Demystifying the Commercial Lease: Types of Leases
Every fall, many parents of fourth graders rent an instrument for their child’s school music program. The task is particularly daunting for those renting a string instrument.
Although introductory band instruments come in one size, string instruments come in many sizes, with violins ranging from 1/32 size to 4/4 (or full) size. Most fourth graders need a ½ or ¾ size. To make violin selection more confusing, a ½ size isn’t half the size of a full-size instrument. Rather, for violins, a ½ size is approximately 90% the size of a full-size violin.
Determining the correct instrument size may be the easiest decision when renting a string instrument. After selecting the proper size, parents face several different rental packages, with names such as “Standard,” “Premium,” “Deluxe,” and “Premier,” with the price of the “top” package costing three times that of the standard package.
Lower priced packages, in particular, may require a minimum one-year commitment. Higher priced packages usually boast a better-quality instrument. Some packages may include a service contract for new strings and bow rehair or “insurance” against damage. Most shops offer a rent-to-own option where part of the rental price can be applied to a subsequent instrument purchase. The myriad of rental options can transform an exciting adventure into instrumental music into a frustrating and stressful experience.
Like instrumental music parents, business owners also may face numerous commercial real estate lease options. Whether they are entering into their first commercial lease or are expanding their operations, business owners likewise may find that an exciting time can be wrought with stress and frustration.
This is the first in a series of articles designed to demystify the commercial real estate lease experience. This article discusses the basic types of commercial leases.
Types of Leases
The names of the lease types alone can be mind boggling--full service, modified gross, gross, triple net, double net, and single net being the most common types. The type of lease will vary depending upon the asset class, building type, building class, and the landlord’s and tenant’s needs.
Commercial real estate leases are not one-size-fits all. Business owners who are prospective tenants should know the differences between these lease types so they can understand the total lease cost and the risks they are assuming.
Full Service Lease
A full service lease (also called a gross lease) is most common in office buildings. Full service leases are rare in leases for retail, warehouse, or other asset classes. Under a full service lease, the tenant plays a monthly, all-inclusive monthly rent amount. The tenant does not pay for utilities, real estate taxes or insurance, or maintenance costs to the building. Usually, the tenant also does not pay for cleaning or trash collection.
Under a full service lease, the landlord pays for all building operations expenses, including taxes, insurance, utilities, maintenance costs for the building and rental unit, and cleaning services. The landlord also takes care of common area maintenance (CAM) expenses. CAM expenses include repairs and maintenance for the lobby, elevators, grounds, parking lot, and other areas not allocated to a specific tenant.
Landlords or their property managers usually charge a fee to manage building maintenance. That fee is included in CAM expenses.
Even though the landlord is responsible CAM, each tenant pays its pro rata share of CAM expenses. Often, leases have a base amount of CAM “buried” in the rent charges. In those instances, tenants should expect annual increases in CAM charges. Detailed discussion of CAM expense negotiations is beyond the scope of this article and will be covered in a future article.
A full service lease provides the most predictable monthly expense amount for tenants. Tenants need not concern themselves with building maintenance or repairs and can instead focus on running their businesses. In exchange, the tenants give up control over building operations and expenses, even though they are responsible for CAM increases.
Triple Net Lease
A triple net (NNN) lease is frequently used when a tenant rents an entire building, such as when a pharmacy rents the entire building in a shopping center out lot or office buildings divided into condominiums. NNN leases also may be used for industrial tenants.
With a triple net lease, the tenant pays the landlord a monthly rental amount, which is lower than under a full service lease. Also, the tenant must pay all real estate taxes, insurance, utilities, cleaning services, and maintenance costs for its rental area.
NNN leases are not common in multi-tenant buildings. Unless the building has a condominium or similar ownership structure, double net leases (discussed below) probably will be more suitable.
Where there are multiple tenants in a NNN lease building, each tenant usually will have separate utility and HVAC units. With multi-tenant buildings, as with condominiums, it is likely there will be a shared parking lot, elevators, or other common areas, and NNN lease tenants will pay their pro rata shares CAM or condominium fees.
A NNN lease will place all building maintenance costs, including CAM and external and structural repairs, on the tenant. Where a tenant leases the entire building, the tenant may even be required to rebuild the building if it is damaged or destroyed in a casualty. Where there are multiple tenants in the building, a NNN lease is more likely to require that tenants only maintain the interior of their rental spaces, as well as any HVAC, roof, facades specific to their spaces.
NNN leases may result in a fluctuating monthly rental expense for the tenant, including potentially large expenses for building repairs and maintenance. However, the NNN tenant usually has more control over operational decisions and expenses for its rental space.
Hybrid Leases
Where neither a full service lease nor a NNN lease meets the landlord’s and tenants’ needs, there are several hybrid lease types. These may be called modified gross, double net, or single net leases.
Modified gross leases are common in smaller office building and retail leases. Under a modified gross lease, the landlord usually will pay for taxes and insurance and will arrange for common area maintenance. In addition to monthly rent, the tenant typically will pay its pro rata share of CAM expenses.
A modified gross lease tenant usually must pay for cleaning services and sometimes trash collection or routine maintenance (such as lightbulbs) for its rental space. If the tenant’s space has separate utility metering, a modified gross lease may require the tenant to pay its utilities.
Double net leases are common with shopping centers or malls. With a double net lease, the tenant pays the landlord a monthly rental amount and also must pay property taxes and insurance. However, unlike with a NNN lease, the landlord pays for building maintenance costs, which can be unpredictable. If there are multiple tenants in the building, the landlord usually will arrange for CAM, and tenants will pay their pro rata CAM charges. Since tax and insurance amounts and payment dates are predictable, a double net lease makes it easier for a tenant to predict- lease expenses.
A single net lease is like a full service lease, except the tenant typically will pay real estate taxes. Since real estate tax increases may not be predictable, a single net lease shifts that risk to the tenant. Since gross leases also often are structured to shift all risks of tax increases to the tenants, true single net leases are rare.
Expenses Tenants Always Pay
Different lease types allocate building maintenance, taxes, utilities, and insurance differently between landlord and tenant. However, all leases require tenants to pay certain costs.
For instance, the building’s insurance only covers the landlord and building. The landlord’s insurance does not cover the tenant. Tenants must obtain their own property and liability insurance. Many commercial leases mandate separate tenant liability insurance policies.
Tenants also must pay personal and intangible property taxes for their property. For some leases and asset classes, this might include taxes on property affixed to the real estate.
Finally, commercial tenants almost always pay for certain utility charges, such as telephone, cable, and Internet. Tenants also may have to pay the cost of wire or cable to install those services.
Selecting the Lease Type
Business owners should know the differences between lease types when comparing lease proposals. Prospective tenants should calculate actual operational costs, including CAM, taxes, insurance, utilities, and maintenance for each lease.
Tenants also should consider their ability to pay unexpected expenses, which are likely with NNN and some hybrid leases. A start-up business might want a lease that provides for a predictable monthly amount, even if it costs more over the term of the lease. Likewise, a tenant that lacks the experience to repair and maintain the real estate might prefer to have the landlord handle those items.
When I faced the myriad of violin rental options–I chose an option not covered by this article–purchasing a violin. Since I had more knowledge about violins then the uninitiated parent, I was able to perform some services included in the stores’ rental packages. For our family, the cost of purchasing a violin was less than the annual rental charges.
Some business owners likewise should consider real estate purchase as an alternative to leasing. Listing real estate brokers represent the landlord, not the tenant. They are not necessarily looking out for tenants’ interests and may not be programmed to think about ownership as an option. Therefore, each tenant should consult with its attorney and its real estate or financial professionals to help determine the commercial real estate arrangement which best meets the tenant’s business needs.
(c) 2019 by Elizabeth A. Whitman
Any references clients and their legal situations have been modified to protect client confidentiality
DISCLAIMER: The content of this blog is for informational purposes only and does not provide legal advice to any person. No one should take any action regarding the information in this blog without first seeking the advice of an attorney. Neither reading this blog nor communication with Whitman Legal Solutions, LLC or Elizabeth A. Whitman creates an attorney-client relationship. No attorney-client relationship will exist with Whitman Legal Solutions, LLC or any attorney affiliated with it unless a written contract is signed by all parties and any conditions in such contract are satisfied.