Understanding commercial real estate leases necessitate paying close attention to detail. A lease is frequently classified as either a triple net lease or a full service (gross) lease. Most lease agreements fall somewhere in the middle of this spectrum, with both the landlord and the tenant paying a portion of the operating expenses. These lease agreements are commonly known as “modified gross leases.” In this article, we’ll go over what you need to know about the modified gross lease vs NNN and its calculator.
What is Modified Gross Lease?
A modified gross lease is a type of real estate rental agreement in which the tenant pays base rent at the start of the lease but also bears a proportional share of the property’s other costs, such as property taxes, utilities, insurance, and maintenance.
Modified gross leases are commonly used in commercial spaces with multiple tenants, such as office buildings. This type of lease is typically between a gross lease, in which the landlord pays for operating expenses, and a net lease, in which property expenses are passed on to the tenant.
Both parties should carefully review all agreements. Even if the lease uses common terminology, it should be treated as a one-of-a-kind document for your specific situation.
How a Modified Gross Lease Works
Commercial real estate leases are classified into two types based on rent calculation methods: gross and net. The modified gross lease, also known as a modified net lease, is a hybrid of a gross lease and a net lease.
Modified gross leases are a hybrid of these two types of leases, as operating expenses are shared by both the landlord and the tenant. With a modified gross lease, the tenant is responsible for all expenses directly related to his or her unit, such as unit maintenance and repairs, utilities, and janitorial costs, while the owner/landlord is responsible for all other operating expenses.
The extent to which each party is responsible is negotiated in the lease terms. Because the expenses for which the tenant is responsible vary greatly from property to property, a prospective tenant must ensure that a modified gross lease clearly defines which expenses are the tenant’s responsibility. A modified gross lease, for example, may require tenants to pay their proportionate share of an office tower’s total heating expenses.
Pros and Cons of Modified Gross Lease
Pros of a Modified Gross Lease
#1. Greater budgetary control
Because the landlord pays for maintenance, the corporate tenant has more budgeting control over expenses that directly affect their business operations, such as salaries, rent, business taxes, and so on.
It also allows you to save time and money. You can, for example, pay for your utility usage and make it more efficient.
#2. Reduced accountability for office buildings
Corporate tenants prefer modified gross leases because they are not responsible for building maintenance. This enables corporate tenants to concentrate on the critical aspects of their business operations. Because the landlord will be responsible for paying the CAM, they will become more involved in the building’s condition. This is beneficial because it allows you to focus on the most pressing needs of your company.
Cons of a Modified Gross Lease
#1. Less control
The landlord’s attitude toward building maintenance can have an impact on the building’s appearance. If the appearance of the building is important to your business, it may have an impact on how it operates. There have been several cases where landlords have neglected building maintenance, resulting in unkempt common areas that may discourage customers and embarrass corporate tenants.
#2. Fluctuation
In contrast to a standard gross lease, costs in a modified gross lease can be expected to fluctuate. This can have an impact on your financial plans, particularly for startups and small businesses. Furthermore, the landlord may overestimate their operating costs. This may have an impact on the rental rate, and you may end up overpaying for some costs. As a result, it is critical to consult with a tenant representative to determine which lease option is best for you.
While there are obvious pros and cons to using a modified gross lease, it can be a great lease if you can’t decide between the two commercial real estate extremes of gross and net leases. A modified gross lease is generally a good idea for both tenants and landlords. It enables tenants to pay for costs over which they have control, while also giving landlords control over certain responsibilities, such as CAM charges.
Modified Gross Lease Examples
A modified gross lease is a lease in which the expenses are shared by both the landlord and the tenant. While any expense between the landlord and tenant is negotiable, commonly negotiated expenses include property taxes, property insurance, common area maintenance (CAM), utilities, and structural repairs.
Several recovery structures are used to determine which of these expenses are reimbursed by the tenant to the landlord.
The tenant could simply pay its pro-rata share of all operating expenses in a basic lease agreement. Assume a tenant occupies a 10,000-square-foot space in a 100,000-square-foot building. This means that the tenant’s pro-rata share is 10,000/100,000, or 10%. If the total building expenses were $1,000,000 and the tenant reimbursed its pro-rata share of all building expenses, the tenant would owe 10% x $1,000,000, or $100,000.
The tenant may sometimes pay a pro-rata share of some expenses while paying a flat dollar amount per square foot for others. The tenant, for example, could pay its pro-rata share of property taxes and insurance, as well as contribute $1/SF per year to structural repairs.
Related Article: PROPRIETARY LEASE: Definition and how it works
Tenants in more complicated reimbursement structures may have an expense stop on individual expenses or groups of expenses. The landlord will pay for the expense up to a certain amount (the “stop” amount) with an expense stop. For example, with a $2.00/SF expense stop, the landlord would pay up to $2.00/SF of the expense. Anything above $2.00/SF would then be the tenant’s responsibility.
Individual expenses are fairly straightforward. However, expense stops are frequently applied to entire groups of expenses rather than to individual expenses. This distinction is critical and frequently confusing because the amount owed by the tenant under each scenario may differ.
For example, if a $1/SF expense stop is applied to an entire group of expenses (for example, common area maintenance expenses), the reimbursement will begin as soon as the total of all expenses in that group exceeds the stop amount. If the same $1/SF expense stop is applied to each expense, the expense stop will be triggered for each expense rather than the sum of all expenses.
Consider the following example. Assume we have a 100,000-square-foot structure with the following costs:
- Property Taxes – $100,000
- Insurance – $25,000
If both of these expenses were included in an expense group and a $1/SF expense stop was applied to our expense group, the tenant would be reimbursed for its pro-rata share of the excess. The total expenses, in this case, are $125,000, and the building area is 100,000 square feet, so the total expenses per square foot are $1.25. That is, the tenant would pay the excess over the $1/SF stop, which in this case is $0.25/SF or $25,000.
Related Article: GUARANTOR ON LEASE: What are the Requirements?
If we instead applied the $1/SF expense stop to each individual expense (rather than the entire group); we’d get the per square foot expense amounts shown below:
- Property Taxes – $100,000 / 100,000 = $1/SF
- Insurance – $25,000 / 100,000 = $0.25/SF.
Because neither individual expense exceeds the $1/SF expense cap, the tenant would receive no reimbursements.
As you can see, it is critical to clarify whether or not expenses are grouped together for reimbursement purposes. This is why, if you want to fully understand the reimbursement structure for a lease, you must read the lease.
These are just a few examples of modified gross lease recovery structures. Structures of reimbursement can and do vary greatly. Other features of recovery structures could include caps, floors, administration fees; ancillary tenant reimbursement requirements after an anchor tenant pays a flat fee first; complicated rules for how building areas are measured for reimbursement purposes, and so on.
Modified Gross Lease Vs. NNN
A NNN lease structure is one in which the tenant is responsible for all operating expenses associated with a property. Triple net leases (NNN) are popular with large single-tenant properties like national restaurant chains because they provide a turn-key investment.
The modified gross lease, as we’ve seen throughout this article, is a lease structure in which the landlord and tenant share the cost of operating expenses. A modified gross lease is much more complicated vs. a NNN. This is significant because the reimbursement structures under a modified gross lease can vary greatly and can be difficult to understand.
Modified Gross Lease Calculator
Tenants can compute base rent and operational expenses using a commercial lease calculator with an advanced mode. The base rent is simply the area multiplied by the rate. The operational expenses are determined by the lease terms. This is useful for a modified gross lease because tenants are only responsible for certain expenses. To use the modified gross lease calculator, go here.
Conclusion
We discussed the modified gross lease vs NNN and its calculator in this article. We defined the modified gross lease, compared it to all other commercial real estate lease types, and then walked through several reimbursement structure examples that could be used under a modified gross lease.
Frequently Asked Questions
What Is a Gross Lease?
A gross lease is a commercial lease in which the tenant pays a flat fee that includes rent and all other costs of ownership.
What Is a Lease?
A lease is a legal document that outlines the terms on which one party agrees to rent property from another.
Triple Net Lease (NNN)
A triple net lease (NNN) makes the tenant solely responsible for all costs associated with the asset being leased, in addition to rent.
Single Net Lease
A single net lease is a lease agreement in which the tenant pays one of the building’s major operating costs in addition to rent.
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