Understanding the Three Types of Commercial Real Estate Leases
When choosing your leased space you need to be certain you are comparing apples to apples. Your decision to enter into a lease without understanding the significance of the type of lease may have a drastic financial impact on your company. The three most common types of commercial leases are the full service lease, triple net lease and the modified gross lease. There are variations of these but most leases are based on one of these types.When choosing your leased space you need to be certain you are comparing apples to apples. Click To Tweet
The full service lease
The full service commercial lease type covers all of the basic expenses that the landlord would normally incur including taxes, insurance, utilities, trash, lawn care, janitorial services, repairs and maintenance, etc. The landlord quotes a rate that includes paying the taxes, insurance utilities and CAM. In order to protect itself from escalating costs, the landlord will include either a base year or an expense stop. To understand a full service lease it is crucial to understand these concepts.
In a base year approach the landlord represents that the quoted rate will include the costs that were incurred for taxes, insurance and CAM equal to what was spent in a given year. The year could be last year, this year or next year. The base year chosen often depends on the time of year the lease is signed. For example, a lease signed in January 2015 will have a 2015 base year while a lease signed in November or December will typically have a 2016 base year. Note that it is usually to the landlord’s advantage to use the earliest year possible and to the tenant’s advantage to use the latest year possible. Full service leases with a base year typically provide for an annual escalation in operating expenses (frequently 3%). The downside of this escalation is that the annual base rent will increase regardless of any real fluctuations in the operating expenses.
An expense stop is similar to a base year except that instead of using the actual number for a given year the landlord simply quotes an amount. If the actual expenses are higher than the amount quoted, the tenant will have to pay his/her share of the increase. Tenants should ask for the previous years’ actual amount and all projected expenses to try and ensure that the expense stop is in line with expected costs. If it is too low there will be significant overages to pay. Most office leases are full service. Full service leases are common for office leases
In a full service lease if there is a major problem with plumbing, roof, or structural building elements the landlord pays to correct these items and is responsible for the maintenance and replacement of items such as HVAC.
The triple net lease
The triple net (NNN) commercial lease type is almost the reverse of the full service lease. There is a quoted base rent but the tenant is responsible for all of the costs incurred with the operation of the space. The tenant pays the taxes, insurance premiums, utilities, etc. The tenant has all the responsibilities of ownership with none of the advantages. This type of lease is frequently used for single tenant properties and, retail and industrial properties. In multi-tenant properties, the landlord pays for these expenses as they occur but each tenant pays in advance for his/her pro rata share of the expenses. The landlord estimates the cost of taxes, insurance and common area maintenance (CAM) charges at the beginning of the year and will bill the tenant for 1/12th of these estimated charges with the monthly rent. At the end of each year the landlord will compare the actual expenses with the estimated expenses. If the landlord has spent more than estimated, the tenant will receive a bill for the difference. In a triple net lease the quoted rates does not include the cost of taxes, insurance or CAM.
In a triple net lease the tenant is often responsible for major mechanical, electrical and plumbing expenses that occur within the tenant’s space. If a pipe breaks within your space, you the tenant will incur the cost to fix it. In most cases the tenant is responsible for maintaining the HVAC too.
The modified gross lease
A modified gross (MG) lease (sometimes referred to as “industrial gross” is similar to a gross lease in that the rent is requested in one lump sum which can include any or all of the “nets” property taxes, insurance, and CAM. Utilities and janitorial services are typically excluded from the rent and paid by the tenant. The “nets” included in the base rate vary by region and by landlord. It’s always important to ask exactly what is included in the modified gross rent.
When evaluating options for space it is important to compare the different lease options with an eye towards all expenses, not just the base rental rates. Market forces will tend to even out rental rates for comparable properties regardless of the type of lease. Tenant should expect to pay roughly the same amount with a triple net, modified gross, or full service lease for similar quality space in the same area.
The most important rule of commercial leases is for tenants to read their leases carefully, and to clarify exactly which expenses they are responsible for. Depending on the market (booming or recession) and the tenant’s credit, caps may be negotiated and expenses shifted to the landlord.