Commercial leases are a crucial part of commercial real estate investing. The different types of commercial leases in real estate, as well as the responsibilities they require of the tenant and the landlord, are important factors to consider when it comes to evaluating a property’s overall worth.
A commercial lease is a binding agreement between a property owner and a tenant. There are many variations to the terms of commercial real estate leases, but they can be divided into two main types: gross leases, where the landlord is responsible for operating expenses, and net leases, where the tenant is responsible for the operating costs. Residential properties, such as multifamily units, will typically have gross leases. Commercial spaces tend to have net leases. A tenant for an apartment building will likely be required to pay for utilities but wouldn’t be paying for property taxes or common area maintenance in the same way a commercial tenant would be. Similarly, a tenant in an apartment wouldn’t be responsible for the overall insurance cost of the building or major building repairs.
For a gross lease, the landlord pays all operating expenses and charges the tenant a fixed price for rent. The operating expenses include the costs associated with running the property, including taxes, insurance, management and common area maintenance.
In a modified gross lease, a tenant is responsible for paying some of the operating expenses, such as maintenance, insurance or utilities. This lease type is often used for buildings with common areas, where the tenant pays rent plus a portion of the maintenance for the common areas, like an office building or a mall.
In a net lease, the tenants are responsible for paying operating expenses, and the landlord charges a net cost for rent. Net leases are considered the most desirable type of lease from a landlord’s perspective, as the tenant is responsible for the operating expenses of the property and any unexpected expenses. The tenant also has the flexibility to fix the property in the way they would like. This is why net leases vs gross leases are more common in commercial real estate. These are the three most common types of net leases:
In a single net lease, the tenant pays the property taxes and the landlord pays all other operating expenses.
In a double net lease, the tenant pays both the property taxes and insurance and the landlord pays the remaining operating expenses. Industrial buildings often use double net leases.
In a triple net lease, the tenant pays for all of the operating expenses related to the property, including insurance, maintenance and taxes, in addition to the rent of the property. For landlords, this is the most hands-off type of lease and the most ideal. Retail and chain stores like Starbucks and McDonalds are almost always triple net, according to Desmond Holzman-Hansen, a former Capital Markets Analyst at Lev.
An absolute net lease, also called a bondable lease, is most similar to a triple net lease structure, except the tenant is also responsible for all property-related expenses. In a triple net lease, the tenant pays utilities, base rent, and minor repairs and maintenance. In an absolute net lease, the tenant also pays for major repairs and maintenance such as the roof, HVAC and parking lot.
A single-tenant net lease can be a single, double, or triple net lease in which the property is 100% leased to one tenant. Typically these are single-tenant triple net leases, and the tenant is responsible for all property-related expenses. Expect to use this type of commercial lease for retailers and restaurants.
Green leases are still relatively rare, but their popularity is increasing. They can be gross or net leases. Green lease agreements occur when the landlord and tenant agree to take measures to keep the property energy efficient. If you invest in or develop net-zero energy buildings, you’ll likely include energy-efficiency language in the lease agreement.
With a build-to-suit lease, the landowner agrees to develop a building to the specifications of the lessee. A build-to-suit lease is a type of commercial lease often used by fast food restaurants. For example, Pizza Hut buildings always have their signature sloped red roof because they are built to suit. You may also hear about reverse build-to-suits.
Percentage leases are structured so that the tenant pays base rent plus a percentage of what the business earns in profit. Base rent is usually determined from a dollar amount per square foot.
Landlords may use this type of commercial lease in multi-tenant commercial properties to curate a set of businesses for a certain demographic. In turn, each business in the property receives more traffic, and that traffic is their target customer. For example, small strip malls that include only family-geared shops and restaurants may benefit from a percentage lease.
A ground lease is literally a lease of the ground. A landowner will lease a plot of land and the lessee can develop it to their specifications. In some lease structures, the landowner may include a clause stating that structures must be removed at the end of the lease at the lessee’s expense. However, many ground leases are 99-year leases.
As a property owner, you’ll want to consider different factors when signing a lease with a new tenant, or investing in a property with a pre-established lease. The type of lease already on the property might make a difference in your investing strategy. For example, landlords will want to be careful of any variable expenses in the lease. “The biggest problem for lenders with a double or a single net lease is if the landlord is responsible for repairs and maintenance, because you don’t really know what that expense will look like on a year-to-year basis,” Holzman-Hansen explained. Open-ended obligations like these can be risky.
“Say your building needs new roofs — that’s 50 grand. That could cost more than you’re going to make that year,” Holzman-Hansen said. “Lenders look at [a lease] as a little bit riskier if they have to cover expenses they can’t predict or put within a range.” On the other hand, if the landlord covers operating expenses that are fixed and predictable, like insurance or taxes, the costs don’t pose additional risk. “Lenders can still get comfortable with single and double net leases, but it really depends on the variance of expenses,” Holzman-Hansen said.
When it comes to investing in commercial real estate, the lease on a specific property will impact your considerations and the value of the property.
If you want to buy a property you’ll never have to visit, a multifamily unit may not be the right choice. Maintaining it would require dealing with multiple tenants, fixing repairs and managing tenant leases, which can quickly amount to a full-time job if you don’t opt for a management company. On the flip-side, when you invest in a property with a triple net lease, you may not ever need to visit the property in person. In addition to monthly rent payments, the tenant will handle everything related to the property itself, including all operating expenses.
Lease terms for commercial real estate properties typically span 10 years and can go up to 15. If you are interested in investing in a property, you’ll first want to know how many more years are on the lease, as this will impact the property’s value. For example, a property with one year left on a triple net lease would be considered a riskier investment than a property where you are guaranteed to inherit an eight-year lease. “It’s the first question that comes up on the phone with lenders if I’m dealing with these types of deals,” Holzman-Hansen said. “You have to size your hold period as an investor to the length of the lease, or you have to be confident that they’re going to resign.”
If you don’t know what kind of tenant will sign your new lease once the old one ends, that uncertainty could restrict your ability to earn a stable income on your property. A property with only one year remaining on the lease will have a lower value than one with a longer lease. “You can certainly sell a property for more if you have 10 years remaining than one year. So, as an operator, you have a decision to make. That being said, ‘Should I sell my property for what is potentially a discounted price because there’s only one year remaining and there’s uncertainty surrounding what’s going to happen, or, should I try to get my tenant to renew and then sell?’” Holzman-Hansen explained.
He recommended doing the latter because you will likely get a better price for the property with a longer lease term.
Guarantees on a lease are an important factor to consider when evaluating a property. A corporate guarantee means a publicly-traded corporation guarantees the lease — basically, your lease is ironclad, Holzman-Hansen said. Compare that with a lease with a personal guarantee — even one of a high net worth individual — or a lease backed by a small company with a poor balance sheet. If there’s no guarantee on the lease, or the terms are less secure, you’ll be taking on more risk as a property owner.
Guarantees are also important because they’re what people used to enforce the lease, Holzman-Hansen added. “At the end of the day, as an investor looking at that property, you have to know that if the lease goes out, you’re probably not going to get paid,” he said.
When it comes to investing in commercial real estate property, the lease tied to the property will be an essential determinant of its value. As an investor or landlord, a comprehensive understanding of the different types of commercial leases — and what they imply for the tenant’s responsibilities and the landlord — will help support a search for the right investment property. When evaluating different leases, the lease term and whether there is a guarantee on the lease are two important factors to consider, beyond whether the lease is gross or net.
