Last week I completed a continuing ed elective required by the North Carolina Real Estate Commission.  One of the topics Cindy Chandler discussed was the major types of leases used in commercial real estate. A few weeks back I discussed the differences between a gross lease and a net lease.  This week I’ll will expand on those two lease types but also highlight other major leases commonly used in the commercial field.

Gross Lease
The easiest way to understand a gross lease is to consider a typical apartment lease.  The lease designates a flat monthly rate the tenant is responsible for paying each month.  From the monthly rents, the landlord is required to cover all real estate taxes, insurances and most other operating expenses of the property (sometimes this includes the water and electricity of each unit – sometimes it doesn’t). The same concept of apartment rentals applies to gross leases in the commercial world as well.  The rent rates are high enough for each tenant that the landlord uses all proceeds to cover the operating expenses (taxes, insurance and other items) of the building.  In some gross leases, an expense stop can be used to limit the landlords exposure.

During the class we discussed pro’s and con’s of the gross lease for both the landlord and the tenant.  Some of the items that came up were: The tenant knows and can budget real estate expenses (both current rent and future escalations) and the future escalations are protected (or set) for the life of the lease (limited exposure).  However, the gross lease may not provide additional costs or above standard services that the tenant might need (like server room infrastructure support – generators, additional cooling, etc.).  Gross leases are easy to administer for the landlord, but the landlord has more exposure from the set escalations and could lose money if operating expenses increased drastically.

Modified Gross Lease
This is simply a gross lease except it excludes a specific expense.  For example, a gross lease except for taxes or except for insurance, etc.

Net Lease
As I mentioned earlier, net leases have a set number expenses associated with the property added onto the tenants base rent.  Triple net or full net leases require tenants to cover all expenses (taxes, insurance, repairs, etc.) of the property, while other (single and double net) require to the tenant to pay only some of those expenses.

Net leases are easy to measure in value and can be compared across property types quite easily since operating expenses of the property are not included.  However, a net lease can have a greater burden on a tenant in an older building that requires significant expenses to maintain.  Net leases can also generate a lot of confusion about what is included in the base rate and what is not.  It’s important the tenant understands what components of the property they will be responsible for covering.

The net leases may also contain expense stops, which would limit the exposure the tenant might have in the building.  It is important to understand that expense stops can impact or protect both the landlord and tenant based on the type of lease.  In a net lease, the tenant is protected with an expense stop (the landlord would cover the cost over and above the stop).  In a gross lease, the landlord is protected and the tenants would pick up the costs over and above the stop.

Percentage Lease
In a percentage lease, rent is based on the revenues generated by the tenant.  Percentage rent leases are typically used with retail tenants and can take on various forms:

• straight percentage, with no minimum amount
• minimum plus a percentage
• minimum or percentage, whichever is greater
• minimum plus percentage, with a ceiling on the total amount
• minimum plus percentage if gross sales exceed a certain amount

The advantage to percentage rent leases is the landlord and tenant share in the same goal: to increase the tenants gross sales.  The tenant will also experience lower rental rates if there is a downturn or decrease in sales, which may help with their survival especially in tough economic conditions.  However, this will hurt the landlord if the tenant doesn’t do well.  Poor sales by the tenant may not be a direct result of the real estate, it could be poor management, bad concept, poor customer service – numerous things.  The landlord also has to rely on the tenant to provide accurate and timely sales reports.

Ground Lease
A ground lease is specific to the land only.  Usually a long-term lease that allows the lessee to develop the land and at the end of the ground term the property returns to the land owner.  Most ground leases call for the land to be returned as-is (leaving the building intact) while others may require the ground to be returned in its original condition.  According to Cindy Chandler, ground leases are prevalent in areas that have a shortage of highly desirable land (like New York City).

Ground leases are a great way to generate revenue for a land owner that does not have an immediate use.  The benefits include lease income to help offset taxes and the property reverting to the owners possession at the end of the ground lease term.  The downside obviously is the land owner loses control of the property for a significant length of time.  Most ground leases also lack rent adjustments that keep up with the appreciation of the lot.

Sublease
A sublease allows a tenant to lease a portion of the property they are currently leasing to another tenant.  This is a good way for a tenant to fill space they are currently paying rent on but don’t have a need for.  For example, a tenant in an office tower may lease five floors, but only have immediate need for four of the five floors.  This tenant can sublease the fifth floor to another tenant for a term that coincides with the use requirements of the main tenant.

Obvious advantages to the tenant include filling unused space to reduce operating expenses.  But at the end of the day, the original tenant is responsible for rent on the space and usually has to guarantee the sublease.

Assignment
An assignment is simply transfering all of the interests and rights a tenant has in the property to another tenant.  The same is true for landlords.  For example, if I’m an owner of a parcel that I currently lease to a company that manages surface lot parking, when I sell the property, I can assign the lease I have with the parking vendor to the new landlord.  This transfers all rights that I have as the landlord to the new landlord.

Assignment is similar to a sublease, but usually releases the liability of the party transfering the lease (which subleases do not do).

Sale/Leaseback
I examined the sale/leaseback opportunities available with Ryan Homes several months back.  The concept of the sales/leaseback allows the landlord/owner to free up capital that could be put to better use elsewhere.  Under the terms of the deal, the owner sells the property to an investor and then leases back the property for a set number of years.  In the residential development area you will see sale/leaseback terms of one to two years.  Other sale/leaseback opportunities could include free standing branch bank developments.  These deals range in the five year term, but allow for extensions to the lease.

As mentioned, the sale/leaseback model frees up capital for owner and also allows the owner more flexibility (the owner can vacate the premises at the end of the lease term).  The downside however is the lack of control on the property, especially when it comes to capital improvements.  The investor obviously accepts some return as a result of the deal.  The return would likely be less than a straight development deal because the investor is accepting less risk (all the value is built into the deal already).  But, the investor has greater control of the expenses at the property, especially as it relates to capital improvements.

These are the primary lease types found in the commercial development field.  Many of them are used frequently, but it will likely vary based on the type of property you work with.  If there are additional pro’s or con’s associated with a specific lease type that I’ve missed, feel free to add them to the comments.