Types of Commercial Leases
As the user compares their interests and needs analysis with the various landlord proposals, consideration must be given to subjective interests and criteria, which will help narrow the property choices. Such criteria include location, amenities, visibility, parking, transportation, expansion capabilities—essentially all interests and factors not driven by costs. Those interests then must be combined with the financial analyses to make the final determination. The financial pieces must take into account the user’s available cash, borrowing capacity, and financial situation, as well as alternative uses for the cash. These factors drive the type of occupancy the user might consider entering.
For example, Property A might have an overall lower cost of occupancy than Property B, but it requires a higher upfront cash outlay. The user’s financial situation may not be able to accommodate that upfront cost, or it may be more prudent for the user to preserve or otherwise use the capital. Thus, the user may determine that the best decision is to enter the more expensive lease with less upfront costs. If the user’s business is young and projected to have increased cash flow, the user might decide to defray some of the lease costs until later in the business’s lifecycle. The user also might decide to enter the more expensive alternative if that choice better meets the user’s subjective interests. The bottom line is that the choice with the lowest cost of occupancy may not always be the best decision for the user.
The various types of leases, with one exception, are defined primarily by which operating expenses are included in the base rent—in other words, which operating expenses the landlord pays and which operating expenses the user pays. Given that lease terminology and included expenses vary from market to market, landlord to landlord, and even building to building, it is extremely important for the user to understand exactly which operating expenses will be included as part of the base rent and which operating expenses he will pay in addition to the base rent.
Leases can be viewed on a continuum. At one end is the full service lease (sometimes referred to as a gross lease), in which all operating expenses are included in the base rent (the landlord pays the operating expenses). Moving in the continuum, next is a modified gross lease, in which the user is responsible for paying some of the operating expenses, and the landlord is responsible for paying the balance. On the other end of the continuum is net leases (or triple-net or absolute-net leases), in which the user pays all operating expenses in addition to the base rent.
Full Service Lease
These leases typically are used for multitenant office buildings in which all operating expenses are included as part of the rent. This includes costs such as property taxes, property insurance, repairs, maintenance, management fees, utilities, and janitorial service. An expense stop (defined later) often is utilized to set a ceiling on expenses paid by the landlord.
Modified Gross Lease
Sometimes called flex or industrial gross, these leases typically are seen in small office, service, or warehouse buildings (sometimes called showroom buildings) or R&D (research and development). While similar to full service, a modified gross lease includes fewer operating costs in the base rent. For example, depending on the lease structure, a modified gross lease may include property taxes but not insurance, or vice versa. It’s especially important for the user to understand exactly which operating expenses are included in the base rent and which expenses must be paid in addition to base rent. As a rule of thumb, if the property is not a multitenant office or industrial building, the user will pay electricity directly to the utility provider and coordinate their own janitorial service. Modified gross leases generally are applicable for single-story buildings with separate electrical meters, enabling the utilities provider to directly charge each tenant.
These typically are used for large warehouse or industrial properties, retail buildings, and office properties in some markets. With a net lease, the user pays all operating expenses in addition to the base rent, on a pro rata basis. The cost, sometimes referred to as triple nets, includes property taxes, property insurance, and common area maintenance (CAM). As in the modified gross lease described above, the user typically pays their own utilities (with the possible exception of water) and janitorial directly to the provider.
Percentage Rent Lease
The one exception to the continuum of standard leasing types is a percentage rent lease, which typically is found only in retail leases. Percentage rent leases usually are structured as net leases, but in addition to the triple-net costs such as standard operating expenses, utilities, and janitorial service, the tenant also pays the landlord a predetermined percentage of their retail sales above a defined breakpoint. Note: Regardless of the lease structure, the user ultimately pays operating expenses either as part of their base rent or in addition to their base rent.
© 2011 CCIM Institute