Gross vs. NNN Leases
What is a Gross Lease?
A lease where the tenant pays a fixed amount, and the owner of the asset pays all regularly incurred expenses (e.g. utilities, taxes, insurance, maintenance). The owner usually takes into consideration the cost to cover estimated operating expenses when generating a rental rate.
Pros
For owners: utilities, taxes, insurance, and other regularly incurred expenses, are usually predictable and consistent. Any reduction/cost savings related to these expenses is passed along directly to the owner. This provides the owner with more control over maintenance duties, especially related to aesthetic changes, since the owner is incurring the cost.
For tenants: makes budgeting/forecasting expenses easier.
Cons
For owners: if expense inflation outpaces rent inflation, then margins will erode.
For tenants: if the operating expenses end up being lower than expected, then those savings are not factored into rent being paid by tenant (i.e. no savings passed on).
Common example: multifamily leases.
What is a Modified Gross Lease?
A lease where the tenant and owner both bear some responsibility for paying the property’s operating expenses. The specific expenses the tenant and owner are responsible for vary widely. Under a modified gross lease, the tenant is often responsible for certain operating expenses (e.g. taxes, insurance and maintenance) beyond a base-year/stop amount.
Common provisions/modifications in a gross lease:
Base year stop – allows owner to recoup any expenses beyond “base year” expenses (the year chosen as the “base year” establishes a basis for what expenses can be passed through to tenants in subsequent years). The “base” year can be the year before acquisition, the year after acquisition, or whatever other year the owner/tenant agree to establish in writing.
Stop amount – allows owner to recoup any expenses beyond the “stop amount” (a pre-determined amount agree upon in the executed lease). Here, the “stop amount” is the basis for what expenses can be passed through to tenants.
What is a NNN Lease?
A lease where the tenant is responsible for a proportionate share of all operating expenses associated with their occupancy, plus any common area maintenance (CAM) charges which are usually divided up based upon the tenant’s square footage percentage or the property (usually excludes capital expenses, but not always – see CAM blog for examples of capital expenses being passed through to tenants).
Pros
For owners: burden of operating expenses shifted to tenant. Reduces variability/risk for owner. More predictable stream of income.
For tenants: NNN leases require a lower rent to be charged compared to gross leases, so any reduction in operating expenses is especially helpful to tenants as they will see those savings. Transparency related to operating expenses being incurred.
Cons
For owners: Reconciliation risk (if actual operating expenses incurred are less than estimated operating expenses, then part of the rent paid by the tenant may have to be reimbursed).
For tenants: Fluctuation risk. Rents will fluctuate from month to month and year to year as operating expenses fluctuate, making budgeting expenses more difficult.
