Commercial leases come in many formats. Still, tenants must understand the differences and how these leases affect cost and responsibility. The primary differences between leases lie in the various passed-through liabilities placed on the tenant.
What is a Lease?
A lease is a legal agreement between two parties where one party is allowed to use and occupy a property for a specified period in exchange for regular payments, often called “rent.” It is typically an agreement between the “Landlord” or owner and the “Tenant” or occupier of the space. The lease outlines the rights and responsibilities of both parties and the conditions under which a Tenant can use the property.
What is the difference between a Lease and a “Service Agreement”?
It’s common for occupiers to confuse these two terms. While the two agreements are similar, a lease agreement and a service agreement have some key differences.
A lease is a contractual arrangement in which the owner grants the legal right/ownership to use and occupy a specific property for a predetermined period for a specified rent.
A service agreement is a contract between two parties where the service provider agrees to provide specified services to the client or customer for a service fee.
The primary difference between these two is the legal right to the space versus a temporary permit to use an area; a service agreement instead focuses on delivering a service, such as providing office space services in a coworking space or executive suite. You don’t sign a lease in a coworking space because that would need to be approved by the landlord, the actual owner of the property. You sign a service agreement where the office space leaseholder or owner provides you the service of office space.
Common types of leases:
1. Triple Net Lease (NNN Lease)
Today’s most common type of lease is the triple-net or “NNN” lease. This has become the popular choice for landlords because it splits the building’s operating expenses and the rental rate to clearly define the property’s income for the owner. It shifts the exposure of ownership costs onto the leaseholder or occupier. Such expenses include taxes, maintenance costs, utilities, and insurance premiums, which are passed onto the tenant and provide the landlord with a more consistent net income without fluctuating expenses.
In the past, most buildings used a “Gross” lease, which combined all expenses and rental rates into one number. Now, landlords favor the triple net lease because it shows a lower face rate when marketed and ensures predictable income.
In these leases, occupiers need to be more perceptive of the landlord’s assumptions and the costs included in the operating expenses. A good broker and real estate attorney can help protect occupiers by exercising thorough due diligence and implementing other measures such as operating expense caps, audit rights, defining/negotiating exclusions, adjustments to base rent, termination rights, and sublet/assignment rights.
2. Double Net Lease (NN Lease)
The double net lease is a much less common type of lease where the occupier pays a base rent and two primary expenses, usually associated with real estate taxes and building insurance. In this lease, the landlord typically covers the maintenance.
This type of lease seeks to shift many of the “non-controllable expenses” to the tenant, whereby the landlord takes on the maintenance.
3. Single Net Lease (N Lease)
A single net lease is another rarely seen type of lease today. However, it allows the occupier to pay a base rent and one of the primary “non” controllable expenses. The primary expense for this type of lease is usually property taxes, but it can vary.
Due to the lower pass-through expenses, a single net lease will have a higher base rent than a triple or double net lease.
4. Absolute Net Lease
Most commonly in industrial leases where a tenant occupies an entire building, an absolute net lease provides the most protection for a landlord allowable in a lease format. This type of lease consists of the tenant taking on all or nearly all the expenses and repairs for the space they are leasing. They allow the tenant to take on the landlord’s responsibilities and costs, including maintaining and repairing the property, taking out insurance, organizing utilities, and reimbursing the property taxes. Repairs on this lease typically can include repairing structural items on the building or other major capital items such as roofing, structural supports, or HVAC units. Occupiers should exercise extreme diligence on such properties and ensure proper insurance coverage if something happens during the lease term.
These leases typically provide the lowest base rent due to the increased liability, cost, and duty on the tenant.
5. Full Service (Gross) Lease
Another common type of lease, the full-service or “gross” lease, is typically found in older buildings. It provides the tenant with an “all-in” rent amount. The landlord then covers all other expenses from the gross rent collected, including taxes, insurance, and maintenance.
The benefit to this type of lease is that the tenant does not assume any of the expenses associated with the property and has more predictability on the cost of their leases. The base rent is typically the highest in these leases because of the security provided for the tenant and the exclusion of other expenses.
A notable exception: gross leases typically provide the tenant with a “base year” on which the landlord pays expenses. Expenses that increase over the base year are typically passed to the tenant during the lease term. These provisions are in place because while the landlord provides the tenant with a predictable rent schedule, landlords also work to protect themselves from unforeseen cost increases in the future that may negatively affect their cash flow.
6. Modified Gross (MG Lease)
A modified gross lease is a compromise between gross and net leases. The occupier will pay rent and some of the net expenses, which are negotiated between the tenant and landlord. In many situations, a modified gross lease requires the tenant to pay for or reimburse one or two utility expenses, such as water or electricity.
These types of leases can provide more flexibility are customizable to both parties.
7. Percentage Rent Lease
A percentage-rent Lease is typically found in the retail industry, shopping centers, or malls. These leases require tenants to pay their base rental rate plus a portion of their gross revenue earned at the location.
These arrangements are created because landlords benefit when the tenant’s business does well. They also incentivize the landlord to bring other highly trafficked or popular brands to the real estate park to provide further traffic to the company.
Tenants, however, will need to understand their exposure/liability under these types of rental agreements because it could affect the economics of their business. It also typically provides tenants with increased reporting standards since landlords will want to audit the tenant’s books regularly to see what additional rent it may be able to collect from the location.
8. Ground Lease
A ground lease is a lease of the land only. These leases are most commonly found in the development industry and typically have term lengths of anywhere from 30 to 99 years.
In this scenario, a tenant often constructs a building on the leased land. At the end of the lease, the land and all improvements revert to the landlord. The tenant will own the improvements on the land until the end of the lease term; therefore, the tenant may be able to sell its leasehold interest and improvements to a new buyer in the future.
Developers or occupiers typically use such a lease when developing a property on costly land, such as a central business district, or in prized locations where an owner does not want to give up their rights in the land. These leases can be valuable to new owners because they can get a low-cost lease in an excellent location for an exceptionally long term, providing them with favorable economics to build and lease a building.
9. Synthetic Lease
A synthetic lease is a financing arrangement where a company will purchase a property under a different entity, which is then leased back to the parent company. The end result is that the synthetic lease is treated like a lease in the company accounting, but like a loan for it’s taxes.
Typically, an operating or parent company will create a separate special purpose entity (SPE) that purchases an asset and leases it back to the operating company. This is often used by companies wanting to control a property without showing the asset (or associated debt) on their balance sheet.
