This post is intended to shed light on the world of commercial leasing for people who don’t have very much experience in this area. It might even expose a couple of points unknown to veterans as well. It’s a long post and I’ve tried to break it up into the important sections.
To start off, leases can take various forms of what the landlord is able to charge for rental amounts. The stance taken is always from the landlord’s perspective and how the rent collected is applied. Where leases differ is how the Operating Costs that a landlord incurs over the tenancy are treated. This is what makes it a Gross Lease or a Net Lease.
Before I get into what makes it a Gross Lease or a Net Lease, the first thing that needs to be defined and understood are operating costs. Operating Costs are the non-capital, cash expenses a user occurs while operating the property. This can be the landlord or the tenant. The most common operating costs, by definition, are property taxes; utilities; insurance; repairs and maintenance; and management fees. Repairs and Maintenance can be quite broad in definition and can include anything from repairs on HVAC systems, snow removal, landscaping, garbage removal, roof maintenance, or parking lot maintenance. What are NOT operating costs are things of a capital nature such as replacement of mechanical systems (boiler, HVAC, furnace, etc.), roof replacement, structural repairs, or repaving a parking lot. Non-cash items which are not supposed to be included as Operating Costs are items such as depreciation on the building. A description I have came across helps to explain the difference:
The cost of making improvements to a building asset are capital expenses if the improvements add to the value of the asset, appreciably lengthen the time you can use it, or adapt it to a different use. You can deduct repairs that keep your property in a normal efficient operating condition as an Operating Cost. You cannot deduct the cost of a replacement that stops deterioration and adds to the life of the property; capitalize the cost and amortize it. Treat as an Operating Cost to replace parts of a machine that only keep it in a normal operating condition.
Gross Leases vs Net Leases
Now that operating costs are defined we can get into how they are paid for.
A Gross Lease is a lease in which the tenant’s rent payments are to be gross to the landlord. This means that the landlord needs to deduct from the gross rent payments, all Operating Costs incurred by the landlord in order to calculate the landlord’s Net Operating Income generated from the property. The majority of residential leases are gross leases; you pay your monthly amount and that’s it, the landlord deducts his taxes, insurance, and every other Operating Cost to arrive at his Net Operating Income. All increases or decreases in the Operating Costs are at the risk of the landlord during the term of the lease. Therefore the landlord needs to charge a rental amount sufficient enough to cover any anticipated increases in Operating Costs to maintain a Net Operating Income expected for a property of its nature.
By contrast, a Net Lease is a lease in which the tenant’s Basic Rent (or Net Minimum Rent) payments are to be net to the landlord, in that the tenant also promises to pay, by way of Additional Rent, its share of all Operating Costs. The Basic Rent is the landlord’s Net Operating Income and the Additional Rent is the rent charged to cover off all Operating Costs for the property. Net Leases typically obliges the tenant to pay instalments, monthly in advance, an estimate of the year’s Additional Rent to cover off all Operating Costs that the landlord reasonably expects to incur together with the Basic Rent payments. Any increases or decreases in the Operating Costs are at the risk of the tenant during the term of the lease. The majority of commercial leases are Net Leases.
Net Leases and Industry Jargon
Net leases can also go by the name of Triple Net Leases or NNN Leases. These terms are used interchangeably and mean the same thing; the Basic Rent is net to the landlord. Likewise, Operating Costs can also be referred to as Common Area Costs (CAC), NNN’s, Triple Nets, Additional Rent, Common Costs, or Common Area Maintenance (CAM). These are all just industry jargon but mean the same thing. It’s the Operating Costs (as defined above) a landlord incurs over the tenancy.
The Additional Rent charged to the tenant to cover off the Operating Costs is an estimate of what those amounts will be. At the end of the year (or year end) all of the Operating Costs are tabulated and reconciled with the Additional Rent that the tenant paid over the year. If the tenant paid more Additional Rent than what the Operating Costs came in to be, the tenant would receive a credit on its account. Likewise if the Additional Rent was less than the Operating Costs, the tenant would receive an invoice for the shortfall. This ensures that the tenant only pays what was actually incurred for operating the property. A landlord using a Gross Lease could potentially obtain a higher Net Operating Income than he would if using a Net Lease.
The reason the majority of commercial leases are Net Leases is because the landlord’s Net Operating Income is known – it’s the Basic Rent charged to the tenant. This has various implications with mortgage financing and property valuations as everything is always calculated from the Net Operating Income the property generates. Commercial tenancies typically extend past one year, usually not more than five but can go as long as ten years in length. If the landlord was unable to adequately predict what his Net Operating Income would be in a few years time, then it would be quite difficult to value the property (since it is an investment). To compare to stocks, a stock price partially reflects what a person is willing to pay for the company’s future earnings. This is why stock prices are so volatile because economic factors can change in an instant and affect earnings. By using Net Leases, the volatility of the Net Operating Income is mitigated and property values can be better predicted and mortgage financing more effectively applied.
Additional Rent Explained Further
It is a common misconception, among both landlords and tenants, that the tenant pays the Operating Costs directly. This is not true, the tenant has merely agreed to pay a rental amount equal to the Operating Costs. One major reason for the distinction is that GST is paid on all amounts, including Additional Rent. Property Taxes are probably the most applicable to this distinction. A landlord does not pay GST on Property Taxes but it must charge GST on the Additional Rent to cover the Property Taxes. If the landlord doesn’t, the potential arises for the CRA to flag the landlord for the shortfall in tax. Rental income is considered passive income and as such is subject to GST (disclaimer: I am not an accountant and likewise do not rely on this information for tax purposes).
Operating Costs are usually levied against the property as a whole (such as property tax) and as such need to be spread across multiple users of the property. If there is only one tenant occupying the property, then it is quite simple as to who is responsible for the Operating Costs. However in most cases, more than one tenant occupies a site and these costs need to be proportionately applied to all tenants of the property. This may or may not apply to one building; these costs are applied to all tenants that fall under the same land title for the property or condo title for a property (you can think of condo fees as Additional Rent and you won’t be far off; property taxes are the only thing that condo fees typically don’t cover).
The Additional Rent that a tenant is charged is only for the Operating Costs that the landlord incurs. If the landlord does not incur a cost then there is no rental charge to cover it. The most applicable example is having power and gas utilities that are separately metered to individual units in the property. Since the cost can be directly billed to the tenant (and the utility company charges the GST) then the landlord does not need to incur this cost. However, water and sanitary services are typically not individually metered for each unit and only one meter is used for the entire property. In this case the landlord pays the bill for this utility and charges the amount back to the tenants. The same applies for the insurance on the building and also snow removal of a parking lot (benefits all tenants). In a single tenant situation for a property, the majority of the Operating Costs are incurred directly by the tenant, all of the insurance bills, water utilities, snow removal, landscaping, etc. is done directly by the single tenant and the landlord does not need to charge back these amounts. The only Operating Costs the landlord would incur in this situation would typically be property taxes and landlord’s liability insurance.
Most rental amounts are quoted on a Per Square Foot basis and this is usually the annual rental amounts. This is merely a mechanism for calculating the annual rental amounts on a property and a method for comparing different properties. The other advantage is that it represents a tenant’s proportionate share of the Operating Costs. The more space that a tenant leases, the higher its portion of the Operating Costs. However, in a formal lease, all methods of calculation should be eliminated to avoid any misunderstandings.
When looking at spec sheets (and our brochures and listings on this website) the jargon terms described above is the Basic Rent and Additional Rent. Whenever someone quotes the “Triple Nets” or “NNN” or “Common Area Costs” then they are referring to the Additional Rent payments. Likewise Basic Rent is often referred to as the “Lease Rate”. In a negotiation, you are negotiating the Lease Rate or the landlord’s Net Operating Income.
Adding the Additional Rent and Basic Rent together will give you the Gross Lease amount.
Leases can take on blends and be a “Semi-Net” or “Semi-Gross” lease. All this means is that the landlord has agreed to incur a portion of the Operating Costs (typically the property taxes) and take on the risk of any increase in these costs which will be deducted from the Basic Rent he collects.
Finally, there is a VERY wide ranging definition as to what is an Operating Cost. It is the biggest grey area when negotiating leases. Operating Costs charged to the tenant should only be cash expenses incurred by the landlord. There are various examples of landlord’s trying to charge capital expenditures and non cash items such as depreciation back to tenants. Whatever is agreed to in the formal lease is what is required to be paid. If these “Operating Costs” are not scrutinized by a professional (a commercial realtor or a lawyer) the tenant can be stuck paying costs that it shouldn’t need to incur. Because of the wide range of what is considered an Operating Cost, it is good practice to list all expenses that should NOT be included as Operating Costs.
As always, the professionals at Salomons Commercial are here to answer any questions you may have on commercial leasing.