Landlords & investors have a number of options for the types of leases they can sign with tenants. The format of the lease has the potential to make or break a deal, which is why it’s important to understand the benefits and the drawbacks of each.
We're reviewing the benefits and downsides of gross or full service leases, modified gross or net leases and net leases, including single net (N), double net (NN), triple net (NNN) leases and absolute triple net leases, elaborating on why NNN leases are particularly popular.
The three main categories in CRE are gross or full services leases, net leases and modified gross or net leases. Largely similar, the differences lie in which party is responsible for which operating expenses.
Each lease type offers pros and cons for both the tenant and the landlord.
With a gross or full service lease, the tenant’s rental covers all of the costs such as property taxes, insurance, utilities and maintenance as a single expense to the landlord, who then manages the necessary payments and maintenance. Full service leases are typically higher than other types, but they offer tenants a predictable cost and spare them the effort of having to arrange maintenance and repairs. On the other hand, this lease type offers tenants little control over maintenance schedules and the property’s appearance. For the landlord, the full service lease generates more capital than other lease types, with the assurance that they have control over the condition of the property and that taxes and utilities payments are made correctly. However, there are costs to the landlord in managing payments and maintenance.
A modified gross or net lease allows the landlord and tenant to negotiate which party pays what, when. This is a popular option for properties such as office parks and condo towers where it is in the tenants’ interests to contribute to the maintenance expenses and have control over the costs of utilities. For landlords, a modified gross lease can simplify property management, but could come with risks in properties where short term leases result in a high turnover of tenants.
Net leases cover specific operating expenses, which are for the tenant’s account. These expenses are categorized as "three nets": property taxes, insurance, and maintenance, and the net lease types refer to which of the expense ‘nets’ are covered by the tenant.
There are four types - single, double, triple and absolute triple. All leasing options have particular benefits and downsides, with varying degrees of risk related to factors such as structural damage, property depreciation, extreme weather events and tenant turnover.
Single Net Leases
A single net lease (or an N lease) involves the tenant paying for one of the operating expenses - often property tax - as part of their rent. Landlords generally charge a slightly lower rental to make up for this. Tenants will also pay utilities. For landlords, a minimal amount of risk is transferred to the tenant, but the responsibility for keeping taxes up to date rests with the landlord, as do all maintenance and repairs.
Double Net Leases
If a tenant signs a double net lease, they are responsible for base rent and two of the expenses, typically property tax and a portion - to be negotiated - of the property insurance. The landlord will cover maintenance of common areas, and the tenant will pay their own utilities. This form of lease achieves a compromise on operating costs and maintenance, but the terms should be carefully considered to ensure that costs, risks and responsibilities are allocated fairly.
Triple Net Leases
Triple net leases are known as NNN leases because of the three nets that tenants pay - common area maintenance, property taxes, and building insurance. The landlord remains responsible for any other expenses. These are typically long-term leases. This means that for landlords, income is predictable and ongoing running costs and risks are relatively low, which can make them an attractive option. For tenants, this type of lease offers flexibility and control with a relatively low base rent, but it can also incur higher than expected maintenance costs.
Absolute Triple Net Leases
Absolute triple net leases see the tenant take responsibility for all of the expenses and running costs of the property. This option is not commonly applied in commercial real estate as it burdens the tenant with all the costs and responsibilities of running the property, without the benefits of owning it, which is why they are sometimes referred to as ‘hell or high water’ leases.
Recession-resistant NNNs
Triple net leases in particular are very popular with landlords and tenants alike, and is commonly used for commercial properties such as offices, retail stores, restaurants and gas stations. With the right tenant and the right location, NNN leases have proved to be relatively recession resistant over time.
Here are the pros and cons:
Limited expenses
NNN leased properties are very low maintenance investments - you could almost call them passive income generators - with the investor only needing to get involved when leases come up for renewal. However, there is the risk that tenants will neglect necessary maintenance, resulting in depreciation of the property’s value. For tenants, their contribution on top of rent gives them leverage when it comes to negotiating and/or renewing leases.
Long-term leases
NNN real estate properties typically come with long-term leases - 10, 15 or even more than 20 year periods are common. This provides relative income certainty for investors who acquire NNN leased properties as a defensive long-term strategy, with fewer risks and overheads than shorter term lease models. However, there is a cap on earnings due to the long term nature of the leases.
Fit for (tenant) purpose
Triple Net Lease (NNN) properties are often tailored to meet the needs of the specific long-term renter. On the one hand, this makes it less likely for the tenant to leave. On the other, it means the owner has to potentially improve or retrofit the property to make it suitable for the next tenant and incur the cost of doing so, which may be substantial depending on the size and nature of the property.
Transfer options
While the long-term nature of NNN real estate leases means there is limited immediate upside, for the investor the one advantage they have is that these leases are transferable. Investors looking to put funds into a secure, stable vehicle for a number of years often look to NNN leased properties, holding onto them for as long as it fits their investment goals, and then transferring the lease.
Additionally, if the investor sells the property, they can put their capital into another NNN lease without paying tax through a section 1031 exchange.
The short version
NNN real estate leases are one of the best options for CRE investors and can be applied to a wide variety of asset classes - from retail & restaurants to industrial and more. They offer a secure, stable option and have become popular in recent years as they have outperformed other types of investments (including bonds).
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