Commercial leasing can be very lucrative and rewarding, but the lease contracts themselves can be complex and require careful construction and review. Whether you are an individual landlord or an organization leasing a commercial space, it is important to understand the terms of your commercial lease.
This article will discuss the different types of commercial leases and address some of the ins and outs of what they can and should include. An experienced commercial transactions attorney can help you understand your commercial lease agreement or help draft an agreement that works best for you or your business.
What is a commercial lease?
A commercial lease is any rental contract to lease real property to conduct business from it. This is distinct from a residential lease, which most people are more familiar with: a rental contract between a landlord and tenant to rent a home or place for living. The different types of commercial leases are arranged to give more responsibility to the tenant and less to the property owner. Because of this, they can provide more profit for the landlord depending on the type and terms.
Commercial Lease Types – Net Leases
The most common types of commercial leases are net leases and gross leases, both with multiple sub-types, which we will dive into further.
A net lease is a catch-all term for lease agreements, most often commercial, where the renter pays a portion or all of the landlord's operational costs in addition to rent. Any commercial lease must specify whether the tenant will be responsible for any of the property owner's expenses and whether it is a "net lease."
Sub-Types of Net Leases
There are different sub-types of net leases: a single net lease, a double-net lease, and a triple-net lease. These lease agreement types are split into three categories because there are generally three main types of expenses associated with a commercial property:
(1) property taxes,
(2) insurance, and
(3) maintenance costs.
The type of lease designation (single, double, or triple) depends on which, or how many, of the expenses, a lessee takes responsibility for under the rental contract. Net leases are the opposite of gross leases, which we will cover later in this article. Let's go into each net lease a bit further and look at some examples.
A single net lease is a commercial lease agreement where the tenant promises to pay only one of the three property expenses, typically the property taxes, in addition to rent. In this situation, the landlord is still responsible for paying other operational expenses associated with the upkeep of the property, such as the building insurance and maintenance costs. Still, the property tax liability (obligation) is passed from the landlord to the tenant. The one expense obliged to the tenant under the lease may be something other than the property taxes, such as the insurance premiums or costs for maintenance, but it is not as common.
A double-net lease is a commercial contract in which the tenant takes on the obligation to pay two of the property expenses that the owner usually pays. The most common expenses paid by the renter under this type of agreement are property taxes and property insurance premiums. In a commercial lease for a property located within a shared building, such as a shopping mall, these expenses are generally shared with all building tenants based on proportionality.
For example, if you rent out individual stores in a shopping mall containing 20 total spaces and leases, you would divide the expenses by 20, and each renter with a net lease would take on 1/20th of the expense amount (or amounts). In these situations, staying up-to-date on the math and how everything splits up would be very important.
As premiums and taxes fluctuate and maintenance costs go up and down, a landlord should pay close attention to how they allocate expenses to each tenant to avoid unnecessary headaches or legal issues. It might be best practice to hire someone to keep an eye on this or to utilize an attorney to keep track of a multi-lease building.
Lastly, for net leases, triple-net leases are commercial rental agreements by which the renter agrees to pay all of the operating expenses of the building in addition to rental payments. This means the tenant pays the landlord rent, usually monthly or in lump sum payments as agreed, on top of paying the full amount of property taxes and all insurance premiums, and covers all maintenance costs.
These types of leases are a bit rarer and are typically common to large companies with long-term leases. Triple-net leases might not be as commonplace for smaller-business owners or shorter-term commercial leases. It won't make much sense for the tenant to invest that much into a building they aren't very committed to, or if they don't have a lot of capital at their disposal.
Pros and Cons of Triple-Net Leases
A trade-off with these types of arrangements is that the rental costs are lower for the tenant since the landlord is not responsible for the other expenses associated with owning the property. The tenant also gets the benefit of complete control over the maintenance and operation of the building itself.
On the flip side, this type of lease can greatly benefit regular investors because it provides low risk and low involvement in the property. Any landlord leasing a space under this type of contract might have difficulty finding a lessee with the financial and operational stability necessary for it. Still, once they do, it is generally a very easy agreement to deal with and provides consistent income.
Key Provisions to Include in Net Leases
Key provisions to include in net leases are clear and definite terms about the expenses. Do not leave anything open for interpretation or debate. Under a single-net lease, if the renter pays 100 percent of the property taxes for the duration of the lease, say just that. If the building is shared, such as with the shopping mall example, be precise with how taxes are allocated among the net-lease holders. Also, include any necessary language about how the tax amounts may change during the lease term.
Typically, the responsibility to pay one of the three expenses under a net lease is either all or nothing, but it is possible that it could simply be a flat amount or a percentage. Be precise about that, as well. If the renter will only pay a set flat rate towards one of the operating costs, including the exact amount to be included with rent; if this is a percentage of, instead, spell out the percentage amount in numbers and words.
Use language such as “in full” or “total amount.” Consulting an attorney specializing in commercial leases to help construct or review your lease is always the best option.
The other type of commercial lease is a gross lease, which is fairly common. The basic idea is that the tenant pays one flat rental fee to the landlord for the exclusive use of the property instead of a bunch of different payments broken up. In general, the rental amount in gross leases will be higher than in net leases, but this is because the other expenses are rolled into the rental payment, as opposed to the tenant paying those expenses to outside agencies directly.
Since the rental amount is a flat fee agreed upon at the outset of the contract formation, gross leases allow the tenant to budget their yearly expenses accurately. Otherwise, the tenant would have their costs fluctuate throughout the year, making things unpredictable for their business.
Are Net Leases or Gross Leases More Common?
The two types of gross leases are modified leases and full-service leases. However, gross leases are more common than net leases because they are particularly beneficial to small businesses or businesses with limited resources.
Another benefit to gross leases is that they are much less complex than net leases, as they more closely resemble residential leases in that there is just one part of the rental amount provision. However, these types of leases could be less beneficial for the landlord since they require them to precisely estimate their operational costs before executing the lease.
Importance of Calculating Yearly Expenses
Property owners leasing commercial spaces should be careful to accurately calculate their yearly expenses associated with the building and ensure the rental lease reflects those expenses accordingly.
This is important because the operational costs (taxes, insurance, and maintenance) will fall to the landlord. If the landlord doesn't agree on a high-enough rental amount with the tenant, they could sacrifice their profits. Or even worse, they could lose money on the arrangement if some of their costs are more than anticipated. Again, using an attorney or tax consultant to help with these estimations might be the best idea for anyone leasing a commercial space under a gross lease.
What is the difference between a modified gross lease and a full-service lease?
A modified gross lease and a full-service lease are only slightly different. Sometimes they are even referred to simply as a "full-service gross lease," and the term "modified" is taken out. A modified gross lease is somewhat of a hybrid between net leases (multiple and fluctuating costs) and true gross leases (one flat rental fee) because it outlines a base rent amount. However, the contract stipulates for typically one other, small-ish, operational cost associated with running the building, such as trash removal or landscaping.
Sometimes the cost for this additional expense is shared among multiple tenants, such as with the same shopping mall example discussed earlier. In contrast, a full-service lease is closer to a true gross lease in the sense that it calls for just one flat rental fee while the landlord covers all other operational costs.
Expense Stop Provisions
It should be noted, however, that full-service leases can get more complex if they include an “expense stop” provision. This provision is an agreed-upon threshold above which the tenant will have to start contributing to the operational costs.
An example is when the tenant does not have to pay any operational expenses for the first year, but if those costs rise beyond a certain point, they will have to after the first year is over. This arrangement can seem complicated but gives the tenant some predictability while protecting the landlord from sharply rising costs during the lease term.
At a very basic level, commercial leases of any type should include the following provisions:
- Name and information of the parties;
- Location and description of the property to be leased;
- The rental amount and any additional costs covered by the tenant, including any up-front administrative or "move-in" fees or security deposits (be sure to follow local laws regarding security deposit holding and disclosures);
- Length of the agreement, also called the rental term (start and end dates);
- Termination notice requirements and procedures/rules for renewals;
- Rules for the property and purpose of property used by the tenant;
- Improvement and alterations clause;
- Subletting rules and procedures, if any;
- Insurance and/or maintenance requirements;
- Indemnification clause and provisions regarding dispute resolution;
- Any state or local disclosure requirements, such as lead paint or renter's rights information; and
- Signatures of all parties.