All you need to know about Commercial Leases

At first glance, projecting the cost for renting space in a commercial building may seem pretty straightforward. Once you and your team decide on a commercial space to lease, you negotiate a cost and terms, sign on the dotted line, and move into the space. In reality, fully understanding a commercial lease requires attention to detail and help from an experienced attorney. Who will be responsible for paying property taxes and insurance, you or the landlord? Who will pay for utilities? To discover the answer to those important questions, you need to know exactly what kind of commercial lease you are signing. Let’s review the different types of commercial real estate leases so you’ll know what to expect as far as cost and how to negotiate an agreement.

In most commercial leases, tenants are required to reimburse the landlord for their respective share of the operating expenses. This is typically accomplished through the use of one of four basic lease types: (1) the full gross lease, (2) the gross lease with a base year, (3) the gross lease with an expense stop, or (4) the net lease. The net lease is further broken down into either a net, double net, or triple net lease. There are also “hybrid” leases that have characteristics of more than one.

Full Gross Lease

This is the simplest form of lease. Under a gross lease, the tenant’s share of the operating expenses of the building are included in the tenant’s monthly base rent. Therefore, under a typical gross lease, the tenant’s only payment obligation to the landlord is payment of base rent. Increases in the costs of building operating expenses are absorbed by the landlord. In practice, true gross leases are seldom used today except for leases involving small amounts of space or leases of a short duration.

Gross Lease with a Base Year

This is the most common form of commercial lease in a multi-tenant building. Under this type of lease, the tenant is responsible for a portion of the operating expenses of the building during the first year of the tenant’s lease, but this portion is deemed included in base rent (in the same manner as in the case of a full gross lease). However, in subsequent years, the landlord is permitted to pass through to the tenant a portion of any annual increase in operating expenses. This is typically accomplished through the designation of a “base year,” which establishes the baseline amount for each of the various categories of expense. In any lease year in which the landlord’s operating expenses exceed those of the base year, the tenant is responsible for its proportionate share of the excess expense.

When negotiating a base year lease, or any lease with a base year component, you should consider the following:
Base year designation. Generally speaking, the tenant will want the base year to be as late as possible, typically no earlier than the first year of occupancy, whereas the landlord will want an earlier base year, which, in an inflationary environment, will result in the tenant being responsible for operating expense increases that occurred prior to the tenant’s occupancy of the premises. What is and is not included in expenses subject to base year escalation calculations should be carefully negotiated and clearly defined in the lease.

Gross up. It is common for a base year lease to provide for the “gross up” of operating expenses when the premises are located in a building that is not fully occupied. A gross-up provision allows a landlord to overstate operating expenses to reflect their value as if the building had been fully occupied for purposes of calculating each tenant’s proportionate share. This avoids a situation where a landlord fails to recoup the full amount of the expenses incurred when occupancy of the building is at less than 100%. For example, assume a landlord pays $100 per month for trash removal of a 100% occupied building. If tenant A is subleasing 10% of the building, it pays $10, the remaining tenants (90% of the building) pay $90, and the landlord pays nothing. If, however, the building is only 50% occupied, the actual cost of trash removal is $50. Tenant A pays $5 (10%), the other tenants (40%) pay $20, and the landlord is left with an unpaid balance of $25. In that situation, the landlord will gross up the expense from $50 to an artificial assumed expense of $100. As a result, Tenant A will be charged $10 (10%) and the remaining tenants $40 (40%), for a total of $50.

Gross Lease with an Expense Stop

An expense stop lease accomplishes essentially the same result as a base year lease. Rather than establishing baseline expense amounts through reference to costs incurred in a base year, an expense stop lease simply specifies an amount of operating expenses above which any actual operating expenses are the responsibility of the tenant on a proportionate share basis.

Net Lease

Under a net lease, operating expenses are not included in the base rent but are paid separately by the tenant and usually designated as “additional rent” payable to the landlord. The tenant is responsible for some or all operating expenses (e.g., taxes, utilities, insurance, and the like) incurred in connection with the premises. In addition, the tenant will typically be responsible for the cost of repair and maintenance of the premises. Net leases are categorized more specifically as (1) a “net” lease or single net lease or “N” lease in which a tenant pays rent plus property taxes, (2) a “net-net” lease or double net lease or “NN” lease in which a tenant pays rent plus property taxes and insurance, or (3) a “net-net-net” lease or triple net lease or “NNN” lease in which a tenant pays rent plus taxes, insurance, common area maintenance charges (referred to as “CAM” charges), and any other charges designated for payment by the tenant such as utilities. (Common areas are those areas usually on the larger property of which the leased premises are a part that are intended to be used in common by all tenants of the facility, as well as their visitors and customers. These areas, such as parking lots and entryways, are not leased to any particular tenant. A triple net lease NNN is most common where a single tenant rents all or large portion of the entire commercial property.

Hybrid Leases

Commercial leases frequently combine concepts from many of these basic lease types. For example, a lease may treat some expenses as included in base rent under a gross lease, designate others for allocation to the tenant as in the case of a net lease (ex: modified gross lease), and further designate others for inclusion in base rent with increases in expenses being passed through to the tenant on a proportionate share basis as in the case of a base year lease.