Understanding commercial real estate leases takes careful attention to detail. People will often categorize a lease as either a triple net lease or a full service (gross) lease. The reality is that most lease agreements fall somewhere in the middle of this spectrum where both the landlord and the tenant each pay some share of operating expenses. These types of lease agreements are commonly referred to as modified gross leases. In this article we will take a closer look at what you should know about the modified gross lease.
What is a Modified Gross Lease?
A modified gross lease is defined as a lease structure where both the landlord and the tenant are responsible for paying a property’s operating expenses. The specific operating expenses paid by a tenant or a landlord under a modified gross lease can and do vary widely. This variation is due to market conditions and negotiations between the tenant and landlord. As such, the only way to understand who is responsible for paying specific expenses is to thoroughly read the lease agreement.
The Spectrum of Commercial Real Estate Leases
There are two basic types of commercial real estate leases: absolute net leases and absolute gross leases. With an absolute net lease all operating expenses for the property are paid by the tenant. With an absolute gross lease all operating expenses for the property are paid by the landlord. All other lease agreements will fall somewhere in the middle and are commonly called modified gross leases.
You Must Read the Lease Agreement
The most important part about understanding commercial real estate leases is that the only way to understand a commercial real estate lease is to actually read the agreement. Although descriptive terms such as gross lease, net lease, double net lease, and modified gross lease can be a good starting point to understand the basic lease structure, it is not a substitute for reading the actual lease agreement itself. This is important because these descriptive lease terms can take on various meanings depending on who you are talking to or what part of the world you are in.
Modified Gross Lease Examples
The modified gross lease is a term applied to a lease where the expenses are both the landlord and the tenant’s responsibility. While any expenses could be up for negotiation between the landlord and tenant, commonly negotiated expenses include property taxes, property insurance, common area maintenance (CAM), utilities, and structural repairs.
When it comes to which of these expenses are reimbursed by the tenant to the landlord, there are a variety of recovery structures that are used.
In a basic lease agreement, the tenant could simply pay its pro-rata share of all operating expenses. For instance, suppose that a tenant occupies a 10,000 square foot space in a 100,000 square foot building. This means the tenants pro-rata share is 10,000/100,000 or 10%. If total expenses for the building were $1,000,000 and the tenant reimbursed its pro-rata share of all building expenses, then the tenant would owe 10% x $1,000,000, or $100,000.
Sometimes the tenant could pay its pro-rata share of some expenses while paying a flat dollar amount per square foot for other expenses. For example the tenant could pay its pro-rata share of property taxes and insurance and also contribute $1/SF per year towards structural repairs.
In more complicated reimbursement structures tenants might have an expense stop on individual expenses or even on groups of expenses. With an expense stop the landlord will pay for the expense up to a certain amount (the “stop” amount). For instance with an expense stop of $2.00/SF, the landlord would pay up to $2.00/SF of the expense. Anything above $2.00/SF would then be the responsibility of the tenant.
For individual expenses this is pretty straightforward. However, it is not uncommon for expense stops to apply to entire groups of expenses rather than each individual expense. This distinction is important and can often be confusing because the amount owed by the tenant under each scenario could be different.
For instance, if there is a $1/SF expense stop applied to an entire group of expenses (ie common area maintenance expenses), then the reimbursement will kick in as soon as the sum of all expenses in that group exceed the stop amount. On the other hand, if the same $1/SF expense stop applied to each individual expense, then the expense stop would trigger for each individual expense rather than for the sum of all expenses.
Let’s look at a quick example. Suppose we have a 100,000 square foot building with the following expenses:
- Property Taxes – $100,000
- Insurance – $25,000
If both of these expenses were in an expense group and a $1/SF expense stop was applied to our expense group, then the tenant would reimburse its pro-rata share of the amount over the expense stop. In this case the total expenses are $125,000 and the building area is 100,000 square feet, so the total expenses per square foot are $1.25. That means the tenant would pay the excess over the $1/SF stop which in this case is $0.25/SF, or $25,000.
If we instead applied the $1/SF expense stop to each individual expense (not the entire group), then we’d get the following per square foot expense amounts:
- Property Taxes – $100,000 / 100,000 = $1/SF
- Insurance – $25,000 / 100,000 = $0.25/SF.
Since neither individual expense exceeds the $1/SF expense stop amount, the tenant would have $0 in reimbursements.
As you can see, clarifying whether or not expenses are grouped together for reimbursement purposes is important. This is why it is critical to read the lease if you want to fully understand the reimbursement structure for a lease.
These are just a few examples of modified gross lease recovery structures. Reimbursement structures can and do vary widely. Recovery structures could include other features such as caps, floors, administration fees, requirements for ancillary tenants to reimburse after an anchor tenant pays a flat fee first, complicated rules for how building areas are measured for reimbursement purposes, etc. Our Proforma software makes it easy to model cash flows with these types of complicated reimbursement structures. But again, the most important takeaway is to always read the lease.
Modified Gross Lease vs Base Year
In our examples above we went over a reimbursement structure that included an expense stop. Sometimes expense stops use a specific amount such as a dollar per square foot figure. Other times expense stops will use a base year amount and are often called a base year stop.
The base year stop works the same way as our expense stop examples above, with one key difference. The difference between an expense stop and a base year stop is that a base year stop simply uses the expense amount in the base year of the lease. For example, if the expenses during the base year of the lease were $100,000 and our entire building was 10,000 square feet, then our base year expense amount would simply be $100,000 or $10/SF. In all subsequent years, the tenant would be responsible for paying its share of expenses above this base year amount.
How is the base year defined? This depends, and the only way to know for sure is to read the lease. However, the base year typically follows the calendar year in which the lease begins. For example, if a lease begins in June 2020, then the base year would be the 2020 calendar year between January 1st 2020 and December 31st 2020.
Sometimes the base year is defined as the actual first year of the tenants lease. In this case it would be June 1st 2020 – May 31st 2021. However, with multi-tenant buildings this becomes cumbersome to track and therefore landlords often just use a calendar base year.
Modified Gross Lease vs Triple Net (NNN) Lease
A triple net lease is a lease structure where the tenant is responsible for paying all operating expenses associated with a property. Triple net leases are common with large single tenant properties such as national restaurant chains and are popular because they offer a turn-key investment.
As we’ve seen throughout this article, the modified gross lease is a lease structure where the landlord and the tenant both share the cost of operating expenses. The modified gross lease tends to be much more complicated than a triple net lease. This is largely because the reimbursement structures under a modified gross lease can vary so widely and can be cumbersome to figure out.
Modified Gross Lease vs Gross Lease or Full Service Lease
The full service or gross lease is a lease structure where the landlord pays for all operating expenses for the property. Gross leases tend to be the simplest lease structure for the tenant to understand because the tenant is not responsible for any operating expenses.
This is in contrast to a modified gross lease which is when the tenant and the landlord both share in the responsibility for paying the property’s operating expenses. As seen above, the reimbursement structures that define how and when the tenant reimburses the landlord can get complicated fast and become difficult to understand.
Whether or not a commercial real estate lease is a gross lease or a modified gross lease will largely depend on market conditions. Of course, the only way to understand what type of lease you have, and more importantly who pays for what (and when), is to read the actual lease agreement.
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In this article we discussed the modified gross lease. We defined the modified gross lease, compared it to all other commercial real estate lease types, and then walked through several reimbursement structures examples that could be used under a modified gross lease. Finally, we compared and contrasted the modified gross lease to other popular lease types including the gross lease and triple net lease.