Other than giving a general sense of the way the lease deals with variable costs of operating a rental property, the labels, “gross lease” and “net lease” give no usable information. A good rule when it comes to preparing a lease or when reviewing a lease is to look at each obligation and ask two questions: “Who does it? Who pays for it?” In the truest of “net” leases, the tenant does both. You’ll see that most often for a single tenant property where the leased premises include all of the land as well as the building. That can come about in a number of ways, most often when the tenant developed the property and then sold it to an investor (a sale-leaseback). It is also common when a developer does a build-to-suit project for the tenant. Less often, but not rare, is where an existing single-tenant property is leased. In each of those cases, the overwhelming “rule” is that the tenant will do all of the work at its own expense. A very common, though limited exception, is when it comes to the building’s structure and, less often, the building’s roof. A “smart” exception would be that the landlord maintains the property insurance, though the tenant pays that cost. Such a lease is rightly called “triple net,” “net” or, as Ruminations prefers, ‘absolute net.”
The confusion about these labels comes with virtually all leases involving a multi-tenant property and some single tenant properties (especially those where the leased premises don’t include more than the building itself). In the case of this category of leases, the landlord will have responsibilities for the operation, maintenance, repair, and replacement of the property. That means it will be writing checks and incurring other expenses. In all but a limited number of leases, tenants will be reimbursing the landlord for those costs. The limited number of exceptions are mostly for very short-term leases, from month-to-month ones to those for only a couple of years. Yes, there are exceptions, but exceptions are said to prove the rule. [In that context, to “prove” means, to “test.” Try doing a word substitution.]
The most common “extra” costs paid by the tenant are for taxes, insurance, and operating costs and there are two basic ways leases are structured to get the tenant’s payments for these costs into the landlord’s pocket. The lease can just make all of the costs into “additional” rent to be paid on top of the stated rent. Or, the lease can call for the tenant to pay the amount by which those expenses exceed whatever they were in an agreed-upon year, typically called the “base year.”
In the latter case, the one where the tenant pays only the increases over the “base” year’s costs, the lease is called a “gross” lease. At one time, that label may have meant that the tenant’s obligation was limited to paying only the stated rent, but that understanding, especially in the retail market, is an anachronism. Today, a tenant under a “gross” lease can expect to pay increases in taxes, operating expenses, and insurance premiums over what they were in the year before the lease took effect, the year in which it took effect, the year after the lease took effect or, sometimes, the year after a multi-tenant property reached a given occupancy rate. The selected “year” would be that lease’s “base year.”
We separately listed taxes, operating expenses, and insurance premiums because “old-timers” remember when it was common to separate each of those categories when describing a tenant’s reimbursement responsibilities. Many lease forms originating long ago cover each of those three cost categories separately, even though the leases repeat the same words over and over and over when they come to explaining just how the reimbursement process works. Newer lease forms are trending to consider them as a single category, “operating expenses” as contrasted to “common area expenses,” and use a single reimbursement provision. Those three categories, however, give rise to three labels associated with a “net” lease – “triple net” (NNN), “double net” (NN), and “net.” Calling a lease “NNN” or “triple net,” (and our preference, “absolute net”) is a signal that the tenant is expected to reimburse its landlord for all three categories. From that explanation, the meaning of “double net” and “net” should be intuitive, though many in the industry use “net” and “triple net” interchangeably. Of course, that adds to the confusion and is why, when pressed, Ruminations prefers “absolute net” because that term doesn’t carry the same baggage.
All of that is fine and dandy, as in “that’s fine and dandy, but how much will it cost?” The bottom line is that a lease’s label does not tell anyone: “Who does it? Who pays for it?” Just as reading that some food is “organic” only suggests a meaning, labeling a lease as a “net” lease only suggests a meaning. It is probably best to ignore the label altogether so as to be able to study the “deal sheet” without any preconceived notion.
At the end of the day, a tenant has to figure out its “occupancy cost” for the leased premises and a landlord needs to figure out its net return. It doesn’t matter what the lease is called. What is needed is to carefully review the lease and go back to those two questions: “Who does it? Who pays for it?” At the end of the day, things need to be done; things need to be paid for.
We’d like to stop here, but that wouldn’t be Ruminations. So, we’ll ruminate about the economics of a “gross” lease as contrasted to those of a “net” lease. If the answers to “Who pays for it?” are the same for each lease, then, at the outset, the economics are the same. An example will best illustrate that. Assume that the combined cost of taxes, operating costs, and insurance premiums come to $5 per square foot of leasable space. Further, assume that the “pure” rental price for that space is $15 per square foot. With those figures, in the first year, a “net” lease would be priced at the $15 and the tenant would separately pay the $5 to its landlord. Under a “gross” lease, the tenant, for the first year, would pay “rent” of $20 per square foot of leased space. If, in the next year, the $5 per square foot rises to $5.25, the net lease tenant would pay the base rent of $15 plus an additional rent of $5.25, for a total of $20.25 per square foot. The gross lease tenant would pay the $20 rent plus the extra 25 cents (the increase of $5.25 over the base year’s $5.00). That is the “same” $20.25. So, if the covered “cost” items are the same, the tenant’s total rent is the same.
So, if the outcome is the same, does it really make a difference as to how a lease’s rent is structured? Well, no, but only if one doesn’t “pass over” another critical rent “factor”: the percentage rent increase approach. When a gross lease and a net lease each call for a 2% annual rent increase, the gross lease always becomes more expensive. In our example above, the “base” rent for the $20 “gross” lease would go from $20 per square foot of leased space would go up by 2% (in the second year) to $20.40 per square foot. The “net” lease’s first year’s rent of $15 per square foot would go up to $15.30. In the 10th year, however, the figures would be $17.94 (for the net lease) and $23.91 (for the gross lease). That’s a $2.94 increase for the “net” lease, but a $3.91 increase for the “gross” lease, almost a full dollar difference. In our example, the equivalent of a 2% annual rent increase in the “net” lease would be a 1.014% increase for the “gross” lease.
Sometimes, arguing over the amount of the late fee or how long it should take to cure a default can blind negotiators to direct dollar and cents items. The need to focus on the two questions we’ve set forth too many times today and “doing the math” can’t be shunted aside by showing how smart we are by raising all of those other important, but secondary matters. Basically, the numbers matter and long after the arguments over whether notice by email is proper, the checks will still be written, month after month.