An important part of understanding a property’s potential cash flow is understanding the nuances of different commercial lease types. All contracts outline the rental obligation of the tenant and are broken down into two categories: the base rent and reimbursements.
The base rent is based on the rentable square footage of the tenant’s space and may include some shared space. Reimbursements include the taxes, insurance, and common area charges (CAMs). While investors may know that commercial rental contracts are different from residential lease agreements, they may not know there are several types.
There are a variety of different rental leases, all of which operate differently depending on the terms and structure. The five most common types of leases found in commercial real estate are gross (or full-service), net, modified gross (or modified net), percentage, and variable.
In a gross lease, the tenant’s rent covers all the property operating expenses (“opex”). These expenses may include property taxes, utilities, maintenance, or similar costs. The owner pays these expenses using the tenant’s rent to offset the cost.
Base rent under this structure is typically high compared to other structures. The benefit to this is the rent is the only cost a tenant has to worry about. Some tenants tend to prefer this type because they do not need to get involved in the day-to-day operations of the building and the rent is fixed, even if expenses fluctuate. For example, during the summer, the rent remains the same even though air conditioning causes an increase in electricity costs.
This type is common for industrial, retail, and some office properties. Many owners try and include some variable cost flexibility in the lease by adding “escalation clauses” that take into account an increase in insurance or taxes. This may also allow them to temporarily increase rent based on variable costs.
The net lease is a highly adjustable commercial real estate rental agreement. The base rent for this type is lower than that of a gross lease, but the tenant must also pay fixed opex such as property taxes, insurance, and common area maintenance items. There are four types of net leases: single net, double net, triple net, and absolute triple net.
In a single net rental lease, tenants pay a set rent and a piece of the property tax, which is usually negotiated with the owner. The owner then pays building expenses while the tenant pays for the utilities and other services directly.
Double net lease is similar to the single net, except the tenant also pays a piece of the property insurance as well as the tax. The owner pays for CAM, but the tenant is still responsible for their own utilities and garbage services.
Triple net lease includes property taxes, insurance, and CAM, while the tenant pays for some or all of the cost of these three things on top of their base rent. It is usually the most common structure. This lease structure is favorable to owners, but it also benefits the tenant. Under this lease, tenants may have the ability to review the owner’s opex and all savings go directly back to the tenant.
Absolute triple net leases are the triple net magnified. Tenants take on all costs, enabling them to have sole responsibility of the building. The benefit is that the tenant virtually controls the building without outright buying it. A potential risk, however, is that if the property ever becomes extremely damaged, such as in a fire, then the tenant is on their own and responsible for repairs.
The third type of commercial real estate lease structure is the modified gross, or modified net, lease. It offers a middle ground for tenants and owners. This type allows for a broader range of negotiations when it comes to opex. In general, it means the tenant pays base rent, utilities, and a portion of operating costs, though details vary from contract to contract. For example, in some modified gross leases, tenants pay only base rent and utilities for the first year, but in each additional year, pay a pro rata share of the building’s opex.
This type of lease structure requires tenants to pay base rent in addition to a percentage of gross business sales, once sales have passed a certain threshold. Owners commonly ask for 7% of sales. Retail mall outlets typically have these types of commercial real estate leases.
A variable lease structure changes according to certain conditions but can be sorted into one of two subtypes: index and graduated leases. An index lease ties the rent amount to an index of some kind, usually the Consumer Price Index or local rental market conditions. For example, a renter in a large, urban center may negotiate a yearly rent review based on average office rent in the city.
In a graduated lease, the rent amount increases according to a pre-determined schedule. For example, a renter may negotiate for a yearly increase of 3% every August or seasonally. It’s common for seasonal and tourist businesses to pay more rent during the high season and less during the low season.
Commercial leases tend to vary quite a bit in length. Some run month-to-month while others have yearly leases or even lease terms for 20 or more years. It all depends on the property, size of the business, and how long the business has been in operation. Generally, commercial leases will take one of the following forms.
Fixed End Date: A lease with a fixed end date gives each party certainty around when the tenancy will end. All terms of the lease remain the same during this lease term and neither party needs to give the other notice before terminating the lease. The contract simply ends at the on the fixed date.
Automatic Renewal: Some contracts are structured to automatically renew after a certain period unless either party gives advanced notice to the other. For example, a hair salon owner might sign a yearly lease that automatically renews on January 1 each year. The terms of the contract remain in effect, including the rent payment, unless the lease is renegotiated.
Lease Options: Between a fixed-end date lease and an automatically renewing lease is a lease option. In this type of agreement, the tenant agrees to occupy the premises for a fixed period. At the end of this period, the tenant is given the option to extend their contract, usually for a specific duration at already-agreed-upon terms. For example, a software company may sign a 5-year contract for a space in an office building with the option to renew for an additional five years once the initial lease expires.
An owner will typically include a rent escalator so that, if the company agrees to renew their contract, the landlord will benefit from an increased rent payment. This helps create predictability and flexibility for both parties.
Whether an investor plans to also function as an owner or not, it may still benefit them to know about the different types of leases. Knowing may help in calculating how profitable an investment will be and allow an estimate for potential overall profit.
If you’re looking to invest in commercial real estate, contact our team at Avistone. We are a rapidly growing commercial real estate investment firm focusing on the acquisition and operation of multi-tenant flex industrial properties and the acquisition and asset management of hotel properties nationwide.
Accredited investors have the opportunity to purchase equity shares with the potential for distributions from in-place cash flow and capital appreciation upon sale. Since our founding, we have acquired 26 commercial properties with the more than 4 million square feet of space. Get in touch with us to learn more about our current opportunities.