Comprehending commercial real estate leases warrants careful awareness of the details. Many times, people will classify a lease as either a triple net lease or a Full Service (Gross) Lease. In reality, the majority of commercial real estate lease agreements fall somewhere in the continuum of the spectrum meaning that both the landlord and the tenant each pay some portion of the property’s operating expenses. This type of lease agreement are is typically classified as a ‘modified gross lease’. Let’s take a closer look at what you will want to know about modified gross leases.
Modified Gross Lease
A modified gross lease is a lease formation that sets out terms where both the landlord and the tenant are responsible for paying a property’s operating expenses. The specific operating expenses paid by a tenant or a landlord using a modified gross lease vary greatly. This variation is caused by changing market conditions and arms-length negotiations between the landlord and tenant. Accordingly, the only way to understand who is responsible for paying specific expenses is to carefully READ THE LEASE AGREEMENT.
Types of Commercial Real Estate Leases
There are two basic types of commercial real estate leases: absolute net leases and absolute gross leases. With an absolute net lease all operating expenses for the property are paid by the tenant. With an absolute gross lease all operating expenses for the property are paid by the landlord. All other lease agreements will fall somewhere in the middle and are commonly called modified gross leases.
Read the Lease Agreement !
The most important part about understanding commercial real estate leases is that the only way to understand a commercial real estate lease is to actually read the agreement. Although descriptive terms such as gross lease, net lease, double net lease, and modified gross lease can be a good starting point to understand the basic lease structure, it is not a substitute for reading the actual lease agreement itself. This is important because these descriptive lease terms can take on various meanings depending on who you are talking to or what part of the world you are in.
Modified Gross Lease Examples
The modified gross lease is a term applied to a lease where the expenses are both the landlord and the tenant’s responsibility. While any expenses could be up for negotiation between the landlord and tenant, commonly negotiated expenses include property taxes, property insurance, Common Area Maintenance (or CAM), utilities, and structural repairs.
When it comes to which of these expenses are reimbursed by the tenant to the landlord, a variety of expense recovery methods are used.
In a basic lease agreement, the tenant could simply pay its pro-rata share of all operating expenses. For instance, suppose that a tenant occupies a 10,000 square foot space in a 100,000 square foot building. This means the tenants pro-rata share is 10,000/100,000 or 10%. If total expenses for the building were $1,000,000 and the tenant reimbursed its pro-rata share of all building expenses, then the tenant would owe 10% x $1,000,000, or $100,000.
Sometimes the tenant could pay its pro-rata share of some expenses while paying a flat dollar amount per square foot for other expenses. For example the tenant could pay its pro-rata share of property taxes and insurance and also contribute $1/SF per year towards structural repairs.
In more complicated reimbursement structures tenants might have an Expense Stop on individual expenses or even on groups of expenses. By using an expense, stop the landlord will pay for the expense up to a certain amount (the “stop” amount). For instance with an expense stop of $2.00/SF, the landlord would pay up to $2.00/SF of the expense. Anything above $2.00/SF would then be the responsibility of the tenant.
For individual expenses this is fairly straightforward. However, it is not uncommon for expense stops to apply to entire categories or groups of expenses rather than each individual expense. This distinction is an important one and can often be a tad confusing due to the amount owed by the tenant under various scenarios.
For instance, if there is a $1/SF expense stop applied to an entire group of expenses (i.e. common area maintenance expenses), then the reimbursement will become a liability when the sum of all expenses in that group exceed the stop amount. Conversely, if that same $1/SF expense stop is applied to each individual expense, then the expense stop would be triggered for each individual expense, rather than for the sum of all expenses.
An Example:. Suppose we have a 100,000 square foot building with the following expenses:
- Property Taxes – $100,000
- Insurance – $25,000
If both of these expenses were in an expense group and a $1/SF expense stop was applied to our expense group, then the tenant would reimburse its pro-rata share of the amount over the expense stop. In this case the total expenses are $125,000 and the building area is 100,000 square feet, so the total expenses per square foot are $1.25. That means the tenant would pay the excess over the $1/SF stop which in this case is $0.25/SF, or $25,000.
If we instead applied the $1/SF expense stop to each individual expense (not the entire group), then we’d get the following per square foot expense amounts:
- Property Taxes – $100,000 / 100,000 = $1/SF
- Insurance – $25,000 / 100,000 = $0.25/SF.
Since neither individual expense exceeds the $1/SF expense stop amount, the tenant would have $0 in reimbursements.
Clearly, determining whether or not expenses are grouped together for reimbursement purposes is very important. For this reason, it is crucial to read and understand your lease and its reimbursement structure.
Above are just a few examples of modified gross lease recovery models. Reimbursement structures can and do vary widelynchor tenant pays a flat fee first, complicated rules for how building areas are measured for reimbursement purposes, etc.
Modified Gross Leases vs Base Year Leases
At times, expense stops use specific amounts like a dollar per square foot figure. Alternatively, expense stops will use a base year amount and are often called a “base year stop”.
The base year stop works much the same way as the expense stops – with one primary difference. The distinction between an expense stop and a base year stop is that a base year stop uses the expense amount in the base year of the lease.
As an example, if the expenses during the base year of the lease were $100,000 and our entire building was 10,000 square feet, then the base year expense amount would simply be $100,000 or $10/SF. In all later years, the tenant would be responsible for paying their share of expenses above the base year amount.
How is the base year selected? This depends. The only way to know for sure is to READ THE LEASE. Generally, the base year follows the calendar year in which the lease commences. As an example, if a lease begins in June 2020; the base year would be the 2020 calendar year between January 1st 2020 and December 31st 2020.
Sometimes the base year is defined as the actual first year of the tenant’s lease. In this case, it would be June 1st 2020 – May 31st 2021. However, with multi-tenant buildings this becomes cumbersome to track and therefore landlords often just use a calendar base year.
Modified Gross Leases vs Triple Net (NNN) Leases
A Triple Net Lease is a lease structure where the tenant is responsible for paying all operating expenses associated with a property. Triple net leases are common with large single tenant properties such as national restaurant chains and are popular because they offer a turn-key investment.
As we’ve seen throughout this article, the modified gross lease is a lease structure where the landlord and the tenant both share the cost of operating expenses. The modified gross lease tends to be much more complicated than a triple net lease. This is largely because the reimbursement structures under a modified gross lease can vary so widely and can be cumbersome to figure out.
Modified Gross Leases vs Gross Lease or Full Service Leases
The Full-Service Lease is a lease structure in which the landlord pays for all operating expenses for the property. Gross leases tend to be the simplest lease structure for the tenant to understand because the tenant is not responsible for any operating expenses.
This is in contrast to a modified-gross lease where the tenant and the landlord both share the responsibility for paying the property’s operating expenses. As seen above, the reimbursement structures that define how and when the tenant reimburses the landlord can get complicated quickly.
Whether or not a commercial real estate lease is a gross lease or a modified gross lease will primarily depend on market conditions. Of course, the only way to understand what type of lease you have, and more importantly who pays for what (and when), is to READ THE LEASE AGREEMENT.
If you need help with understanding your lease or require representation, please contact us at (210) 601-4642.