The defining feature of a commercial real estate asset is that it contains space that is leased to tenants. So, it stands to reason that it is critically important that potential investors understand key lease terms like: lease rate, start date, end date and…lease type.
In this article, we are going to describe two common commercial real estate lease types – the net lease and the ground lease. We will define what they are, what makes each of them unique, and why they matter in the pre-purchase due diligence process.
At First National Realty Partners, we offer investments in properties that have both ground leases and net leases. To learn more about our current investment opportunities, click here.
What is a Net Lease?
A net lease is a commercial real estate lease agreement that requires the tenant to pay a base monthly rental amount plus their proportionate share of the property’s operating expenses. There are four types of net leases that could potentially be found in a commercial property:
Single Net Lease
In a single net lease, the tenant pays base monthly rent plus one of the property’s major operating expenses categories, usually property taxes.
Double Net Lease
In a double net lease, the tenant pays base monthly rent plus two of the property’s major operating expenses categories, usually property taxes and insurance.
Triple Net Lease
Tenant pays base monthly rent plus three of the property’s major operating expenses categories, usually property taxes, insurance, and maintenance.
Absolute Net Lease
In an absolute net lease, the tenant pays base monthly rent plus all of the property’s operating and maintenance expenses.
Of these four types, the triple net lease is particularly common with investors seeking the benefits of real estate investment, but not the hassle of managing the property on a day to day basis.
Property owners like net leases because it passes responsibility for operational costs on to the tenant and, in some cases, relieves them of the day to day burden of managing the property. Tenants like net leases because it gives them more control over operations and maintenance. In addition, the base monthly rental cost tends to be lower than other commercial real estate lease types.
What is a Ground Lease?
A ground lease is a type of commercial real estate lease in which the tenant leases a vacant piece of land rather than completed commercial space. As part of the lease agreement, the tenant gains the right to develop a project and then sub-lease the space to end tenants. Ground leases are particularly common in high density cities like New York and Los Angeles where an owner of a prime parcel of land may want to monetize their property, but not sell it outright. The terms of a ground lease can be net or gross.
Property owners like ground leases because it allows them to retain ownership of their property while earning income from it. In addition, some ground leases have a clause that transfers ownership of the improvements (the building(s)) back to the property owner at lease expiration. Tenants (the developer) like ground leases because they get access to a prime parcel of real estate without the upfront cost of having to purchase it.
Net Lease vs. Ground Lease: 5 Key Differences
Key differences between net leases and ground leases include:
1. Leasable Area
A typical net lease is for a particular space in a commercial property. It is usually indicated by a unit or suite number. A ground lease is for a vacant parcel of land, upon which a project will be developed.
2. Term
Comparatively, net leases have short terms, usually 5-10 years. Ground leases usually have terms of 25 years or longer. Sometimes they can even stretch to 99 years because of the amount of time it takes to design, build, and lease a commercial property.
3. Financing
Financing for commercial real estate with net leases is a straightforward process. Financing for properties with ground leases can be more complex because it requires the property owner to “subordinate” their interest in the property to the lender, which is not something they usually want to do.
4. Operating Expenses
In a net lease, the tenant is responsible for their share of the property’s operating expenses. A ground lease could have a net or gross structure. If it is gross, the landlord is responsible for the operating expenses.
5. Use of the Leased Premises
In a net lease, the leased premises is usually used by a tenant to operate a business like a retail store or an office. In a ground lease, the tenant’s aim is to develop a project on the vacant land. Once complete, they will sublease the completed space to end tenants.
The above points are just generalizations. In order to understand the full scope of differences between a net lease and a ground lease, it is necessary to actually read the leases in detail and make note of the differences in the most important clauses.
How Are Net and Ground Leases Used In Private Equity Commercial Real Estate?
Real estate private equity firms own and operate properties that have net leases and/or ground leases. However, private equity firms tend to favor those with net leases because they are easier to finance, easier to manage, and have higher levels of demand from investors.
For those that choose to invest with a private equity firm, it is important to understand the lease structure of the target property and the key terms within it to ensure it is a good fit from a risk, return, and timeline perspective.
Summary and Conclusion
A net lease is a commercial real estate lease structure that requires the tenant to pay a base monthly rental amount plus some portion of the property’s operating expenses.
A ground lease is a commercial real estate lease structure that allows a tenant to lease a vacant piece of land from a property owner for the purpose of developing a project on it. Once complete, the space is leased to end-user tenants.
From an investment perspective, there are key differences between net leases and ground leases regarding the leasable area, term, financing requirements, operating expenses, and use of the leased premises.
Real estate private equity firms own and manage properties with both net leases and ground leases, but tend to favor those with net leases due to their simplicity, ease of financing, and demand from investors.
Interested in Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
