Commercial real estate leases are dense legal documents that contain dozens of clauses pertaining to how a space may be used, when it may be occupied, and how much space the tenant is entitled to use. One of the most important clauses outlines the amount of rent that the tenant is required to pay each month for the privilege of occupying the space. Depending on the type of lease, the rental amount could be one fixed, “all inclusive” rate, or one rate plus some portion of the operating expenses.
The purpose of this article is to explain the second scenario. But first, it is first necessary to explain the basic differences between the two major commercial lease types, net and gross.
Gross Lease vs. Net Lease Difference Explained
There are two major commercial real estate (CRE) lease types—net and gross. The key difference between the two lies in who is responsible for paying the property’s operating expenses.
In a Net Lease, the tenant pays a base rental amount plus a portion of the property’s operating expenses. In general, there are four types of net leases:
- Single Net Lease: Tenant pays base rent plus property taxes
- Double Net Lease: Tenant pays base rent plus property taxes and insurance
- Triple Net Lease: In a triple net lease, the tenant pays base rent plus property taxes, insurance, and utilities
- Absolute Net Lease: Tenant pays base rent plus all operating expenses for the property
The base rental amount for a net lease tends to be lower because the tenant is responsible for some or all of the operating expenses. This is not the case in a Gross Lease.
In a Gross Lease, the tenant pays one monthly dollar amount and the landlord pays for the property’s operating expenses. Because of this, the monthly rental amount tends to be higher so the owner(s) can recoup as much of the operating expenses as they can. However, this structure exposes the property owner to the risk of rising operating costs. The higher they are, the more they have to pay. The more they have to pay, the lower the net operating income and profitability of the property. To mitigate this risk, some owners may choose to negotiate an “expense stop” into the lease.
Expense Stops Explained
An expense stop is a contractual provision that protects the property owner from rising expenses over the lease term. In such a case, the property owner typically agrees to pay all of the operating expenses in the first year of the lease, this is known as the “base year amount” and it sets the expense stop. If the actual operating expenses are higher than the base year amount in subsequent years, the tenant is required to pay the overage. To illustrate this point, consider the following example.
Suppose that a tenant signs a lease in an office building for 5,000 square feet of space. The base rental amount is $10 per square foot. In year one of the lease, the landlord pays for all of the building operating expenses and the total comes out to $10,000. This is the base year stop amount.
Now, assume that in year two of the lease, the actual expenses turn out to be $12,000. This is above the base year stop amount and the tenant is responsible for the $2,000 difference. This additional rent is sometimes referred to as the “recaptured amount” or the “recovered expenses.”
Benefits and Risks of the Expense Stop Clause
There are benefits and risks to the inclusion of an expense stop in a commercial lease.
For the property owner/landlord, the obvious benefit is that they are protected from significant escalations in the property’s operating expenses over the term of the lease—and it also provides them with some clarity for budgeting purposes, since they can know exactly what their operating expense budget needs to be annually. However, the risk for them is that they may not be able to attract as many tenants with this structure.
For the tenant, the benefit of an expense stop is that it reduces their required contribution to the landlord’s operating expenses. But the risk they bear is in having no control over the payment of operating expenses. A major increase in property taxes or property management fees could cause their rental costs to increase materially, and they would have no control over it. For this reason tenants should take precautions to ensure that their base year stop is not set artificially low, potentially exposing them to a large increase in the second and subsequent years of the lease.
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