In a typical commercial real estate investment, the tenant lease structure falls into one of two high level categories, Gross leases or Net leases. But, within each of these types of commercial real estate leases, there are subtypes that could be used depending on the situation. A Modified Gross Lease is one of those subtypes.
In order to understand what a Modified Gross Lease is and how it works in commercial real estate, it is first necessary to describe how a Gross Lease works.
What is a Gross Lease in Commercial Real Estate?
If the tenant’s lease agreement is structured as a “Gross Lease,” it means that they are responsible for making one monthly rent payment while the landlord pays for all of the property’s operating expenses.
For both the tenant and the landlord, this commercial lease structure is simple to write and track. But, it also means a higher lease rate for the tenant because the landlord uses these funds to pay for the operating expenses. For the landlord, this means exposure to the risk of rising operating costs since they are required to pay for them. For example, if the property insurance premium rises unexpectedly one year, the amount of the tenant’s rent does not change. The landlord must absorb this cost, which lowers their net income.
Landlords don’t like this risk so some of them offer tenants another type of lease known as the “modified gross lease.”
What is a Modified Gross Lease in Commercial Real Estate?
To solve for the risk of rising operating costs, the “modification” in the gross lease is that some of the operating costs are passed through to the tenant. This means that each month the tenant pays a base rent amount plus the operating/maintenance costs that they are responsible for. In terms of structure, a modified gross lease is a hybrid type that sits somewhere between a full service lease (gross lease) and a pure net lease.
Given this modification, it is important to separate the expenses that the tenant is responsible for and those that the landlord is responsible for.
What Expenses are the Landlord and Tenants Responsible For?
The short answer is … it depends. When determining what expenses the landlord and tenant are responsible for paying, it is important to read the lease agreement. Typically, specific expense responsibilities are a point of negotiation between the tenant and the landlord. While the tenant could be responsible for any of the building expenses, the most commonly negotiated points are: property taxes, building insurance, common area maintenance (CAM), utilities, and any sort of high dollar repairs. Generally, there are two ways that a landlord can “recover” or allocate expenses to a tenant, pro rata or using an “expense stop.”
The easiest, and most basic, way to allocate expenses to a tenant is on a pro rata basis. This means that the tenant is responsible for paying the expenses for the portion of the property that they occupy. For example, suppose that a commercial real estate property has 50,000 total square feet and the tenant leases 5,000 SF or 10% of the total. Now assume that the total operating expenses for the property were $100,000. The tenant’s pro rata share to be reimbursed to the landlord is $10,000.
The “expense stop” option is a more complex arrangement that is typically seen in the largest commercial real estate leases. With this reimbursement method, the landlord may set an “expense stop” for a single expense or group of expenses and pay everything up to the “stop” amount. Anything over the stop amount would be the responsibility of the tenant. For example, assume that the landlord of the same 50,000 SF property placed an operating expense stop at $5.00 PSF for the tenant who leases 5,000 SF. At the end of the year, the actual expenses came out to $5.50 PSF. This means that the tenant pays $5.00 PSF and the landlord pays the overage of $.50 per SF. Again, the specifics of this arrangement are detailed in the lease so it is important to read it in detail.
When Are Modified Gross Leases Used?
A modified gross lease could be used in any type of commercial space (it is up to the landlord), but they are most prevalent in retail space, office buildings, and industrial properties. The reason is that these property types tend to have multiple tenants and variable operating costs. So, the landlord will try to pass through at least some portion of them to the tenant.
Pros and Cons of Modified Gross Leases
There are pros and cons to this type of lease for both the tenant and the landlord.
For the tenant, the primary benefit of a modified gross lease is that their base rent payment is slightly lower. In addition, they come much closer to paying for only the costs that are relevant to the space that they lease, which gives them more control. In other words, they aren’t paying for all of the real estate taxes, just their portion.
For the landlord, the benefit of a modified gross lease is that they are able to pass on some portion of the operating costs to the tenant. This serves to both reduce their risk exposure to rising operating costs and increase the amount of net cash flow that they realize.
For the tenant, the downside to a modified gross lease is that it could potentially end up being more expensive in the long run, even if the base rent is lower. They also take on some of the risk of rising expenses since they are required to pay some portion of them.
For the landlord, the downside to modified gross lease is the administration of it. Not only are they responsible for collecting the tenant’s rent each month, they must track operating expenses at the line item level and then allocate responsibility for them to each tenant based on the allocation method chosen. Usually this requires an investment in software and/or employees to monitor, which adds to property management costs.
Summary & Conclusions
A modified gross lease is a common type of commercial real estate lease that occupies the middle ground between a full service gross lease and a net lease. In it, a tenant is responsible for paying a base monthly rental amount plus some portion of the property’s operating expenses. The exact operating expenses and the method with which they are allocated are outlined in the specific lease terms. They can vary by lease, but typically include some combination of taxes, insurance, utilities, maintenance, janitorial services, and any other expense associated with the basic upkeep of the property.
For the tenant, the benefit of a modified gross lease is that the base rent is lower and they have some level of control over what operating expenses they are responsible for paying. For the landlord, the benefit of a modified gross lease structure is that they can mitigate the risk of rising operating costs by passing some of them through to the tenant.
For the tenant, the downside of a modified gross lease is the cost. In some cases, it could be more expensive than a full service gross lease in the long run. For the landlord, they can be more expensive to track and manage.
From an investment standpoint, it is important to understand how the modified gross lease structure works to create an accurate model of income and expenses for the property, which is needed to calculate potential investment returns.
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