One of the first issues that comes up in negotiating a commercial lease is the rental structure, and how the landlord and tenant’s responsibilities for items outside the base rent are paid. Generally, the leases are structured by making the rent either “net” or “gross” rent payments. A “net” lease generally means the tenant pays a lower base rent, but an additional monthly payment, usually calculated annually and reconciled at the end of the year, to cover actual landlord expenses. A “gross” rent is where the tenant pays a consistent lump sum for rent. This article will explain these commercial lease types, along with the “modified gross” lease, which is a blend of these two concepts.
Gross Lease or Full Service Lease
As discussed above, the rent in a gross lease is intended to be all-inclusive. The commercial tenant pays a pre-determined rental rate. From this amount, the landlord pays all or most expenses associated with the property. This typically includes such things as taxes, insurance, and maintenance. This oftentimes also includes utilities and janitorial-type expenses.
However, from a tenant’s perspective, it is important to know which, if any, janitorial services are provided as part of the rental amount. Moreover, it is critical to clarify which utilities, if any, are covered. Moreover, there may be limits on the amount/timing of using certain utilities, and how excess utility consumption beyond building standards may be charged back to tenant (so, if you are a tenant that needs substantial utilities, such as electricity 24/7 to run equipment, it is crucial to deal with this in the lease). Generally, the tenant also pays its own property insurance and taxes.
Gross leases are great for tenants as they can predict exactly what their expenses are going to be and not have unexpected surprise or disputes with the landlord if the building needs some major repair or there is a sudden increase in maintenance costs. Landlords assume some risk in these leases, as they take all responsibility for the building, regardless of unexpected changes that may occur in the future.
In a net lease, the landlord charges a base rent plus a monthly (usually, but can be charged at other intervals) allocation of expenses associated with operations, maintenance, and use that the landlord pays. These typically include real estate taxes; property insurance; and common area maintenance items (CAMS), which include janitorial services, property management fees, sewer, water, trash collection, landscaping, parking lots, fire sprinklers, and any commonly shared area or service.
Most people are familiar with the term “Triple Net” Leases, however there are several types of net leases:
Single Net Lease (“N” Lease)
In a Single Net lease, the tenant typically pays base rent plus a pro-rata share of the building’s property tax (based on the proportion of total building space leased by the tenant); the landlord covers all other building expenses. The tenant typically pays for its utilities and janitorial services.
Double Net Lease (“NN” Lease)
In a Double Net lease, the tenant typically pays a base rent plus a pro-rata share of property taxes and property insurance. The landlord covers all over other expenses (ie common area expenses and structural issues). Again, the tenant pays for their own janitorial and utility expenses.
Triple Net Lease (“NNN” Lease)
In a Triple Net lease, the tenant pays a base rent plus all or part of the three “nets”–property taxes, insurance, and common area expenses (“CAMS”). Common area utilities and operating expenses are usually lumped in as well (ie the cost of security or a front desk attendant). In addition, the tenant generally pays the costs of their own utilities, janitorial services, and their own insurance and taxes.
Landlords typically estimate expenses and charge tenants a portion of these expenses based on their proportionate, or pro-rata share, of the entire property. Commonly, the landlord sets an estimated monthly payment, which is reconciled at the end of the year and any shortfall or overpayment is dealt with at the beginning of the next year. It is critical for tenants to incorporate protections and opportunities to review or challenge the reconciliation at the end of the year.
Triple net leases tend to be more landlord-friendly, as common lease language provides that virtually all expenses can be passed through. Moreover, tenants cannot be sure what the NNN amounts may be in any year or month, so there is less predictability. Tenant should therefore negotiate caps on the amounts the NNN fees can be raised annually.
There are some tenant benefits in the NNN leases. NNN leases provide transparency in the business operating expenses in relation to what they are charged. Moreover, if landlord costs decrease, these cost savings are passed on to the tenant.
Modified Gross Lease
As see above, gross leases tend to be preferable to tenants, and net leases tend to be preferable to landlord. Thus, there exists a compromise lease for the convenience of both parties. The modified gross lease (aka modified net lease) is similar to a gross lease in that the rent is requested in one lump sum, however the parties specifically negotiate which other “nets” are included in the base rent or will be considered additional rent.
The modified gross lease can be a good alternative for both sides, depending of course on which nets are included or not. These leases can include significant negotiation, but can be beneficial if done correctly.
Any of these types of commercial leases can work in different situations, however the critical aspect is to make sure your rights are protected. For example, a NNN lease can be a perfectly workable solution for tenants as long as they have a clear sense of what the monthly expenses will be, that there is a cap on these expenses is something unforeseen happens, and that there is a clean way to reconcile and challenge expenses. Future articles will address some of the critical components landlords and tenants should negotiate for in all of these situations.