Commercial real estate leases come in many formats, but it is crucial for tenants to understand the differences and how these types of leases affect cost and responsibility for the tenant. 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. It is typically called a “Landlord” and “Tenant” but is sometimes called a Lessor and Lessee. A lease allows the tenant to use and occupy a property owned by the landlord for a specified period in exchange for regular payments, often called “rent.” The lease outlines both parties’ rights and responsibilities and the conditions for how the tenant uses the property.
Leases vs. Service Agreements
A lease is a contractual arrangement in which one party grants another party the legal right/ownership to use and occupy a specific property for a predetermined period of time for a specified rent.
A service agreement, on the other hand, is a contract between two parties wherein one party (the service provider) agrees to provide specified services to the other party (the client or customer) for a service fee.
The primary difference between these two is that a lease agreement pertains to the use and rights of a particular tangible asset, while a service agreement instead focuses on the delivery of a service, such as providing office space services such as co-working space.
Common types of leases:
The Triple Net Lease (NNN Lease)
One of the most common types of leases is the triple-net lease, in which the tenant pays a base rental rate and covers the remaining “operating expenses” associated with the Building or Property. These operating expenses typically include reimbursing the landlord for taxes, utilities, insurance, and maintenance (sometimes called “CAM” or common area maintenance).
In recent years, landlords have begun to move from “gross” Leases to these types of “net” leases because it shifts the exposure of swings in the costs of taxes, maintenance costs, utilities, and insurance premiums onto the tenant and provides landlords with a more consistent net income without fluctuations in expenses.
However, Triple net leases will have lower base rents due to the increased cost/exposure from the passed-through operating expenses.
Tenants can protect themselves 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.
Full Service (Gross Lease)
Another common type of lease, the full service or “gross” lease, is typically found in older buildings and provides the tenant with an “all-in” rent amount. The landlord covers all other expenses, including taxes, insurance, and maintenance from that rent.
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 expenses the landlord pays are based. During the lease term, expenses over this base year are typically passed to the tenant. 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.
Modified Gross (MG Lease)
A modified gross lease is a compromise between a gross lease and a net lease. The tenant pays base rent and some (but not all) of the net expenses, which are negotiated between the tenant and landlord. In many situations, a modified gross lease will require the tenant to pay for or reimburse for one or two of the utility expenses: water or electricity.
These types of leases can provide more flexibility and be customized to fit the specific needs of both parties.
Alternative Leases:
The Double Net Lease (NN Lease)
A less common type of lease is one in which the tenant pays a base rent and two primary expenses, usually associated with real estate taxes and building insurance. The landlord typically covers maintenance.
This type of lease seeks to shift many of the “non-controllable expenses” to the tenant, whereby the landlord takes on the maintenance.
The Single Net Lease (N Lease)
A single net lease is also a less common type of lease today; however, it allows the tenant to pay a base rent, and one of the primary expenses is usually property taxes.
Due to the lower pass-through expenses, a single net lease will have a higher base rent than a triple or double net lease.
Absolute Net Lease
Most commonly found 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. These leases consist of the tenant effectively taking ownership of the space they are leasing. They also require the tenant to take on the landlord’s responsibilities and costs, namely, maintaining and repairing the property, taking out insurance, organizing utilities, and reimbursing the property taxes.
These leases typically provide the lowest base rent due to the increased liability, cost, and duty on the tenant.
Percentage Rent Lease
A percentage-rent Lease is typically found in the retail industry and in shopping centers or malls. These types of leases require a tenant to pay a base rent plus a percentage of their gross revenue.
These arrangements are created because the landlord benefits 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.
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.
A tenant in this scenario often constructs a building on the leased land, and 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.
These leases are most commonly found in 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 may get a low-cost lease in an excellent location for an exceptionally long term, providing them with favorable economics for building and leasing a building.
Synthetic Lease
A synthetic lease is a financing arrangement treated as a lease for accounting purposes but as a loan for tax purposes.
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.
These leases provide off-balance sheet financing and potential tax benefits to the “tenant.” However, these types of transactions can be complex due to the increased scrutiny, reporting, and regulatory requirements imposed on many companies.
