Understanding the differences between Net Leases, Modified Gross Leases, and Gross Leases
If you are new to commercial leasing, the myriad options – and seemingly boundless terminology – can appear both confusing and intimidating at first. However, if you are able to understand the basic types of commercial leases, it’s easier to spot issues and understand what type of lease makes the most sense for your business.
Three Types of Leases
There are three primary types of commercial leases: (1) a Triple Net Lease (or “NNN” Lease), (2) a Modified Gross Lease (or Modified Net Lease), and (3) a Gross Lease.
Triple Net Leases
A triple net lease (also referred to as a “NNN” Lease) is the most landlord friendly in terms of economics because it shifts the risk associated with increased operating expenses from the landlord to the tenant. Under a triple net lease, the tenant pays two forms of rent: (1) base rent, and (2) “additional” or “CAM” rent.
The base rent is agreed to among the parties pursuant to the terms of the lease and is typically calculated based on the square footage of the premises being leased, usually subject to regular escalations that occur annually or monthly. The base rent is, effectively, similar to rent paid under a residential lease – tenants pay a pre-defined amount each month for the right to occupy the premises. The amount is set forth in the lease, and is predictable.
However, in addition to the base rent, tenants under a triple net lease are required to pay for certain “common area maintenance” (CAM) charges, which principally include the following three costs (hence the “triple” in “triple net”): (1) insurance, (2) property taxes, and (3) common area maintenance costs. These costs are variable – i.e., insurance, property taxes, and maintenance costs change from year to year – and therefore subject a tenant to market changes. In effect, under a triple net lease, the risk of increased operating expenses is carried by the tenant and not the landlord. For example, an increase in the minimum wage could increase maintenance costs, or an increase in the assessment of the property could increase real property taxes; all of these increases are paid by the tenant – and not the landlord – under a triple net lease as part of the “additional rent” calculation.
How is Additional Rent or CAM Rent calculated?
Typically, at the beginning of each year, the landlord calculates the “estimated” total costs of the additional rent for the year, which estimate is then used to set the amount of the additional rent payable by the tenant each month. At the end of the year, the landlord will calculate the actual amount of the operating expenses for such year, and if the estimate was below the actual costs, the tenant will be obligated to make a lump sum payment to the landlord in the amount of the difference, but if the estimate was above the actual costs, the landlord will be obligated to make a lump sum reimbursement or credit to the tenant in the amount of the difference.
In a single-tenant building, all of the additional rent costs are passed onto the tenant. However, in a multi-tenant building, each tenant typically pays its “pro-rata” or “proportionate share” of the additional rent costs, which proportionate share is calculated based on its percentage of the rentable area of the building. Typically, the tenants proportionate share is set at the beginning of the lease term, and adjusted (if necessary – i.e., if the rentable area of the building has increased or decreased) each year when the landlord prepares its estimate of the additional rent for the upcoming year.
Example of a Triple Net Lease
A landlord owns a 5-unit office building, containing 100,000 rentable square feet. Four of the units are occupied, and landlord, is seeking a tenant to occupy an office containing 17,000 square feet. The tenant and landlord agree to the following terms:
- Lease Term: 5 years
- Base Rent:
- Year 1: $17,000/month ($1.00 per square foot per month)
- Year 2: $17,850/month ($1.05 per square foot per month)
- Year 3: $18,700/month ($1.10 per square foot per month)
- Year 4: $19,550/month ($1.15 per square foot per month)
- Year 3: $20,400/month ($1.20 per square foot per month)
- Proportionate Share Year 1: 17% (17,000 (sqft of the premises) divided by 100,000 (rentable sqft of the building)
In the year prior to entering into the lease, the total additional rent for the building was $500,000. The landlord is expecting a 5% increase, and therefore estimates the additional rent for the building for Year 1 will be $525,000. Tenant’s estimated proportionate share of the additional rent for the year is equal to: 17% x $525,000 = $89,250 per year (or $7,437.50 per month). Therefore, in Year 1, tenant’s total monthly rent is equal to: $17,000 + $7,437.50 = $24,437.50.
At the end of Year 1, the landlord determines that the actual additional rent costs were $550,000, an underestimation by the landlord of $25,000. As a result, the tenant owes its proportionate share (17%) of $25,000 ($4,250), which tenant shall pay to landlord at the end of the year. Ultimately, the tenant’s total cost for the premises in Year 1 was $24,791.67 per month (instead of the $24,437.50 landlord estimated at the beginning of Year 1).
In Year 2, the building value is re-assessed, resulting in a 10% increase in property taxes and the state is experiencing a drought and enacts new legislation that increases water costs by 20%. As a result, landlord estimates that the additional rent for Year 2 will be 20% greater than Year 1 (25% x $550,000 = $660,000). Tenant’s estimated proportionate share of the operating costs for Year 2 is equal to: 17% x $660,000 = $112,200 per year (or $9,350 per month). Therefore, in Year 2, tenant’s total monthly rent is equal to: $17,850 + $9,350 = $27,200.
At the end of Year 2, the landlord determines that the actual additional rent costs were $625,000, an overestimation by the landlord of $35,000. As a result, the tenant is owed a reimbursement of its proportionate share (17%) of $35,000 ($5,950), which landlord shall reimburse or credit to tenant at the end of the year. Ultimately, the tenant’s total cost for the space in Year 2 was $26,704.17 per month (instead of the $29,537.50 landlord estimated at the beginning of Year 2).
As you can see, the total monthly rent increased nearly 10% from Year 1 to Year 2 due to unforeseeable circumstances that resulted in increases to the operating expenses of the building. The tenant – and not the landlord – was ultimately responsible for the increased costs of the operating expenses.
Potential Negotiation
As demonstrated by the example above, it’s clear that what costs are included in the calculation of operating expenses can have a profound impact on a tenant’s total rent due under a triple net lease. While insurance and real property taxes are almost always included, what is included in common area maintenance costs can often be negotiated (i.e. – are security costs, janitorial costs, landscaping costs, etc. included?). For example, in multi-tenant buildings, structural maintenance such as roofing or building systems will be a landlord cost (an “Absolute Net Lease” is often used for single-tenant buildings, and requires the tenant to absorb all costs of owning the property, including structural maintenance such as roofing and building systems). Furthermore, in California, where Proposition 13 artificially keeps property taxes down, tenants will often seek to negotiate how property taxes will be treated if Proposition 13 is repealed (an effort to remove such protections on commercial buildings will be on the California ballot in November 2020 – a presidential election year); however, landlord’s will often reject such an effort.
Another mechanism to control for additional rent increases is to negotiate the additional rent subject to a “Base Year,” where the Base Year additional rent is included in the base rent calculation, and the tenant only pays for increases in operating expenses over the Base Year. Using the example above, the Base Year would be the operating expenses for Year 1, which was $550,000 for the building. In Year 1, tenant would pay $0 in additional rent. In Year 2, the operating expenses increased to $625,000, a $75,000 increase over the prior year. The tenant’s additional rent in Year 2 would only be its proportionate share of $75,000, instead of $625,000 (in effect, the base rent includes a “rent credit” in the amount of the operating expenses for the Base Year). Alternatively, some tenants will negotiate a cap on increases to operating expenses (i.e. – additional rent cannot increase more than 5% each year), with any increases above such amount being paid by the landlord.
Tenants will also often negotiate the right to audit the landlord’s books and records as they relate to the calculation of the additional rent, and further, to contest a tax assessment on behalf of the landlord since the tenant is ultimately on the hook for any increases in property taxes.
Better for Landlord, Tenant, or Neutral?
As demonstrated above, a triple net lease is generally landlord favorable because it shifts the assumption of risk of increased operating costs from the landlord to the tenant. However, a tenant will often have to less in base rent compared to a gross lease as a result of its agreement to assume such added risk.
Modified Gross Leases (a/k/a Modified Net Leases)
A Modified Gross Lease seeks to solve for some of the risk associated with a triple net lease, by dividing some of the operating expense risk between the tenant and the landlord. Under a modified gross lease, the tenant still pays two forms of rent: (1) base rent, and (2) “additional” rent, however the calculation of additional rent is much more limited. Landlords will often pay insurance, property taxes, and maintenance costs in connection with the common areas, but the tenant will pay for maintenance costs of its own premises. These services may still be offered by the landlord, such as janitorial services, landscaping services, electricity, etc., but the tenant only pays for what it uses, as opposed to its proportionate share of the common area costs of the whole building. Furthermore, as noted above, the risk associated with increases in insurance costs and property taxes is often shifted to the landlord instead of the tenant.
The base rent is agreed to among the parties pursuant to the terms of the lease and is typically calculated based on the rentable square footage of the premises, usually subject to regular escalations that occur annually or monthly. The base rent is, effectively, similar to rent paid under a residential lease – tenants pay a pre-defined amount each month for the right to occupy the premises. The amount is set forth in the lease, and is predictable.
Example of a Modified Gross Lease
A landlord owns a 5-unit office building, containing 100,000 rentable square feet. Four of the units are occupied, and landlord, is seeking a tenant to occupy an office containing 17,000 square feet. The tenant and landlord agree to the following terms:
- Lease Term: 5 years
- Base Rent:
- Year 1: $17,000/month ($1.00 per square foot per month)
- Year 2: $17,850/month ($1.05 per square foot per month)
- Year 3: $18,700/month ($1.10 per square foot per month)
- Year 4: $19,550/month ($1.15 per square foot per month)
- Year 3: $20,400/month ($1.20 per square foot per month)
In Year 1, the tenant uses janitorial services, water, and electrical provided by the landlord, for a total cost of $60,000 per year (or $5,000 per month). At the end of each month, the tenant is responsible for paying these costs as additional rent in addition to the base rent payable pursuable to the terms of the lease.
In Year 2, the building value is re-assessed, resulting in a 10% increase in property taxes and the state is experiencing a drought and enacts new legislation that increases water costs by 20%. While the increase in water costs will likely be passed onto the tenant (since the tenant is responsible for paying for the water it consumes), the increase in real estate taxes is of no consequence to the tenant, as such increased cost is ultimately borne by the landlord in a modified gross lease.
Better for Landlord, Tenant, or Neutral?
A modified gross lease is generally a blend of a triple net lease and a gross lease (hence the name), and therefore, is “neutral” in terms of which party is benefited. The base rent may be slightly higher than that of a triple net lease as a result of the increased risk to the landlord, but the tenant shares some risk in terms of operating costs as well.
Gross Leases
A Gross Lease shifts one hundred percent of the risk associated with variable operating costs to the landlord. Under a gross lease, the tenant pays only one form of rent: base rent. There is no additional rent; rather, the landlord prices-in the operating costs of the building, including any risk associated with potential increases in taxes or other operating costs, and offers a fixed rate to the tenant. This drastically simplifies the calculation of payment, as the base rent is agreed to in the lease, and no other amounts other than base rent are due. The tenant will still be responsible for some operating costs of its business, such as communications (telephone and internet), but basic utilities, maintenance, insurance, and property taxes will be paid by the landlord.
Example of a Gross Lease
A landlord owns a 5-unit office building, containing 100,000 rentable square feet. Four of the units are occupied, and landlord, is seeking a tenant to occupy an office containing 17,000 square feet. The tenant and landlord agree to the following terms:
- Lease Term: 5 years
- Base Rent:
- Year 1: $17,000/month ($1.00 per square foot per month)
- Year 2: $17,850/month ($1.05 per square foot per month)
- Year 3: $18,700/month ($1.10 per square foot per month)
- Year 4: $19,550/month ($1.15 per square foot per month)
- Year 3: $20,400/month ($1.20 per square foot per month)
In Year 1, the tenant uses janitorial services, water, and electrical provided by the landlord, for a total cost of $60,000 per year (or $5,000 per month). In Year 2, the building value is re-assessed, resulting in a 10% increase in property taxes and the state is experiencing a drought and enacts new legislation that increases water costs by 20%. In a gross lease, one hundred percent of these costs are paid by the landlord, and the tenant is only responsible for the base rent agreed to under the lease.
Better for Landlord, Tenant, or Neutral?
As demonstrated above, a gross lease is generally tenant favorable because it shifts the assumption of risk of increased operating costs from the tenant to the landlord. However, a tenant will often have to pay a premium in the base rent in exchange for the landlord assuming this risk.
