance costs.
What is a Gross Lease?
In a gross lease, the tenant pays one monthly rental amount and the landlord uses these funds to pay for the property’s operating and maintenance costs. These include things like property taxes, insurance, utilities, and admin. Because the landlord is responsible for these items, the rental charge is higher in a gross lease vs. net lease.
What is a Net Lease?
In a net lease, the tenant pays a base monthly rental amount, plus some portion of the property’s operating and maintenance costs. The exact portion depends on the type of net lease, and there are three:
- Single Net Lease: In a single net lease, the tenant pays their base monthly rental amount plus one of the three major expense categories, usually property taxes.
- Double Net Lease: In a double net lease, the tenant pays their base rent plus two of the three major expense categories, usually property taxes and insurance.
- Triple Net Lease: In a triple net lease (nnn lease), the tenant pays their base monthly rent plus all three of the major expense categories, property taxes, insurance, and maintenance.
Popularity of the Triple Net Lease
The triple net lease is a very popular commercial lease structure for investment because it reduces the management burden on the property owner/investor. A triple net lease can be used with any property type, but is most commonly found in office and retail properties.
Because triple net leases are so popular, it makes sense to dig in a little further and describe exactly what costs the tenant and property owner are responsible for paying each month.
What is the Tenant Responsible for Paying in a Triple Net Lease?
The reason it is called a “triple net” lease is that the base rental payment is “net” of the operating costs. This means that the tenant is also responsible for the costs associated with the three major expense categories: taxes, insurance, and maintenance. But, these can be broken down into line item detail to more clearly understand exactly what the tenant is responsible for paying:
- Property Taxes: Property taxes are fees that must be paid to local and/or state municipalities for the privilege of using their electricity, roads, and other services. Practically, property taxes are paid by the property owner, but they are reimbursed by the tenant.
- Insurance: Hazard/building insurance protects the property owner against financial loss from property damage due to storms, natural disasters, or other type of event.
- Maintenance: This is the broadest category and can encompass several different line item expenses depending on the specific lease terms. Maintenance expenses could include things like: parking lot repairs, landscaping, HVAC repairs, janitorial services, and other repair costs and additional expenses as necessary. The key here is to review the specific lease clause to understand exactly what the tenant is responsible for and what they aren’t.
Often, triple-net leased properties have just one tenant, which means that the single tenant is responsible for the above expenses. If the property has multiple tenants, the expenses are divided between the tenants. The exact method of division is outlined in the lease, but it is usually pro rata based on the amount of square footage each tenant occupies.
Given all of the costs that are the tenant’s responsibility, it is only natural to ask what costs the property owner/landlord is responsible for.
What is the Property Owner Responsible for Paying in a Triple Net Lease?
For a property owner, the primary benefit of a property with a triple net lease is that many of the operating costs are passed on to the tenant. But, that doesn’t mean the tenant pays for everything. In a triple net lease, the property owner is responsible for:
- The Mortgage: The property owner uses the income stream produced by tenant rents to pay the mortgage on a monthly basis.
- Property Insurance: Depending on the specific terms of the lease, the property owner may be responsible for certain insurance deductible and premium amounts.
- Maintenance: Again, depending on the specific terms of the lease, the property owner may be responsible for structural repairs to things like the roof and exterior walls as well as plumbing and electrical components.
It must be stressed that the specific delineation of cost responsibilities is outlined in the real estate lease, which be read thoroughly to ensure they are clear.
Why It’s Important to Understand Rental Income vs. Expense Reimbursement Income
When evaluating a commercial property for investment, one of the most important responsibilities is to create a proforma projection of the property’s income and expenses for a defined holding period. This exercise will result in the calculation of key financial metrics like Net Operating Income, Cash on Cash Return, Internal Rate of Return, and the Equity Multiple.
Although the proforma is just an estimate, a great deal of care and effort goes into ensuring that the proforma is as accurate as possible. Understanding how much income can be expected from rent versus how much income comes from expense reimbursements is a critical part of this effort. In addition, understanding actual expenses versus expenses that are reimbursed can provide a clearer picture of exactly what the landlord is responsible for paying. For both of these reasons, investment property leases must be read very carefully and the income/expense information must be translated into the proforma to ensure accuracy.
Conclusions and Summary
A triple net lease is a specific type of lease structure where the lessee pays a base monthly rental amount plus the property’s insurance policy premiums, real estate taxes, and maintenance. This structure is beneficial for the property owner because many of the costs related to the property’s upkeep are passed on to the tenant, which lessens their financial responsibility and managerial burden.
Understanding key triple net lease provisions like the rental rate, rent increases, and expense reimbursements are critical to the accuracy of the proforma, on which the investment decision is ultimately based.
Interested In Learning More?
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