In commercial real estate, the type of lease on a property can significantly impact the property’s value. There are many variations when it comes to commercial real estate leases and whether the tenant or the landlord is responsible for the operating expenses. This article compares the two main types of commercial lease structures, gross leases and net leases, and how they may impact commercial real estate investments.
The main difference between a gross lease and a net lease is that in a gross lease the landlord is responsible for paying the operating expenses, while in a net lease the responsibility of the operating expenses falls on the tenant. Beyond this broad distinction, there are different types of gross and net leases that further break down which specific operating expenses the tenant and the landlord will be responsible for. Residential properties tend to use gross leases, while commercial spaces tend to operate with net leases.
In a gross lease, the tenant pays a fixed price for rent, and the landlord is responsible for all operating expenses. This is the type of lease most common for residential properties and multifamily real estate because it is considered tenant-friendly. Tenants who are renting a residential property will pay for rent, and the landlord will be responsible for covering the operating expenses of the building, including property taxes, insurance, management and common area maintenance.
The main advantage of a gross lease, from the landlord’s perspective, is the potential for higher income. Because the landlord is taking on a greater risk by being responsible for the real estate’s operating expenses, they can typically charge tenants a higher rent and potentially profit from a higher return on investment (barring any unexpected costs for maintenance and repairs).
In a net lease, a tenant is responsible for covering the operating expenses and pays the landlord a fixed fee for rent. Net leases are more common for retail and office buildings, where the tenants may want more flexibility and control over the property. This type of commerical lease is considered more desirable from the landlord’s perspective because it guarantees a fixed income every month without the liability of potential damages and repairs. There are three types of net leases: single net leases (N), double net leases (NN) and triple net leases (NNN). These leases range from high to low in terms of how many operating expenses the landlord is responsible for covering. For a single net lease, the tenant will pay the property taxes, and the landlord will be responsible for all other expenses. For a double net lease, the tenant will pay for both property taxes and insurance, and the landlord will cover all other operating expenses.
A triple net lease is considered the most landlord-friendly, as the tenant will be responsible for all operating expenses of the property, including insurance, maintenance and property taxes.
In a modified gross lease, the tenant is responsible for paying rent and a portion of the operating expenses, such as maintenance, insurance or utilities. Modified gross leases are often used in multi-tenant buildings with a shared common space, like an office building or a retail center, where each tenant pays for their own individual unit and a portion of the common area.
In a triple net lease, the tenant is responsible for all of the operating expenses, in addition to base rent. This is considered the most ideal type of investment from a landlord’s perspective because it’s the most hands off and the fixed monthly income is the most secure. The lack of variable expenses guarantees to the property owner that there will be no unexpected maintenance or repair expenses. In many cases, investors may not ever need to visit the property of the triple net lease, because all of the property is managed and maintained by the tenant. Many retail stores and chains like McDonalds, CVS and Starbucks will have triple net leases, said Desmond Holzman-Hansen, a former Capital Markets Analyst at Lev. Leases for a publicly-traded company will also typically come with a guarantee, which means that this corporation signing the lease guarantees the rent payments regardless of the future of the individual franchise. Guarantees are typically how leases are enforced, Holzman-Hansen said. When you have one from a publicly-traded company, it ensures your lease is ironclad.
When it comes to a triple net lease, the lease term is another important key factor to consider. The length of time remaining on a lease is the first question investors usually ask about, Holzman-Hansen said. Triple net leases usually last between 10 and 15 years, with 10 years being the most typical. For the decade or more of the lease’s duration, the landlord does not have to worry about tenants coming and going and is guaranteed a fixed income. When a lease term begins to decrease, however, it can be stressful if a tenant does not resign, or is in limbo about resigning. A shorter lease term will also impact the value of the property. Finding a replacement tenant may be difficult. These properties are typically constructed specifically for the tenant’s needs, whether that be a fast-food drive-through or a Dollar General.
While there are essentially two main types of leases, gross and net leases, there is more nuance regarding which operating expenses the tenant or landlord will cover. There is no one-size-fits-all approach to commercial leases. When considering a new commercial real estate property, the lease structure, whether it’s a gross or net lease, and whether it’s single, double or triple net lease, will be a significant determining factor of the property’s overall value.
