What’s In A Name: Gross And Net Leases

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Gross vs. Net Leases. Rent is the dominant continuing connection between a landlord and a tenant.  Almost always, all expenses arising out of real estate development are paid by tenants – taxes, insurance, maintenance and other operating costs, environmental costs, and the rest.  These costs may already be included in the initial rent.  In such a case, unless the lease is for a very short term, the tenant will thereafter separately pay the amounts by which taxes, insurance premium, and maintenance costs increase over the “base year” cost of those items.  The base year is almost always the first year of the lease term.  So, it doesn’t matter if the initial rent has already taken into account the then current taxes, insurance premiums, and maintenance costs or whether it doesn’t.  When they are included, the rent is higher and the tenant only pays subsequent cost increases – that’s called a “gross” rent lease.  When the rent doesn’t included these initial “pass-through” expenses, the tenant will pay, as “additional rent,” its entire share of the cost for taxes, insurance, and maintenance over and above the seemingly lower rent.  Leases employing this latter approach are frequently referred to as some form of “net” lease – “triple net” (NNN), “absolute net” or “net.”  Unfortunately for the inexperienced practitioner, those terms (and similar ones like them) mean little because, from their “nickname” alone, they cannot tell who is responsible for paying the costs to fix the building’s structure or flooring or items of similar character.  As a result, it is imperative that anyone preparing a lease find out “who pays for what.”

It is a challenge to set an appropriate rent that will be acceptable at the outset and throughout a long lease term.  That means the parties must agree on something that approximates a fair market rent (or a fair market return) for an initial period by determining a method of fairly adjusting the rent (or return) to keep up with inflation and investment expectations.

It isn’t helpful to dismiss the challenge of setting rent as being solely one of negotiation.  While a particular property may be somewhat unique, except in rare circumstances, prospective tenants are not.  With some tolerance for different philosophies, there is a limit as to how much a prospective tenant will pay.  When that amount equals or surpasses what the prospective landlord will accept, the initial fair market rental will have been found.  Sometimes, the initial rent may be structured in a way that lowers the initial burden on the tenant until the tenant begins to use the premises.  One way or another, however, after that point the rent “deferral” will be collected by the landlord.  In the usual case, there isn’t anything approaching an auction market when this negotiation is taking place to estimate the fair market rental.  So, one or both parties resort to information from brokers or from professional appraisers.

An even greater challenge than setting the initial rent is adjusting future rental amounts to keep up with economic reality.  Over time, a property’s rental value will change.  Also, with inflation (which has been a historical certainty), a dollar received ten years from now will not buy as much then as it would today.  Lastly, investment return rates fluctuate over time.  So, the rent is going to change, but when, how often, and to what extent are the questions that need to be answered.

The landlord certainly would prefer only upward adjustments, early and often.  While that is unlikely to happen, resetting rent every five, ten, or twenty years is quite common.

There are three mainstream approaches to the rent “reset” challenge – fixed rate adjustments; indexed changes (such as using a cost of living index); and fair market value resets.  Each has its advantages and limitations.

Fixed rate adjustments.  They are predictable and provide a stable basis for financing.  On the other hand, the further out in time the parties set fixed incremental rent adjustments, the more dangerous the result.  The landlord’s return may turn out to be too low.  Or, the rent may be more than even a successful tenant can sustain.

Indexed rent changes.  They also have their advantages, but disadvantages as well.  Over the long run, inflation rates adjust for price levels and economic return expectations.  There are a variety of published indices and judicious selection may help approximate the conditions that were taken into consideration when the initial rent was set.  On the other hand, over short time periods, economic dislocation can create a situation where the chosen index is out of line with reality.  For example, during times of high inflation when a cost-related index may be high, the market for rental space may be depressed.  The economic crisis of 2008 is illustrative of such a case.  Also, indexed rent adjustments are unpredictable, making it difficult for a landlord’s or tenant’s mortgagee to “cost” a loan.  Certainly, loans relying on leases with indexed rent changes will still be made, but they will almost always be priced assuming the highest inflation expectations.  Using index caps and setting annual transitional thresholds may mitigate the downside of applying indexed rent adjustments, but after any reasonable time period the rent may still be substantially out of line with what it would be if the marketplace were setting the rent.

Fair market value resets. That’s where the third common method steps in.  Whether used at frequent intervals or only after a number of interim adjustments have already been made, the parties can return to their initial goal – finding the fair market rental.  They can try to reach a consensual agreement, but agree that if it cannot be done, the rent will be reset by appraisal.  The challenge is setting the rules.  Will the appraised value take into account that the tenant is in the space already?  How will it account for improvements to the space that were made by the tenant?  What appraisal method will be used and what qualifications will be required of the appraisers?  That’s only a start, but such an analysis will give the lease parties an idea of the challenge of setting rental rates according to fair market value.

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