When it comes to leasing a property, there is a wide variety of leases that you may encounter. Some of these leases put more of the risk on the landlord while others shift the risk to the tenant; most important to know is that each comes with a different amount of risk.
Which type of lease you agree to, either as a landlord or tenant, depends on your risk tolerance as well as what is more or less typical by property type. Below, we’ll explore the various types of leases you’re likely to run across depending on your business type.
The Types of Lease You’re Most Likely to Encounter
Absolute Net Lease
An absolute net lease is a lease where the tenant is responsible for everything. They pay rent to the landlord and handle all other expenses involved with operating the property. An example of an absolute net lease is a ground lease, where the tenant is technically leasing out the entire property, including any building, the parking lot and landscaping, whether it has a building already on it or not.
An example of this would be many fast food restaurants. The tenant rents the ground, constructs the building, and is fully responsible for anything that happens on the property.
The tenant pays the real estate taxes. If the building is destroyed by a hurricane, it’s the tenant’s problem. They insure the property, pay for any repairs on the building, take care of snow removal and damage to the parking lot. Essentially, they are responsible for the entire property and any expenses that come with operating a business and property
We see absolute net leases frequently in the investment property market since they put the risk almost entirely on the tenant instead of on the landlord.
In a gross lease, the tenant pays just the rent. All the costs of operating, maintaining, repairing, and insuring the property are the responsibility of the landlord.
The most common example of a gross lease is what the most common office leases used to look like. With a gross lease, business owners would often encounter a scenario where when you speak to the landlord, they tell you the rent will be x amount a square foot for the first year, and x+1 for the second year. These numbers would lock in regardless of any changes to the landlord’s expenses.
If a light burned out in your office, you called the landlord to handle the issue. If you had bugs in the office, you’d call the landlord and they’d pay an exterminator to come in and handle the issue. Regardless of how big or small the issue was, the landlord would handle it, shifting the risk to them and off of the tenant.
In addition, tenants may have requested upgrades to the space with the lease renewal. This might be new carpeting or a reconfiguration of the space. The landlord would likely figure the costs of such upgrades into the lease rate, but the tenant wouldn’t pay for the carpet outright. All those costs were on the landlord.
With that being said, gross leases are much rarer these days since absolute net leases and gross leases are the two extremes. In between, you have a number of more moderate lease types.
While the names of leases may change, you can’t always count on the name being the EXACT definition of the lease. You still have to carefully read and review the entire lease, but the typical office lease these days says that in the first year, the landlord is responsible for everything just as they would be in a gross lease.
The landlord records the operating costs are for the whole building for that first year. Unlike a gross lease, in the second year, if the operating costs go up, the tenant is then responsible for the pro-rata share of the increase
Gross leases used to be the most common type of office leases, but in more recent years, modified gross leases have taken over. Costs began to get out of hand for landlords as utility costs rose and inflation increased. As a landlord, you don’t want to lock somebody in for a 10-year lease when you don’t know if you’re going to see a significant increase in your costs.
Triple Net Lease
A shopping center lease is likely to be a triple-net lease. where the tenant is responsible for the cost of most common area maintenance costs, insurance, and taxes. Typically the landlord retains responsibility for the roof and the structure, however, as with any lease, this isn’t always the case.
Diving a little deeper into common area maintenance, this includes the areas that are used in common by all the tenants, including snow removal, sweeping the parking lot, trash removal, etc.
In a typical triple net retail lease, the tenant is responsible for pretty much everything that happens within their space, so if the lights in the store burn out, the tenant replaces them. If the toilet’s clogged, in theory, the tenant calls the plumber.
The tenant is also often responsible for paying their pro-rata share of insurance and taxes.
Modified Gross, Reading Into Leases & Assigning Risks
When it comes down to it, lease types are all about assigning and shifting risk by determining who is responsible for what. This is why it is critical to always read the lease carefully and see what you’re responsible for.
As an example, let’s say you owned a shopping center. You could say the rent is $15 and you, the tenant are responsible for your pro-rata share of all these costs. The estimate of those costs in this case is $6 a foot.
The tenant is going to estimate that the first year’s rent is going to be $21, but all of the risk is on them. If it turns out to be $24, it’s $24. That’s what it is; you, as a landlord, aren’t going to take on any extraneous costs.
On the other side, the landlord could say, okay, I’m going to charge you $21 and I’m going to take care of everything. Then the risk is on the landlord. If there’s an extra $3 worth of cost, it’s the landlord’s risk. It bears repeating that choosing lease types all comes down to the shifting of risk.
What to Look for in a Lease to Understand Your Risk
On the tenant end, when you look through the lease, you’re basically looking at your risk as well as the landlord’s risk. Most times, the landlord is going to try and lay as much risk off on the tenant as possible.
The tenant, on the other hand, is going to try to make the landlord take as much responsibility as possible for the property. Even if a lease says upfront that it’s designed to be a triple net lease, for example, you still have to read the lease and see what costs you’re responsible for.
Whether you’re a landlord or a tenant, our team at TD&A can help you review and negotiate leases so that each party feels they have an acceptable amount of risk in a lease. Give us a call today at (410) 435-4004 or contact Art Putzel for more information.