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Gross vs. Net Lease in Commercial Real Estate

smartland-gross-net-lease-in-commercial-real-estate.mp3 There are two types of leases in commercial real estate: Gross and net leases. The type of lease can have an impact on financial performance Listen to this article

Introduction

There are two main types of leases in commercial real estate: Gross and net leases.

While both lease types are legally binding contracts. The type of lease used can have a significant impact on the financial performance of a commercial real estate investment.

This article will take an in-depth look at gross and net leases in commercial real estate. It will also look at the potential advantages and disadvantages of both types of commercial leases.

Related: Investing in Real Estate Properties: The Ultimate Guide

What is a Gross Lease?

Most tenants are familiar with a gross lease, even if they do not call the lease by that name. For example, residential rentals, hotels, and self-storage units all use a type of gross lease structure.

A gross lease calls for the tenant to pay the same amount of rent every month in exchange for using the property.

Depending on the type of gross lease, the tenant may also pay for utilities or damage beyond normal wear and tear.

Such as when a unit in a multifamily property is rented. Most of the costs of ownership. Including things like repairs, common area maintenance expenses (CAMs), capital expenditures (CapEx), and property taxes and insurance. Fall as the responsibility of the landlord in a gross lease.

Another way of thinking about a gross lease is that the majority of the risks of owning a commercial property, such as the expense for repaving a parking lot or an increase in property taxes, are borne by the property owner.

Examples of Gross Lease

One good example of a gross lease is coworking office space. The tenant pays a flat fee every month for the use of a desk or fully furnished private office in a prestigious location. With this they also receives amenities such as reception, meeting rooms, internet service, and free beverages and snacks.

Another example of a gross lease is an apartment rental. In the Breakwater Tower Apartments in Cleveland, one-bedroom units start at $799 per month. If the tenant signs a one-year lease, they know the rent for the apartment will be the same each month.

What is a Net Lease?

With a net lease, the tenant pays a lower monthly base rent. However, the trade-off to the tenant is that some or all of the landlord’s operating expenses. Risks of ownership – are passed through to the tenant on a pro-rata basis.

For example, if the tenant leases 10% of the total building. Then 10% of the costs of operating the property are also charged to the tenant.

If ownership costs go up. Each tenant receives a proportional increase. Or, if the costs of ownership go down, such as when an investor wins a tax appeal. These savings are then passed through to the tenant in the form of a lower CAM charge.

A tenant under a net lease may have to pay several property cost.

Some of which could include utilities and janitorial service, repairs inside of the unit being leased, CAMs for common areas shared by all of the tenants, trash collection, landscaping and parking lot upkeep, fire sprinkler systems, property insurance and taxes, and property management fees.

Examples of Net Lease

One good example of a net lease is retail space in a shopping center.

If the tenant is leasing a 5,000 square foot suite on a net lease in a 50,000 square foot neighborhood shopping center, the tenant pays the agreed-to monthly base rent plus 10% of the property’s total operating expenses. In addition to paying a pro-rata share of the shopping center expenses, the tenant would also pay for its utilities and janitorial service in the suite.

Another good example of a net leased property is a free-standing fast food outlet or bank branches. Examples being McDonald’s or Bank of America.

When a tenant occupies the entire property under a net lease, the tenant generally pays for the upkeep of the entire property. Oftentimes this includes making structural repairs such as the roof or replacing mechanical systems such as the HVAC system.

Understanding Different Lease Structures

From the above examples, it is clear that not all leases are the same. The leases can be structured around the type of property, the needs of owners, and tenants occupying the building. Even within the same property, a landlord may choose to use a combination of gross and net leases.

For example, a grocery store anchoring a large retail property may occupy its space on a net lease. Where as the smaller mom-and-pop type tenants may use a gross lease structure.

On a basic level, there are two lease structures used in commercial real estate. Gross and Net Leases.

Gross Lease Structures

The monthly rent with a gross lease stays the same regardless of whether or not the building operating expenses change. If the tenant signs a gross lease for three years. That rent may adjust annually based on any change in the consumer price index (CPI).

Having a CPI increase in a gross lease is one way a landlord can protect itself when renting to tenants on a gross lease. Theoretically, if inflation goes up by 2% per year and the cost of operating the property also increases by 2% – due to the increase in the cost of materials or vendor services – the landlord’s net income will still be the same.

If the property is well maintained,
the risk of an unanticipated major repair is minimized.

Advantages of Gross Leases

Gross leases can be beneficial to both landlords and tenants. A tenant knows what the rent expense will be each month and can budget accordingly. A gross lease can be a big benefit to a start-up business or mom-and-pop tenant. Many of whom may be sensitive to changes in cash flow from one month to the next.

Gross leases may also be beneficial to experienced landlords of well-maintained commercial properties. A well maintained property minimizes the risk of unanticipated major repairs.

Because experienced operators understand what the true cost of owning the property is. The gross lease can be structured to include the tenant’s share of the building expenses in the monthly rent.

The landlord may be able to keep occupancy levels high by attracting more tenants to the property with a gross lease while effectively including the property operating expenses in the gross rent the tenant is paying each month.

Now let’s take a look at how a full-service gross lease and a modified gross lease structure would work using a multifamily property as an example. Each unit in the apartment building rents for an average of $1,000 per month. Plus utility expenses such as electric, gas, water, and sewer service which run $200 per unit per month on average.

Under a full-service gross lease, each apartment would rent for an average of $1,200 per month. The landlord has already factored into the monthly rent of $1,000 operating expenses such as property taxes, insurance, and maintenance.

A gross lease structure can offer potential upside to the owner if actual operating costs are lower than anticipated because net income will be higher.

On the other hand, if enough tenants use more utilities than projected, or if there is a sudden increase in utility costs, operating costs will be higher and potential net income lower with a gross lease.

To reduce the risk of ownership, a landlord can use a modified gross lease to have the tenant responsible for some of the operating costs.

With a multifamily property, the owner could have each unit individually metered for utilities or install a sub-metering system to measure the amount of utilities each unit is using.

In either case, the average monthly rent per unit would be $1,000, with utilities paid directly by the tenant. This eliminates the risk to the landlord of higher than expected utility usage or rate increases.

A modified gross lease structure can also be used in other types of commercial property.

In addition to including an annual CPI increase for the rent on a gross lease, a landlord can also modify the gross lease to include a “base year” as an “expense stop” for operating expenses.

For example, assume that in the first year – or base year – of a tenant’s gross lease, the rent is $5,000 per month. The rent includes the tenant’s pro-rata share of $1,000 in CAM (common area maintenance) expenses as part of the monthly rent.

In year two, if the CPI increase is 2% and the tenant’s share of CAM increased to $1,050, the tenant’s rent in the second year of the modified gross lease could be $5,150: $5,000 x 2% CPI increase + $50 for CAM expenses above $1,000 in the base year.

By using an expense stop, the landlord is able to pass through to the tenant any increases
in operating expenses beyond the first year,
while still offering many of the attractive benefits of a gross lease to the tenant.

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Net Lease Structures

In terms of how the property operating expenses are passed through to the tenant. A net lease structure is the polar opposite of a gross lease.

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With a net lease, the monthly base rent is generally lower than with a gross lease. However, the tenant also pays for its pro-rata share of operating expenses. Including property taxes, property insurance, and common area maintenance (CAM).

Using a net lease allows a landlord to reduce ownership risk by passing through part or all of the building’s operating expenses to the tenant. On the other hand, a landlord will not be able to benefit from overestimating operating expenses as it would with a gross lease.

Sophisticated tenants may also find a net lease structure beneficial. With this they have more direct control over the costs of operating the property.

3 Types of Net Lease Structures

There are three types of net lease structures: Single Net, Double Net, and Triple Net (NNN). Let us look at how each net lease structure works. In this scenario, we will assume the following:

  • The tenant is leasing 5,000 square feet in a 50,000 square foot property.
  • The tenant’s base rent is $15 per square foot per year.
  • The tenant pays directly for utilities and janitorial service.
  • Property taxes for the entire property are $20,000 per year.
  • Property insurance for the entire building is $10,000 per year.
  • Common area maintenance (CAM) for the entire property is $2 per square foot per year.

With a single net lease, the tenant pays the base rent plus a pro rata share of the building’s property taxes. In this example, the tenant’s pro rata share of the building is 10% (5,000 square feet leased / 50,000 square foot property) and the total monthly rent under a single net lease would be $6,416.67:

  • Base rent: $15 per square foot x 5,000 square feet / 12 months = $6,250

  • Net charge for property taxes: $20,000 x 10% = $2,000 / 12 months = $166.67

  • Total monthly rent = $6,416.67

With a double net lease, the tenant pays the base rent plus a pro rata share of the building’s property taxes and property insurances. Under a double net lease in this example, the tenant’s total monthly rent would be $6,500:

  • Base rent: $15 per square foot x 5,000 square feet / 12 months = $6,250

  • Net charge for property taxes: $20,000 x 10% = $2,000 / 12 months = $166.67

  • Net charge for property insurance: $10,000 x 10% = $1,000 / 12 months = $83.33

  • Total monthly rent = $6,500

With a triple net (NNN) lease, the tenant pays the base rent plus a pro rata share of property taxes, property insurance, and CAM. The tenant’s total monthly rent under a NNN lease in this scenario would be $7,333.33:

  • Base rent: $15 per square foot x 5,000 square feet / 12 months = $6,250

  • Net charge for property taxes: $20,000 x 10% = $2,000 / 12 months = $166.67

  • Net charge for property insurance: $10,000 x 10% = $1,000 / 12 months = $83.33

  • Net charge for CAM: $2 per square foot x 5,000 square feet = $10,000 / 12 months = $833.33

  • Total monthly rent = $7,333.33

Conclusion

By analyzing how leases are structured with each property and tenant. The investors are better able to understand the effect on property yield. In doing so, they are also better able to make an apples-to-apples comparison when comparing one investment opportunity to another.

“When evaluating a potential real estate investment,
it is important to look beyond the gross rental income and net operating income.”

Interested in investing with Smartland? Get in touch today and see how our real estate investment opportunities can complement your portfolio!

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