Comparing Net, Gross, And Percentage Lease Types in the Commercial Real Estate Industry

So you’ve decided to take the plunge into property ownership of commercial real estate. Investing in and managing commercial properties is quite different than the residential market, and many of those differences start with the leasing process. New landlords often have limited experience with commercial leases, and the differences between residential and commercial real estate arrangements can understandably seem complex and overwhelming. But fear not, there’s no need to stress. Below we’ve compiled simple, easy to understand summaries to help you when comparing commercial lease agreement types and understanding the difference between percentage, gross and net leases.

Net Leases

The most common lease structure for a commercial real estate lease is what are called “net” leases. Net leases are commonly used with all commercial property types. In general, net leases place the bulk of the responsibility in the hands of the tenant. Typically, the landlord will charge lower base rent payments, and, in return, the tenant will cover utilities and some or all of the remaining costs and operating expenses (e.g., building insurance, real estate taxes, property expenses, etc.). There are several different kinds of net leases, and each outlines the amount of additional expenses the tenant is expected to cover.

Single net lease (N lease):

In addition to rent and utilities, the tenant also pays a share of the building’s property taxes. The amount is based on the proportion of total space being leased. For example, if the tenant leases 20% of the building, they’ll pay 20% of the property taxes. Each tenant pays a share of the property taxes per square foot of their rental area. These leases are the least common amongst net leases.

Double net lease (NN leases):

Double net leases are just like single net leases with the addition of insurance. Insurance costs are typically allocated in the same way, based on the share of total space occupied by the tenant.

Triple net lease (NNN leases)

Triple net leases (also commonly known as NNNs) are commercial real estate leases where the tenant or lessee pays all of the above, plus common area maintenance (CAM) costs as well. The tenant ends up paying for most of the property’s operating expenses, including rent and utilities, real estate/property taxes, property insurance, and maintenance costs.

CAM expenses apply to spaces and features shared by all tenants. This typically includes hallways, elevators, lobbies, and restrooms. In addition, CAM can cover external spaces like sidewalks and parking lots. The specific items included under CAM in a triple net or NNN lease are negotiable and should be made clear in the lease to avoid any disputes down the road. Because of the added responsibilities, base rent tends to be lower in a triple net lease than other net leases. Triple net leases are most common with large, single-occupant spaces, and therefore should only be used for tenants with strong credit worthiness.

Absolute Net (Bonded) Lease

In each of the previous commercial lease types, the landlord is responsible for covering structural damages, repairs, and maintenance expenses. There is one net lease that serves as an exception: the absolute net lease, or bonded lease. This lease essentially voids the landlord of any financial responsibility for the property. The tenant pays for all the operating costs that the triple net lease covers in addition to damages, repairs, and construction. You should only use absolute net leases with long-term tenants demonstrating excellent credit.

Gross (Full-Service) and Modified Gross Leases

While net lease agreements tend to favor the landlord, gross leases are much more tenant friendly. In a gross lease or “full-service” lease, the tenant makes one negotiable lump sum rent payment. The landlord or property owner uses what they’ve collected from this payment to cover all of the building’s operating expenses (utility costs, taxes, insurance, maintenance, etc.).

A modified gross lease means that the arrangement is somewhat of a happy medium. Modified gross leases are a hybrid between the tenant-favoring gross lease and the landlord-favoring net lease, where the tenant still makes a single lump rent payment, but the landlord does not cover every major expense. The responsibility in a modified gross lease falls on both parties, most commonly passing janitorial or electrical costs to the tenant. These leases are typically seen in multi-tenant commercial spaces where certain tenants have significantly different needs for specific services than other tenants.

While there are retail spaces that utilize a gross lease structure, they are most commonly used for office buildings. Single-tenant spaces are more likely to use a full-service gross lease, while multi-tenant spaces are more likely to use a modified gross lease. While gross leases are much simpler and more consistent from the tenant’s perspective, it may not be clear exactly where all their rent is going. Tenants may fear that you are charging them for more than they actually use. This is of course minimized in the more transparent net leases.

Percentage Leases

Percentage leases are frequently used in retail properties. Tenants in percentage leases pay a base rent plus a percentage of their monthly or annual revenue. As a result, the base rent is typically reduced even further compared to a net or gross rent payment. In addition to negotiating the base rent, a “breakpoint” may be negotiated by the landlord and tenant. This is the amount of sales after which the percentage payments begin. For example, if the breakpoint is set to $500,000, the tenant would provide no additional rental payments until they have achieved $500,000+ in sales. Landlords typically are interested in a higher base rent and a lower breakpoint. Tenants want the opposite. Breakpoints can be calculated using a natural method (a basic formula is applied), or unnatural (a figure is somewhat arbitrarily decided).

A percentage lease benefits the goals of both the landlord and the tenant – the tenant doesn’t have to worry about as many costs as they would in other lease types, and the landlord is more encouraged to keep the property in favorable condition. Both want the business to succeed. Thus, as a landlord, be sure that you understand the business prospects of your tenant. If it’s a wacky, specific retail idea in an area with low foot traffic, a percentage lease (or any lease for that matter) may not be a great idea. Further, in percentage leases, it’s critical that gross revenue be clearly defined. Certain businesses may need to deduct items (returned merchandise, vending machine sales) from gross sales before a percentage rent can be established.

Comparing Commercial Lease Types

When comparing commercial lease types and deciding which is best for your property, it’s important to consider the purpose of the property and the creditworthiness of your tenants. Having multiple tenants in the same building may lend itself well to a gross lease, but if the needs of one tenant are drastically different than the others, a modified gross lease may be necessary. When establishing creditworthiness, it’s vital to properly screen your tenants. For example, while a triple net seems much more beneficial to you as a landlord, a tenant with a subpar creditworthiness will likely default on many of the excess payments. It’s also beneficial to understand the factors that go into determining a credit score for businesses. But regardless of the lease type you choose to use for your property, it’s important to make all of the terms and nuances extremely clear. Taking the time up front to make sure the rules of your agreement are clear with your tenants can be a big step towards your cooperative success (and save you a major headache in the long run!).

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