Business, Profits and Strategy

Andrew B. Zezas, SIOR
Relationship Manager,
Strategist, President
(908) 245-5999 x11
andrew.zezas@realstrat.com

Hidden Dangers of Net vs Gross Rents
(Part One)

So, how's your net lease doing these days? Or, do you have a gross lease? Do you know? Do you even care? Well, perhaps you should!

When most companies lease commercial real estate, they hire attorneys and brokers to negotiate the heck out of the lease document. Then, they most often attain corporate approval, sign the lease, and then turn it over to accounting and never look at it again ...until a problem arises. We recently represented a company in their acquisition of an office space lease for their new headquarters, and the landlord presented us with a 96 page lease! Given how lengthy commercial real estate leases have become, the desire to finish them and move on is understandable, but potentially dangerous.

All too often companies pay little attention to the component cost structure of real estate leases, beyond the rental rate and construction costs. Operating expenses and property taxes can comprise from twenty to as much as sixty percent of annual occupancy cost payments. Given that fact, more companies could reduce costs and increase profits by focusing on how operating expenses are treated and how the structure of their leases could enhance or impede their ability to control occupancy costs. This is true whether the rents are structured on a gross or net basis.

The devil is in the details, as they say. Well, that's also true in commercial real estate leases. On the surface, the differences between gross and net leases may appear to be subtle. But, buried underneath is the answer as to which structure is most appropriate for your company's occupancy.

Gross leases, as they are often called, are typically all inclusive or full service structures, where all or most of a building's operating expenses are built into the rental rate. In gross leases, operating expenses are most often calculated utilizing a base year or expense stop. Under the base year concept, a time period is selected (usually a calendar year, but the particular time period can be negotiated) to serve as the base costs which the landlord will bear. After the base year expires, or once the operating expenses rise above the base year costs, the tenant would be responsible to pay for the incremental difference. Few leases provide for a cap on increases, and most leases do not provide the tenant with a credit in the event of an operating cost decline. These two critical danger zones create little or no incentive for the landlord to reduce costs or operate the building on a fiscally efficient basis. In fact, most leases provide de facto incentives for landlords to regularly increase operating costs, so as to enhance operating profits. Under the expense stop concept, the tenant pays all operating cost increments above a set dollar amount (the expense stop base).

Accurately setting the base year or expense stop base is an important component to controlling the operating expense portion of a company's occupancy costs. Prior to executing a lease, it is imperative to clearly define allowable and excluded operating costs, how those costs are treated over the short and long term, over which time period they may be amortized, and how repairs and capital expenditures are treated, are all critical components of controlling occupancy costs.

Net leases offer a different structure that contains its own cost centers and danger zones. I'll explore net leases in detail and draw comparative conclusions between the two structures in part two of this article, which will appear in the November issue of “Business, Profits and Strategy”. Below is a brief explanation of some of the differences between Gross versus Net lease structures.

Gross Leases (with base year or expense stop)

An all inclusive cost structure, but subject to variation
Traditionally used for multi-story office buildings. Occasionally used in single story office buildings and, in a modified form for industrial buildings.
Usually provides cost increase protection for tenant for a set time period through either a base year or expense stop formula
Tenant could have less control over operating cost increases vs a net lease
Base year formula (set period of time used to calculate maximum costs to be borne by landlord-typically first calendar year during which lease commences. Could be any time period agreed to by landlord and tenant) or;
Expense stop formula (set dollar amount borne by landlord over which tenant pays- if set too low, could result in accelerated tenant cost increases)
Usually includes a formula for operating expense exclusions
Landlord can generate additional profits by providing services
May require more administration by landlord
Operating expenses typically higher than under Net leases.
Typically associated with multi-tenant, multi-story office buildings
Could have varying local definitions, i.e.: gross + te, gross + electric/utilities, modified gross, etc.

Net Leases

Tenant pays for all costs above a net rental rate
Day one operating expense increase potential
Some net leases provide tenant with more control over operating cost increases
May require more administration and cost management by tenant
Landlord can generate additional profits by providing services
Doesn't typically include a formula for operating cost exclusions as extensive as that typically found in gross leases, but exclusions may be achieved through negotiations prior to lease execution
Traditionally employed in one story office flex, light industrial buildings (multi-tenant). Net leases are becoming more common in newly constructed Class A multi-story office buildings
May require less administration by landlord
Could have varying local definitions, i.e.: triple net, double net, usually means some cost(s) is not included in rents and is an additional charge above rents

Andrew B. Zezas, SIOR, is Relationship Manager, Strategist, and President & CEO of Real Estate Strategies Corporation, Publisher of "Business, Profits and Strategy", a monthly online publication read by thousands of business, financial, and real estate executives nationally, and, is the author of two new real estate books, The CFO's Guide to Understanding Corporate Real Estate Transactions and The CFO's Guide to Hiring the "Right" Real Estate Service Provider, both of which will be available shortly at www.thecfosguide.com.

Mr. Zezas is well-known for his ease and informative style of public speaking, and has given talks, presentations, and has lead educational programs for business, professional, government, and trade associations, including the Building Owners and Managers Association, American Management Association, the U.S. Postal Service, RealComm, Society of Industrial and Office Realtors (SIOR), and others. Andrew is National Chairman of the SIOR Tenant Representation Specialty Practice Board, and is a licensed real estate instructor in Texas and Indiana. He can be reached at 908 245 5999 or via email.

Real Estate Strategies Corporation, located in Kenilworth, New Jersey, and serving clients throughout the country, helps companies create and execute Business DRIVEN Real Estate Solutions...and Opportunities, faster and with less risk. Visit www.realstrat.com.

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