Commercial real estate leases come in a variety of forms, and each form has its own pros and cons.
At AQUILA, we take pride in helping our clients understand each type of commercial lease, and how the type of lease can impact their bottom line.
Below you will find the three most common commercial lease types, how they benefit landlords and tenants, and which lease type is most common in Austin.
Three Types of Leases
In commercial real estate, there are three main types of lease structures:
- Net Lease
- Percentage Lease
- Gross Lease
You can think of these as the “starting point” in the negotiation process, as the type of lease is often the first detail to be decided. Below we go into more detail on each type.
1. Net Lease
When you read a report on the Austin office market, the rental rates quoted are more than likely based on net leases. This allows for an apples-to-apples comparison of buildings across every submarket.
A net lease requires the tenant to cover some of the costs associated with the operation of the building, as well as a predetermined base rent. This pro-rata share is referred to as the operating expense (op/ex). The specific costs the tenant is responsible for depends on what type of net lease is being used.
- Single Net: the tenant pays their pro-rata share of property taxes plus base rent
- Double Net: the tenant pays their pro-rata share of property taxes and insurance plus base rent
- Triple Net (NNN): the tenant pays their pro-rata share of property taxes, insurance, electricity, janitorial and maintenance plus base rent
In Austin, the most common net lease type is Triple Net (NNN).
Benefits of a Net Lease for the Tenant
The benefit to tenants under this type of lease is that it takes away the risk of the landlord drastically overestimating op/ex. Since the landlord does not have to project operating expenses far into the future, they are less likely to overcharge tenants for the expense. However, having to pay operating expenses, which can vary year to year, does make it harder for the tenant to budget for their annual leasing costs.
Benefits of a Net Lease for the Landlord
For a landlord, it is also a benefit that they do not have to project the building’s expenses far into the future. Unlike under a gross lease, a net lease offers landlords the ability to charge tenants for the actual annual costs of the building. A net lease can be a benefit to the landlord, and is most common in markets with high demand and high op/ex volatility.
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2. Percentage Lease
Percentage leases consist of a base rent and operating expenses, plus an additional variable monthly cost related to the tenant’s monthly revenue. A percentage lease requires the tenant to pay the landlord a percentage of gross sales made as a result of conducting business on the property.
This lease structure is almost exclusively used for retail tenants. While it may initially seem strange that the tenant would be willing to share their business’s profits, it can end up benefiting both parties.
Benefits of a Percentage Lease for the Tenant
Tenants see the biggest benefit under this structure by the lower base rate they are likely to negotiate. In that case, a slow month of business does not have to put an unnecessary strain on the tenant’s budget, and a good month of business means the tenant can save more of their profit, even after paying a percentage of that profit to the landlord.
Typically, percentage leases are only done for retail spaces located in highly desirable places. This type of lease aligns the interests of both the tenant and the landlord, as both parties benefit from maintaining a high-quality atmosphere.
Benefits of a Percentage Lease for the Landlord
The reverse is true for the landlord. Because the base rate is likely to be lower than it would be in different circumstances, a slow month of business can be extra tough on the landlord’s bottom line. Alternatively, if the tenant generates exceptional levels of revenue month after month, as one would anticipate at these prime retail locations, the landlord gets to share in the profitability and achieve a better return than if they had only used a net or gross lease.
3. Gross Lease
Under a gross lease, the tenant pays one flat annual fee. Unlike a net lease, tenants who sign a gross lease are not billed separately for any of the building’s operating expenses. Instead, the landlord estimates what op/ex will be over the term of the lease and factors it into the overall rental rate.
Modified Gross Lease
While this formula is for a true gross lease, there are some instances where a “modified” gross lease may be offered. Like a net lease, these modifications can include provisions that require the tenant to be responsible for certain expenses related to the operation of the building, typically electrical and janitorial, while still implementing aspects of a normal gross lease.
In this case, the tenant would be billed separately for the expenses specified in the lease.
Landlords in Austin rarely use gross or modified gross leases for their tenants, but if you do encounter one an experienced tenant representation broker will be able to help you decide what is best for you needs.
Gross Lease with Expense Stop
Almost every gross lease (at least in the Austin market) has a provision in it called an expense stop, or base year, that basically allows the landlord to pass back to the tenant any increase in operating expenses, effectively achieving the same result as a NNN lease. Learn more about expense stops in our article defining the elements of a lease.
Taking expense stops into account, there is ultimately not much difference between a gross and net lease, although on certain occasions a gross lease may result in a lower cost in the first year of occupancy. Net leases are generally more popular in a strong market because they are easily understood by all parties and easier to administer.
Benefits of a Gross Lease for the Tenant
The benefit of a gross lease for the tenant is that they will know exactly what they are paying for rent (unless a modified gross lease or expense stop is being used). Rather than having the variability of op/ex, or a percentage of revenue, the set rate of a gross lease offers tenants an easier way to factor leasing costs into their budget.
The downside of this, however, is that their costs may end up being higher than if the lease was done under a net or percentage basis. Since the landlord must forecast the building’s operating expenses, it may be the case that those expenses are overestimated (or underestimated), leading to a higher (or lower) than necessary rental rate for the tenant.
Benefits of a Gross Lease for the Landlord
Gross leases are generally seen as being favorable to the tenant, but that does not mean landlords receive no benefit from this type of lease. If the building has historically had predictable operating expenses and a steady occupancy rate, a landlord may save time by predicting op/ex rather than it being a recurring annual calculation.
Want to Know More?
We hope this article helped clear some of the confusion surrounding commercial lease types, and we know you probably have even more questions you would like answered.
If you want to continue reading, check out our Guide to the Elements of a Commercial Lease to learn more about the terms and points of negotiation in a commercial real estate lease.
If you are ready to begin the leasing process, contact our tenant representation team today to get started.
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