Commercial Leases: An Overview of Net Leases vs. Gross Leases

Posted on November 4, 2012 · Posted in Leasing, Q and A

Once upon a time in the dark ages of commercial leases all leases were pure gross leases. What does this mean for us today? Well first and foremost, for tenants a land of fairy tales no longer exist where the landlord bears all the cost of inflation. Today virtually all leases have a provision that accounts for increased expenses at commercial buildings. So if leases are no longer pure gross leases what are the options today? The choices to use today are a net lease, a gross lease or a variant of the two.

If a tenant has a net lease they pay the landlord rent net of all the expenses, meaning that the tenant is responsible for paying a portion of all of the operating expenses for the building including maintenance, insurance, and tax expenses.

For a gross lease the landlord is responsible for paying the operating expenses. Often time the first year of a lease the tenant will be considered the base year, which means the landlord shall cover all the operating expenses. If in the second year of the lease the operating expenses exceed that of the base year then the tenant shall be required to reimburse the landlord in the amount that the expenses exceed that of the base year. Some landlords are willing to negotiate caps on the amount that the operating expenses can increase per year and be passed onto the tenant. For example, say in the base year the operating expenses were $0.50/RSF (Rentable Square Foot), and in the following year the operating expense went up to $0.60/RSF.

If the lease agreement did not have a provision capping the operating expenses for the tenant then the tenant has to reimburse the landlord $0.10/RSF in the second year to cover the increase in operating expenses. If a provision had been negotiated into the lease that capped the increase of the operating expenses for the tenant at 5% per year instead of reimbursing the landlord $0.10/RSF for the year they would only have to reimburse $0.025/RSF (0.05* $0.50= $0.025) for the year. Another issue that may arise in a vacant building is explained below:

One may ask well what if the building is 80 percent vacant and only has two small tenants in the building; are the two tenants then responsible for covering 100 percent of the operating expenses for the building even though they only occupy 20 percent of the building? The answer to this question is no, because “most” modern commercial leases whether it be a standard AIR or a landlord’s custom lease there should be a provision in the lease stating that the “Operating expenses for any calendar year during which actual occupancy of the Project is less than ninety-five percent (95%) of the Rentable Area of the Project shall be appropriately adjusted to reflect ninety-five percent (95%) occupancy of the existing Rentable Area of the Project during such period.” In other words, a tenant in a vacant building should be protected from covering an outlandish portion of the operating expenses for the building, because the landlord will always calculate a tenant’s share of the expenses as if the building were 95 percent occupied.

The above is a simple overview of net and gross leases. Whether your company is looking for a new location, renegotiating your lease, looking to downsize, or looking to upsize, it is 100% to your benefit to partner with a knowledgeable tenant representative to help you located a site and negotiate your lease. The services of a tenant representative come at no expense to your company and in the end could save you company a substantial amount of money on your bottom line expenses for office or warehouse space.