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Commercial leases: Know how they differ before investing in commercial real estate

Commercial leases: Know how they differ before investing in commercial real estate

by Drew Anderson, Partner

Clients and real estate professionals who lease or own commercial real estate are often curious about the different types of leases used for commercial properties. Specifically, there are important distinctions between a gross lease, a triple net lease, and a modified gross lease that owners and tenants should be familiar with.

Gross Lease

A gross lease is a lease where the tenant pays a base rent amount, and no more, under the lease. The landlord is responsible for paying for all building related expenses (such as taxes, insurance and general maintenance of the property) out of this base rent amount.

From a landlord’s perspective, a gross lease means the landlord needs to have a very good handle on the costs and expenses of running the building at the time the base rent is established, since the base rent amount must be enough to pay for all costs and expenses relating to the building over the term of the lease.

From the tenant’s perspective, a gross lease is beneficial because the Tenant knows exactly what its rent obligations will be during the term of the lease, with no increases or additional payments related to building expenses. At the same time, a tenant under a gross lease must understand that the landlord could be less inclined to spend money on the building since any of the gross rent amount not spent on building expenses means more in the landlord’s pocket.

Triple Net Lease

At the other end of the spectrum, a triple net lease is a lease where the tenant pays base rent, and in addition reimburses the landlord for its proportionate share of all of the landlord’s building operating expenses (things like taxes, insurance, snow removal, and general maintenance).

The tenant’s share of these expenses is based on the percentage of the amount of space a tenant rents within the building. If the tenant rents the entire building, then the tenant is responsible for 100% of these operating expenses. If the tenant rents 15% of the building, then the tenant pays 15% of the operating expenses, and so on. Operating expenses are often collected by the landlord on a monthly estimated basis, with a reconciliation done at the end of the year after the landlord determines the year’s actual expenses. The lease should be clear about what items are included in these operating expenses. For example, typically the tenant is not expected to pay the cost of capital improvements to the property.

Modified Gross Lease

A modified gross lease falls in the middle. This type of lease includes a base rent amount, but the tenant also pays the landlord its proportionate share of the increase in the building’s operating expenses over a base year (generally the first year of the lease). So the tenant is responsible only for its share of increases in operating expenses over and above the base year. This of course protects the landlord against increases in the cost of operating the building, while the tenant’s obligation to make additional payments beyond the base rent amount is somewhat limited by the fact the increases are on a year over year basis only. The tenant’s proportionate share is again based on how much of the building the tenant rents.

Which is right for you?

Generally speaking, the base rent amount will be greater in a gross lease, moderately less in a modified gross lease, and quite a bit less in a triple net lease, since with triple net and modified gross leases the tenant must pay for additional operating expenses. Tenants will usually prefer a gross or modified gross lease because the total rent paid over the term of the lease is more predictable. Landlords usually prefer triple net leases to avoid losses related to increased operating expenses not covered by rent payments.

Modified gross and triple net leases are most commonly used for commercial investment properties. For ease of management and bookkeeping, a landlord of course would prefer to have only one type of lease throughout its building. It can get fairly complicated if some tenants pay on a gross lease basis, others on a modified gross basis, and still others on a triple net basis.

The best type of lease for your arrangement will ultimately depend on the property and the parties involved, but it’s important for all parties to understand the different lease types before investing in a property, whether as an owner or tenant.