Understanding Your Commercial Lease: Triple Net (NNN), Base Year, Gross, Percentage, and Other Commercial Lease Structures
To understand your commercial lease, it is important to understand your commercial lease structure. While no two leases are really the same, there are a few major types of commercial lease structures that most leases fit into. Understanding your lease structure will help you understand the major economic drivers affecting your lease, including the true costs and the major costly risks. And understanding these issues will help you get the most value out of your commercial lease. This post will give you a basic overview of the different commercial lease structures:
- Triple Net (or NNN) Lease
- Base Year Lease
- Gross Lease
- Percentage Rent Lease
- Absolute/Total Net Lease
- Modified Gross Lease
Triple Net (NNN) Lease
The triple net lease is a common lease, particularly in the retail market. The “triple net” lease can be understood best if you understand what “net” means. “Net” in the context of any type of “net lease,” including triple net leases (abbreviated often as “NNN”), refers to rent paid to the landlord that is “net” of operating expenses of one kind or another. In a triple net lease, the rent is net of the three major types of operating expenses: 1. common area maintenance expenses (often called “CAM” expenses), 2. tax expenses, and 3. insurance expenses. So when you hear that your lease is a “triple net lease,” it means that you will pay the landlord base rent and the “actual cost” of all three major types of operating expenses. When you pay the operating expenses as a separate cost in addition to base rent, then the base rent is “net” of the three expenses to the landlord—triple net.
A triple net lease can be advantageous to the landlord, because the landlord takes on less risk of operating expense inflation. If expenses rise, the tenants will pay the difference and the landlord will get the normal base rent despite the expense inflation. The triple net structure can be advantageous to the tenant because it encourages the landlord not to be stingy on maintenance or upkeep. If the landlord is passing through the expenses, the landlord is much more likely to keep the building looking great to attract new tenants. On the other hand, if the landlord saves money operating the building when compared to prior years, the tenant may end up paying less rent in the form of operating expenses. So if prices deflate, the tenants’s rent may deflate as well. This creates a nice equilibrium in many cases, because the landlord is incentivized to both keep costs low and present a great property—both of which are great things for the tenant. In exchange, the landlord collects a reasonable return that is largely protected from reduction through operating expense price inflation.
Triple net leases are common in the retail space because many retail tenants have (at least in theory) greater flexibility when pricing their products and services, which means they can absorb inflation increases faster than many other types of tenants.
Triple net leases can be good for both tenant and landlord. But the definition of CAM expenses particularly, and taxes and insurance less particularly, can be very important to understand the true cost of this lease structure. Some triple net leases pass through only limited CAM, insurance, and tax expenses, while others pass through almost every expense under the sun ((and moon) and stars if the moon is new or if there is a solar eclipse))).
Triple net leases are also often priced based on “base” rent, which can be misleading. The base rent means the rent net of the major operating expenses—you need to add in the “nets” to get a true picture of your rent.
No two triple net leases are the same, and you should understand what triple net (NNN) means in your particular lease.
Base Year Lease
Base year leases resemble NNN leases in the sense that the same types of expenses are passed through to the tenant. But in a base year lease, the pass through costs are not as transparent. Most base year leases are really just a modified type of gross lease—a lease where the tenant pays “gross” rent, or rent that is not net of the major operating expenses.
So instead of listing a base price and separate expenses like in the NNN lease structure, the lease price in a base year lease is an aggregate of the base price and operating expenses expressed as a single number. Instead of the actual costs being passed through to the tenant as in a NNN lease, in a base lease the tenant pays the base year rent—the cost of the landlord’s expenses and profit for the first year of the lease. For any subsequent years, the tenant generally pays the base year rent plus the percentage of increase in expenses to operate the building as compared to the base year rent.
Base year leases are common in office leases, and base year leases generally incentivize the parties in a way that is similar to the NNN structure. But in the base year structure, unlike the NNN structure, the landlord (as opposed to the tenant) is rewarded directly if operating expenses decrease. This also encourages the landlord to “operate as simply as possible but no simpler.”
A base year lease may or may not include other expenses that are not included in the three major expense categories, such as utilities and janitorial. Many base year leases include one or the other but not both. If they were to include both, the resulting lease would more closely resemble a full gross lease:
Full Gross Lease and Full Service Lease
A gross lease (often called a “full gross” or “full service” lease) is one where the landlord provides for all expenses. That is, gross leases include all expenses to operate the building as part of a single rent payment, so the rent is “gross” of expenses. In essence, the tenant makes a single monthly payment and in return gets a fully functional building, generally including utilities, janitorial, and other services in addition to the three major expenses (CAM, taxes, insurance). The landlord takes on the risk of inflation (at least to some extent, depending on how much of a rent “escalator” is built into the lease), and the tenant gets a space where they pay a single bill and everything with the building is taken care of. The landlord is able to more immediately capture more profit if the landlord can decrease operating and administrative expenses while maintaining low vacancy. Gross leases are most common in office leases, particularly shared office and small-office-in-a-complex-of-small-office leases, though gross leases are not very common at all in your author’s experience.
A “true” gross lease would include other expenses like internet, cable, and phone. Though you rarely see these outside of community office leases.
Percentage Rent Lease
A percentage rent lease is a hybrid lease type. The underlying structure of the lease is another type (generally a modified gross or NNN lease), and the Landlord also gets an amount of additional rent that is based on a percentage of the tenant’s revenues or profits. The structure generally calls for a minimum rent amount that is due every month regardless of revenue. And when the tenant’s revenue reaches a hurdle, then the tenant must pay the landlord a share of the sales.
The hurdle is called a “breakpoint,” and the “natural breakpoint” is commonly used. The natural break point is the amount where your percentage rent equals your minimum rent under a percentage lease. Or in other words, it is the amount at which the percentage of the revenue the landlord is entitled to is equal to the minimum rent that is otherwise due. Once the tenant’s sales pass the breakpoint, the tenant must make the additional rent payment. If the tenant’s sales never reach the breakpoint, then the tenant will only pay minimum rent.
Percentage leases are common in retail and restaurant leases, particularly when part of a mall or other retail/restaurant development. The idea is that the landlord is invested in making sure the overall development in which the business operates is a thriving place for the tenants, and if the landlord does so, the tenant must share with the landlord in its success. The landlord has upside in the lease for taking risks on the overall health of the space, and the tenant only pays if its sales (as agreed in the lease) justify it. The landlord and tenant operate more like a partnership than in the NNN, base year, and gross structures.
Percentage leases often use a percentage of gross sales revenue that is modified to exclude certain items. The allocation of expenses and how expenses are defined can mean significant savings for the tenant (and significant profit for the landlord), so the definition of “gross sales” can be heavily negotiated.
Absolute/Total Net Lease
An absolute net (often called a “total net”) lease is a lease where the tenant pays all expenses to operate the building. It can be thought of as the opposite end of the spectrum from a full gross lease. Basically, the landlord provides use of the land and building, and the tenant pays all costs of operating the land and building. The landlord becomes more like a bondholder than a landlord, and the tenant operates the building (and generally takes on most expenses) as the tenant sees fit. These leases are most common with standalone buildings, particularly with nationwide franchises and similar standalone restaurant and retail spaces. These tenants often don’t need a landlord to manage the building, but they may gain capital structure advantages by not owning the property outright.
Modified Gross Lease
A modified gross lease is a type of lease that is somewhere between a gross lease and an absolute net lease—which means it means almost anything. Because the term “modified gross” means many things, it means almost nothing without more. Technically speaking, NNN leases and base year leases are a type of modified gross lease.
“Modified gross lease” often means a single net (N) or double net (NN) lease, which means a lease where the tenant is only responsible for one or two of the major net expense categories in addition to base rent. The term “modified gross lease” most often references a lease that is very close to being a gross lease, but the landlord might make the tenant pay utilities or janitorial, making the lease not quite gross.
The hope with this post is that the descriptions of the different type of commercial lease structures will help you to more easily compare the leases you are considering. But the lease structure descriptions are by default broad generalizations. That is, you can compare the cost and obligations associated with certain spaces better by comparing the type of lease structure “apples to apples”, but no two leases are the same.
Stay tuned for the next posts in the Understanding Your Commercial Agreement Lease series discussing rent, free rent, additional rent and tenant improvement allowances.
If you’d like to learn more about the commercial leasing process or commercial lease agreements, please comment below or contact us.