As I’ve discussed before, there are four main types of commercial lease agreements, classified by their general features. They are full service, gross, modified gross or modified net, and triple net. This blog will attempt the impossible: to simplify the definitions of the gross and modified gross leases.
Night and Day
The gross lease is often described as the opposite of a triple net lease. If you’ll remember from my previous blog, a triple net lease is one in which the Tenant is responsible for their portion of expenses in addition to base rent. In contrast, a gross lease is one in which the Landlord includes the costs for certain expenses in the base rent and the Tenant is not charged by the Landlord for anything in addition to the rent.
The most common gross lease is one in which the Landlord covers these three standard expenses:
- Common Area Maintenance, such as parking lot lighting or landscaping
- Property Insurance, including the building and common areas
- Real Estate Taxes for the building and any land used as common area
In some gross leases, the Landlord covers additional costs, such as utilities or janitorial service. Any variation of the gross lease is called a modified gross lease.
The Color of Money
Gross leases allow the Landlord to make sure the amount of income needed to run the property is collected directly from the Tenant. The Landlord then pays the operating expenses from the amount collected from the Tenant. This provides assurance for the Landlord that the Tenant understands all the costs associated with the lease and has not forgotten to account for additional property expenses.
Gross leases can be used in any situation but are commonly used in multi-tenant, office buildings when dividing out expenses can be difficult or time consuming.
The underlying characteristic of the gross lease is that the Landlord bears the risk of monthly expense increases. However, there are two commonly used options available for the Landlord to pass some of the risk to the Tenant over the long term:
Expense stops – The Landlord is responsible for all of the expenses up to a certain level (the expense stop) and the Tenant is responsible for all expenses above that level. The expense stop is often set as the base year which is the first year of the lease. When a base year expense stop is used, the Landlord should send an end of the year expense statement showing the actual expenses for the base year and setting the expense stop. At the end of each of the following years, the Landlord sends an expense reconciliation statement with an invoice for any increases in expenses over the base year.
Escalation clauses – In order to account for expected future increases in expenses, a Landlord may add a rent escalation clause in the lease agreement. Rent escalations are a predetermined dollar amount that the rent will increase at a prescheduled date during the lease term. Escalations provide clear expectations for Tenant expenses while reducing Tenant risk for surprise bills at the end of the year. In the Tenant’s favor, the Tenant will not owe additional rent should the expenses increase above the amount of the rent escalation. On the other hand, the Tenant will still have a rent increase even if expenses don’t increase.
All the Right Moves
In response to a Landlord negotiating to pass expense risk to a Tenant, the Tenant has a couple options as well:
Expense caps – When a Landlord decides to pass through expenses to a Tenant, the Tenant may put a limit to the amount of expense increase they will receive. Expense caps are usually defined as a percentage increase over the prior year’s expense. For example, Landlord agrees that total Operating Expenses passed through to Tenant in any year will be no greater than five percent more than such expenses passed through to Tenant during the prior year.
Exclusions – The Tenant may limit the expenses that can be passed through. It is common for a Tenant to include a list of the expenses that do not qualify as Operating Expenses, such as depreciation, capital expenditures, and legal fees.
Not Losin’ It
Gross leases are ideal for Landlords who want to directly control the payment of property expenses and have specific control of how much expense risk they pass to the Tenant. Gross leases are best for Tenants who are willing to risk paying a premium in order to have set expectations for future expenses.
Cocktail of Gross Lease and Other Leasing Options
As I’ve said in the past, there are many ins and outs to the types of leasing available within the world of commercial real estate. If you are interested in reading more about leasing options, other than the gross lease, I recommend reading Hell or High Water: Understanding the Basics of a Triple Net Lease or Commercial Real Estate Lease Basics: Cutting the Confusion.
In addition to reading about leasing options in this blog, you can’t go wrong talking to an experienced and knowledgeable commercial real estate agent. Being able to talk to a specific agent who knows what they are talking about, and can help guide you in your understanding of leasing options, is a valuable asset to have.
Thank you for reading, and as always, I welcome feedback in the comments section below.
About Stephanie Gilbert – Stephanie has been working in commercial real estate since 2003. Although she has done a variety of deals, her focus and passion, when it comes to commercial real estate, is leasing and selling office space, primarily in the Pensacola, Florida area. If you would like to contact her, you can call her at 850-434-7500, or email her at SGilbert@SVN.com. You can follow her on Twitter at @.